Economic Systems Analysis and Policies: Explaining Global Differences, Transitions and Developments

Economic Systems Analysis and Policies

Also by S. I. Cohen PRODUCTION, MANPOWER AND SOCIAL PLANNING AGRARIAN STRUCTURES AND AGRARIAN REFORM PATTERNS OF ECONOMIC RESTRUCTURING FOR EASTERN EUROPE HUMAN RESOURCE DEVELOPMENT AND UTILIZATION MICRO ECONOMIC POLICY SOCIAL ACCOUNTING FOR INDUSTRIAL AND TRANSITION ECONOMIES SOCIAL ACCOUNTING AND ECONOMIC MODELLING FOR DEVELOPING COUNTRIES SISTEMA DE PLANEACION DE RECURSOS HUMANOS (In Spanish) (co-authored) INTRODUCTION TO MODERN ECONOMICS, PARTS I & II (In Russian) (co-authored) THE MODELLING OF SOCIO-ECONOMIC PLANNING PROCESSES (co-edited) POPULATION, HEALTH AND NUTRITION (co-edited)

Economic Systems Analysis and Policies Explaining Global Differences, Transitions and Developments

S. I. Cohen Professor, Erasmus School of Economics, Erasmus University, Rotterdam

© S. I. Cohen 2009 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2009 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN-13: 978–0–230–22382–0 hardback ISBN-10: 0–230–22382–6 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Cohen, Solomon I., 1941– Economic systems analysis and policies : explaining global differences, transitions and developments / Solomon I. Cohen. p. cm. Includes bibliographical references and index. ISBN 978–0–230–22382–0 1. Economics. 2. Economic development. 3. Economic policy. I. Title. HB171.C685 2009 330.1—dc22 10 9 8 7 6 5 4 3 2 1 18 17 16 15 14 13 12 11 10 09 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

2008053797

To the memory of two teachers and colleagues Henk Bos and Jan Tinbergen

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Contents List of Illustrations

xii

List of Abbreviations

xix

Preface

xxi

1 Analytical Framework for Understanding Economic Systems 1.1 The study of economic systems 1.2 Behavioural types and behavioural settings 1.3 Distinct behavioural types determining different economic systems 1.4 Positioning countries along behaviourally different economic systems 1.5 Outline of the book 1.6 Summary and conclusions 2 Elaborations on the Analytical Framework and Its Application 2.1 Introduction 2.2 Micro and macro interactive processes in economic systems 2.3 A conceptual model of economic behavioural settings featuring the building blocks 2.4 Evolution of differing behavioural types into different economic systems 2.5 A conceptual model of the emergence and prevalence of behaviourally different economic systems 2.6 The structure, conduct, and economic performance of different economic systems 2.7 Dominance and diversification tendencies across countries and systems: Some applications 2.8 Summary and conclusions 3

The Firm Intensive System: Economic Challenges and Agent Responses in US, EU, Japan 3.1 Economic principles of a pure firm intensive economic system 3.2 Indivisibilities: Problems and firm-state responses 3.2.1 Problems 3.2.2 Natural monopoly and imperfect competition 3.2.3 Technology bias and growth limits 3.3 Uncertainties: Problems and firm-state responses 3.3.1 Problems 3.3.2 Incomplete information 3.3.3 Asymmetric information vii

1 1 3 6 12 16 19 21 21 21 28 30 33 37 46 52 54 54 60 60 61 72 74 74 75 75

viii

4

5

Contents

3.4 Externalities: Problems and firm-state responses 3.4.1 Problems 3.4.2 Positive externalities 3.4.3 Negative externalities 3.5 Collectivities: Problems and firm-state responses 3.5.1 Problems 3.5.2 Responses 3.6 Income distribution: Problems and firm-state responses 3.6.1 Problems 3.6.2 Responses 3.7 Summary and conclusions

81 81 84 88 93 93 94 95 95 100 105

The Firm Intensive System: Polity Functioning and National Accommodations in US, EU, Japan 4.1 Introduction 4.2 The political process as a political market 4.2.1 Overview 4.2.2 Voters 4.2.3 Political parties 4.2.4 Governing politicians 4.2.5 State bureaucrats 4.2.6 Public sector employees 4.2.7 Interest groups 4.2.8 Checks and balances: Country tendencies 4.3 Public regulation and national welfare 4.4 Public spending and national welfare 4.5 National accommodations to differing polities 4.6 Summary and conclusions

107 107 109 109 112 113 114 115 121 123 127 129 130 137 142

The State Intensive System: Past Polity of the Soviet Union and Allied Countries 5.1 Introduction 5.2 The state’s ideology 5.3 The state’s party 5.4 State ownership of property 5.5 The central planning system 5.6 Pursued allocation policies 5.7 The failing past performance 5.8 Causes of system rise and failure 5.9 Summary and conclusions

144 144 145 146 147 148 155 157 161 165

6 The State Intensive System: Economic Transitions 6.1 Alternative paths 6.2 Magnitudes, causes, and effects of the recession in transition countries 6.3 Overview of reforms and their phasing in transition countries

167 167 169 177

Contents ix

6.4 Short transition 6.4.1 Stabilization reforms 6.4.2 Liberalization reforms 6.5 Long transition 6.5.1 Competitive entrepreneurships 6.5.2 Market confidence 6.5.3 Internalizing externalities 6.5.4 Public goods provisions 6.5.5 Public income transfers 6.5.6 Size of the public sector in transition countries 6.6 Systemic inclinations of transition economies 6.7 Summary and conclusions

180 180 182 186 186 194 209 215 217 219 221 223

7 Economic Systems in the Developing World: Regional Differences 7.1 Introduction 7.2 Impacting development epochs 7.2.1 Political and economic epochs 7.2.2 Colonial rule 7.2.3 Nation building 7.2.4 Democratic reforms 7.2.5 Household-led demographic transition 7.2.6 State-led economic development 7.2.7 Firm-led global integration 7.3 Comparative development performance 7.4 Dualism in the economic system: Modern/traditional, rich/poor, in large/small developing countries 7.5 Macroeconomics of dualistic development 7.6 Microeconomics of dualistic development 7.7 Summary and conclusions

225 225 226 226 228 230 233 234 236 244 247

8 Economic Systems in the Developing World: Country Profiles 8.1 Introduction 8.2 East Asia Pacific (EAP) 8.2.1 Regional profile 8.2.2 Systemic change in China 8.3 South Asia (SA) 8.3.1 Regional profile 8.3.2 Systemic change in India 8.4 Middle East and North Africa (MENA) 8.4.1 Background 8.4.2 System development 8.4.3 System performance 8.5 Arab Gulf (GCC) 8.5.1 Background 8.5.2 System development 8.5.3 System performance

273 273 275 275 280 300 300 304 322 322 324 325 326 326 327 329

251 259 262 271

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Contents

8.6

9

10

Sub Saharan Africa (SSA) 8.6.1 Background 8.6.2 System development 8.6.3 System performance 8.7 Latin America and Caribbean (LAC) 8.7.1 Background 8.7.2 System development 8.7.3 System performance 8.8 Summary and conclusions

330 330 332 335 336 336 338 339 340

Comparative Performance of Countries Relating to Different Economic Systems: A Social Accounting Approach 9.1 Introduction 9.2 Frameworks for analysing economic system performance 9.3 SAM applications to countries of Western and Eastern Europe 9.3.1 Introduction 9.3.2 The construction of comparative SAMs 9.3.3 Structural differences in the six SAMs 9.3.4 The comparative analysis of multiplier properties 9.3.5 Size and distribution of multipliers of sectoral injections 9.3.6 Size and distribution of multipliers of household transfers 9.4 SAM applications to Russia and China 9.4.1 Differences 9.4.2 The SAMs of Russia and China 9.4.3 Deriving SAM multipliers for Russia and China 9.4.4 Growth multipliers in Russia and China 9.4.5 Distribution impacts in Russia and China 9.5 Refuted limitations 9.6 Summary and conclusions

342 342 343 347 347 348 352 357 360 365 368 368 370 370 371 375 377 378

Long-Range Convergence and Displacements in Economic Development and Interactions between Economic Systems 10.1 Introduction 10.2 The convergence hypothesis: Supply side theory and evidence 10.3 The convergence hypothesis: Demand side theory and evidence 10.4 Empirical results 10.5 Demonstration 10.6 More convergence through transfer mechanisms 10.7 The displacement hypothesis: Future outlook for China and India 10.8 The displacement hypothesis: Implications for system competition and the relative dominance of alternative economic systems 10.9 Summary and concluding remarks

379 379 380 381 386 389 391 392

396 400

Contents xi

Appendices

402

Notes

406

References

424

Author Index

433

Subject Index

436

List of Illustrations Tables 2.1 2.2 2.3 2.4 3.1 3.2 4.1 4.2 4.3 5.1 5.2 5.3 5.4

Building blocks of the analytical framework Importance of household settings: Percentage of responses to varying ranks of importance of the family in one person’s life Importance of firm and state settings: Pro-firm and pro-state attitudes Indexes of Firms Competitiveness and State Appropriation (Rule of Law) for FIM and SIM related countries, respectively Problem areas leading to market failure, and the subsequent responses of firm and state A game theoretic presentation of the problem of collectivities Political power and political institutions in firm intensive systems: Country tendencies FIM related countries: Fiscal shares in the GDP, 1960–2000 FIM related countries: Public share and economic growth, various periods SIM planning: Demonstrative scheme of material balance for a major commodity, i.e. coal in 000s tonnes Average annual growth of GDP and GDP per capita in the SIM and FIM country groups Annual growth rates of output, inputs, and factor productivity for the SIM and FIM country groups Equity indictors for selected SIM and FIM countries

Required changes in agent behaviour accompanying transition from SIM to FIM 6.2 GDP performance in transition countries 6.3 Socio-economic performance in transition countries 6.4 Economic elements of system transformation 6.5 Transition sequencing 6.6 Proposed discussion in terms of short and long transition phases 6.7 Stabilization programmes and inflation performance in transition countries 6.8 Extent and pace of liberalization in transition countries 6.9 Privatization methods for medium and large state enterprises in six transition economies, by number and by value, per cent 6.10 Extent of privatization in transition countries as indicated by private sector share in GDP

23 47 50 52 59 94 128 131 135 149 158 159 160

6.1

xii

168 170 175 178 178 179 181 184 189 190

List of Illustrations xiii

6.11 Administrative corruption in transition countries: Share of time tax, share of firms paying bribes, and average bribe tax rate, 1999 and 2002, per cent 6.12 Capture corruption in transition countries: Share of firms affected by capture and share of captor firms, both regarding capture of laws and regulation, 1999 and 2002, per cent 6.13 Transition countries: Performance in extending global links, per cent 6.14 Transition countries: Performance relating to share of public spending in the GDP, per cent 6.15 Needs for and realization of public income transfers in transition countries 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 7.15 7.16

7.17 7.18

7.19

Historical epochs and their effects on major settings in the development process War casualties in the developing countries Political regimes in the developing regions Developing regions: Population and urbanization trends Developing regions: Changing concentrations of agents and GDP Developing regions: Indicators of the relative dominance of agriculture/household settings versus industry/firm settings, 2000 Developing regions: Indicators of state influence, 2000 Foreign trade patterns: Shares of manufactured exports by developing region, 1970–2000 Foreign financial flows to developing countries, 1970–2000 Foreign financial flows: Shares of flow types by developing region, 1970–2000 Developing regions: GDP growth and GDP per capita growth, 1960–2005 Developing regions: Economic growth accounting Developing regions: GDP per capita in US$ and in ppp $, 2000 Developing regions: Poverty headcount at $1 a day ppp as per cent of total population, 1981–2004 Developing regions: Indicators of income distribution, 1980–2005 Developing regions: Indicators on distribution of the population by rural/urban, and the urban labour force by formal/informal/ unemployed status; and indicators of income distribution Summary of cross-section between informal/formal and poor/rich in a large developing country The impact of formal and informal sector injections and of transfers on output and the incomes of poorer and richer household groups. Demonstration of results for Indonesia The impact of formal and informal sector injections and of transfers on output and the incomes of poorer and richer household groups. Demonstration of results for Pakistan

200

203 214 217 220

227 233 234 236 241 242 243 244 245 246 247 248 249 249 250

253 255

260

261

xiv List of Illustrations

7.20 Indonesia: Average values of assets and profits in thousand rupiah, and profit rates 7.21 Pakistan: Average values of assets and profits in thousand rupees, and profit rates 7.22 Indonesia and Pakistan: Share of difficulties reported by surveyed establishments, grouped by informal and formal market segments; per cent 8.1 8.2

8.3 8.4 8.5 8.6 8.7 8.8

8.9 8.10 8.11 8.12 8.13 8.14 8.15 8.16 8.17 8.18

8.19

Population and GDP of EAP: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Economic structure and conduct in China and EAP: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Comparative performances of the economies of China and the EAP, 1981–2005 China: Planned versus market components of agricultural procurements and retail sales China: Convergence towards market prices: Rice and wheat China: Distribution of output and employment by state and non-state ownership of industrial enterprises, per cent China: Profit/capital ratios for different types of industrial enterprises, per cent China: Distribution of the number of industrial enterprises above designated size and their gross output value, grouped by status of registration, per cent China: Foreign trade, foreign capital inflow, and foreign exchange reserves, US$100 million China: Economic cooperation with Rest of World US$ 100 million China: Trading Summary for Stocks, shares in 100 million shares, values in 100 million yuan China: Shares of total government revenue and expenditure in the GDP, and their allocation between central and local levels China: Composition of total government budget by revenue sources and expenditure functions China: Average annual growth rates of real gross industrial output and real GDP: Official and physical output based estimates China: Decomposition of sources of economic growth China: Economic growth and Gini index Population and GDP of SA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Economic structure and conduct in India and SA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Comparative performance of the economies of India and SA, 1981–2005

266 268

270 277

278 280 284 284 286 287

288 290 291 292 293 294 295 295 298 301

302 303

List of Illustrations xv

8.20 India: Socio-economic structure under Moghul Empire and British Rule 8.21 India: Shares of the value added of industry and services in the GDP, per cent 8.22 Comparative sources of GDP growth in industry and services, China and India 8.23 India: Foreign trade and its composition, per cent 8.24 Comparative export growth in merchandise and services, China and India 8.25 India: Fiscal features of public revenue and expenditure. Central government and all union 8.26 India: Decomposition of sources of economic growth 8.27 India: Economic growth and Gini index 8.28 India: Distribution of GDP and labour on various population segments, 2000, per cent 8.29 Population and GDP of MENA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.30 Economic structure and conduct in MENA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent. 8.31 Comparative performance of the economies of MENA, 1981–2005 8.32 Population and GDP of GCC: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.33 Economic structure and conduct in GCC: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent 8.34 Comparative performance of the economies of GCC, 1981–2005 8.35 Population and GDP of SSA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.36 Economic structure and conduct in SSA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent 8.37 Comparative performances of the economies of SSA, 1981–2005 8.38 Population and GDP of LAC: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 8.39 Economic structure and conduct in LAC: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent 8.40 Comparative performance of the economies of LAC, 1981–2005 9.1 9.2 9.3 9.4 9.5

Entries in the aggregate SAM SAM for Germany SAM for Poland SAM structure for Germany SAM structure for Poland

308 315 315 316 316 317 318 318 319 323

324 326 327

329 330 332

334 335 338

339 340 349 351 351 352 352

xvi List of Illustrations

9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14

9.15 9.16 9.17 9.18 9.19 9.20 9.21 9.22 9.23 9.24 10.1 10.2 10.3 10.4

East and West Europe: Selected variables expressed as percentages of the matrix total East and West Europe: Components of the GDP from the expenditure side East and West Europe: Returns to labour and capital that go to households as a percentage of matrix total East and West Europe: Government incomings, total and by source, expressed as percentage of matrix total East and West Europe: Distribution of expenditure by want category and income by decile group, per cent East and West Europe: Sectoral shares in the total output and total value added, per cent SAM in the form of Ay  x  y Selected multipliers for further analysis East and West Europe: Income and output multipliers resulting from injections in alternative activities, exogenous shares, and other indicators East and West Europe: RDM analysis for activities resulting from an overall injection in activities East and West Europe: RDM analysis-s for households resulting from an overall injection in activities East and West Europe: Income and output multipliers resulting from transfers to different household groups East and West Europe: RDM analysis of households and activities resulting from an overall transfer to households China and Russia: GDP and Indices of GDP Output of major goods in China and Russia SAM multipliers for Russia 1991 SAM multipliers for China 1989 RDM analysis for Russia 1991 RDM analysis for China 1989

SAM features and GNP per capita of 16 countries Regression results of equations (4) and (5) Selected simulations: Initial runs for rich and poor countries Selected simulations: Alternative runs assuming different income levels 10.5 Future outlook: Country shares in the world population, and the world GDP 10.6 Future outlook: Country Index of Interactive Influenc

353 354 355 355 356 357 359 359

360 362 365 366 367 369 369 372 372 373 376 387 388 390 390 393 396

List of Illustrations xvii

Figures 1.1 Interactions of micro settings and the macro frame 7 1.2 (a,b,c) Configurations of three socio-economic systems: HIM, FIM, SIM 9 1.2 d Configuration of a multi-poles socio-economic system: MPM 11 1.3 Positioning of economies along axis of dominant systemic interactions 14 2.1 Importance of household settings: Country ranking of importance of family 48 2.2 Importance of firm and state settings: Pro-firm and pro-state attitudes 51 3.1 Firm decisions on use of factors 56 3.2 Firm decisions on production of goods 56 3.3 Deadweight loss from restricted output 67 3.4 Deadweight loss from managerial slack 67 3.5 Scheme for tracing the conditions under which a side effect can be identified as an externality and justify a policy measure 83 3.6 Deadweight loss from positive externalities 84 3.7 Deadweight loss from negative externalities 89 3.8 Lorenz curve and Gini index 96 3.9 The untouched normal distribution of abilities 98 3.10 The real world distribution of income 98 4.1 Upward budgetary bias I 117 4.2 Upward budgetary bias II 118 4.3 Upward budgetary bias III 119 4.4 Uniform taxation 126 4.5 Progressive taxation 126 4.6 Negative relationship between public share and GDP growth in FIM countries 135 4.7 Positioning of FIM countries 137 6.1 Transition countries: Time profile of GDP decline and recovery by country group 172 6.2 Transition countries: Relationship between percentage change in GDP 1989–2005 (y-axis), and change in the Gini index 1989–2005 (x-axis) 177 6.3 Transition countries: Average annual inflation rates and the loss and gain in real GDP 182 6.4 Transition countries: Extent of liberalizations as measured alternatively by World Bank Index of Liberalization (WBIL) and Heritage Index of Economic Freedom (HIEF) 185 6.5 Transition countries: Liberalization and cumulative GDP 185 6.6 Systemic inclinations of transition countries 222 7.1 Profit rates, profit values, and asset values of SSI in million rupiah, Indonesia 266

xviii

List of Illustrations

7.2

Profit rates, profit values, and asset values of SSI, in thousand rupees, Pakistan 8.1 Positioning of the world developing regions along axis of dominant systemic interactions 8.2 China: Annual living expenditure per capita in RMB: Rural overall, Urban overall, Urban Beijing, Urban Henan, 1997–2006 8.3 India: Index of GDP/labour for various segments of the population, 2000 (Value of index for Total India = 1.0) 9.1 The analytical framework for comparing performances 9.2 Circular flow 10.1 Relationship between the exogenous share in national income X/Y and income per capita Y/N 10.2 Relationship between multipliers m and exogenous share in national income X/Y

268 274 298 320 344 348 383 385

Boxes 3.1

Changing patterns of nationalization and privatization in FIM countries: 1980–2005 65 3.2 Firm intensity and open competition in FIM countries, 1995, 2000, 2005 71 3.3 Business and state resources in Research & Development in FIM countries, 1970–1980, 1990–2000 73 3.4 Corporate governance patterns in FIM countries, around 2000–2004 80 3.5 Response to liberalization initiatives of the World Trade Organization in FIM countries 88 3.6 Responses of FIM countries to the Kyoto Protocol 92 3.7 Recent trends in income inequality and poverty incidence in FIM countries 102 3.8 State spending on income transfers for the working age population in FIM countries 103 3.9 Social security spending and projected composition of the population in FIM countries 104 6.1 Privatization rush in transition countries 193 6.2 Undervaluation of assets in transition countries: The case of Russian companies 194 6.3 Transition countries: Consensus on subjective perceptions and objective indicators on the imposition of the rule of law.: Differences between country groups 207 6.4 Transition countries: Poll of polls corruption perception index, CPI 208 7.1 An accounting framework for informality and inequality in developing countries 257 10.1 The comeback of China and India 395

List of Abbreviations BCEE BEEPS BRIC CPI DRC DTM EAP ECB EMIS EXSR FIG FIM FMT FDI GATT GCC GDP HIEF HIM ICT III IMF KP LAC MENA MMC MPM NAFTA ODA OECD PHS RDM RPC ROW SA SAM SAP SARC SIM SOE

Baltic, Central and Eastern Europe WB/EBRD Environment and Enterprise Performance Survey Brazil, Russia, India and China Corruption Perception Index Real Domestic Resource Cost Demographic Transition Model East Asia and Pacific European Central Bank Emerging Market Information Service at http://www.securities.com/ Ex-Soviet Republics, except Baltic and Russia Financial-Industrial Group Firm Intensive System, also referred to as F-system Foreign Merchandise Trade Foreign Direct Investment General Agreement on Tariffs and Trade Arab Gulf (Gulf Cooperation Council) Gross Domestic Product Heritage Index of Economic Freedom Household Intensive System, also referred to as H-system Information Communication Technologies Index of Interactive Influence International Monetary Fund Kyoto Protocol Latin America and Caribbean Middle East and North Africa Monopolies and Merger Commission Multiple Pole System North American Free Trade Agreement Official Development Assistance Organization for Economic Cooperation and Development Poverty Headcounts Share in the population Relative Distributive Measure in SAM context Restrictive Practices Court Rest of World South Asia Social Accounting Matrix Structural Adjustment Package South Asian Regional Council State Intensive System, also referred to as S-system State Owned and state-holding Enterprises xix

xx

List of Abbreviations

SSA TVE VAT WB WBIL WTO WVS

Sub Saharan Africa Rural Township and Village Enterprises Value Added Tax World Bank World Bank Index of Liberalization World Trade Organization World Value Surveys

Preface Research, teaching, and advisory work in the two areas of economic systems and development economics have gone through similar ups and downs in the past three to four decades. In the 1960s and 1970s, both areas attracted the positive attention of many scholars, students, and advisors. The 1980s and 1990s witnessed the empirical documentation of disappointments with the socio-economic performance of centrally planned economies and many developing countries, which are the main clients and subject matters of the two areas, respectively. Justified or unjustified, interest in both areas waned in the 1980s and 1990s, and much of the past academic work on economic systems and economic development was criticized on grounds of being remote from what happens in the real world, inability to foresee the disappointing socio-economic performances, and incompetence in advice on policy matters and reforms. The period of the downturn has been followed recently by a period of upturn in the twenty-first century. Interest in both areas has again flourished due to, on the one hand, the general success of many transition economies in reforming and redirecting their economic systems towards a more market–state mixed profile despite their past regime failures, and on the other hand, the reappearance of past state-wise rent seeking interests in some major transition countries. Furthermore, the success of some leading and big developing economies like China and India in likely overtaking rich countries in terms of the size of the GDP, industry, trade, and foreign exchange reserves, and the fall back of some other developing regions far behind, have contributed to the upturn in enthusiasm for the sub-disciplines. Moreover, the unexpected global financial meltdown of 2008, which is hurting free market economies more than others and is accompanied by calls for collective actions to stabilize the economic systems, are very likely to further enhance academic and policy interests in economic systems and economic development. The downturn and the upturn caused profound changes in topics and methods pursued by economists dealing with economic systems and economic development. The two areas have become closer to each other than ever before regarding topics and methods, without tarnishing basic differences between transition economies and developing countries. There is now more insight into, and appreciation of the subtleties of these two sets of countries, and how they differ and develop differently from the economic systems of the richer and predominantly Western countries. It is now again generally appreciated that because of the intrinsic differences in their functioning and future development, economic work on countries manifesting different economic systems need to be framed in distinctive ways. This book is a meeting point between economic systems and development economics. The scope is the worldwide economic dynamics of national economies that manifests itself in distinct economic systems. The book is directed to scholars xxi

xxii Preface

and readers, teachers and students, policy advisors and policy recipients, working on economic systems and development economics. If each book should state its focal point in one or two sentences, then ours will be the following. The future prospects are not those of a universalistic set of economic behaviours that countries would adopt worldwide some time in the future; instead, our contention is that there are behavioural differentiations of a higher order that separate the interacting agents from integrating and converging towards any one economic system. The behavioural differentiations emanate from different sociological, political, and economic behavioural orientations that characterize major settings (such as household, state and firms settings, respectively), and in which agents interact, and lead ultimately to distinguishable dominant behavioural types. I sketched in 1978, a model wherein the social and political domains dominated the economic domain and then applied the idea to study the prospects of land reform in India and Chile, in Cohen (1978). The idea of distinguishable dominant behavioural types in different systems/countries was bound to gain strength over time as it became increasingly supported by theoretical foundations and empirical evidence from various distanced sources. In time, and bolstered with this support from theory and empirics, it was possible to elaborate a theoretically founded analytical framework for explaining distinguishable dominant behaviours in economic systems, and demonstrating its validity and applicability to wider issues including the study of emerging systemic problems and subsequent policy responses, as is being done in this book. The theoretical foundations came with the development of convention theory, starting with David Lewis (1969), who provided the seminal work on common knowledge, and laid the foundations for formal approaches to the study of social conventions and social norms. The formal approaches which at one time consisted of game theory, soon extended to include folk theory, information cascades, evolutionary learning and social network formation, and allowed for the coexistence of multiple behavioural equilibria; thanks to works by Thomas Schelling (1978), Robert Frank (1988), Herbert Simon (1993), and many others. In all these works, typical behavioural patterns that make-up the system anatomies can be described as social conventions in the sense that they result somehow from the interdependency of individual actions subjected to some given initial conditions. While conventions change they tend to follow the down-laid paths of past events and responses, thus resulting in differentiated and sticky systems of joint social, political and economic behaviour. The empirical backing of the persistence of behavioural types and institutional set-ups that associate with such behavioural types in separated societies, whereby intentionally or unintentionally, the institutional set-ups are inclined to benefit specific groups of agents and disfavour others, is the second line of inspiration of the book. Some modern contributors who fit here and who have analysed different economic systems can be quoted as examples: Janos Kornai (1967), Gunnar Myrdal (1968), John Galbriath (1983), Douglas North (2006), and many others.

Preface

xxiii

The book starts with laying in the first two chapters the theoretical foundations for understanding different dominant behaviours in economic systems. The concept of dominant behavioural settings is crucial. I distinguish between household, state, and firm settings that are driven by social, political, and economic motivations, respectively. One motivation tends to dominate over the other motivations, and thus determine the shapes of conduct, structure, and performance. Which motivation prospers where depends on the initial situation, the external environment, and historical events. I introduce a fourth type of setting, calling it persuasive settings, which can play a crucial role in coordinating less integrated multipole social systems. Interactive behaviour of agents in all four types of settings shapes the development path of the economic system. After a motivated classification of world regions to behaviourally dominated prototypes of economic systems, the book examines the real world country counterparts of the prototypes. We devote two chapters for each of the rich industrialized countries, the transition economies, and the world developing regions. The chapters focus on an analysis of conduct, structure, and performance, as well as related policy. Chapters 9 and 10 are devoted to a retrospective comparative analysis between countries belonging to the differing economic systems, and their intercourse in the context of system competition. The book benefited from interactions in lecture courses on the topics treated to undergraduate and master degree students at Erasmus University Rotterdam and courses and visiting lectures delivered abroad in various countries. The deliberations in these courses convinced me that the ten chapters of the book fit together in a coherent whole that meets four goals: describes world economic systems fairly well; gives theoretically founded explanations to global differences, transitions, and developments; provides convincing grounds for using the developed framework for further fruitful analyses; and highlights policy considerations towards higher growth and more equity. If the book succeeds in contributing to any of the four goals, then it would have achieved its objective. Indebtedness goes for the forerunners mentioned above, and to Henk Bos and Jan Tinbergen, who introduced me on systems and development, and not least, have paved the way for a sober and humble academic life. Indebtedness goes also to course participants, and colleagues and reviewers who read and commented on isolated parts of the book. I am also thankful for the generous support and editorial work provided by Palgrave Macmillan. The book has made extensive use of several databanks for which I am gratefully indebted. The majority of computations and tables in the book have relied on these databanks that are generally accessible via the websites that we refer to. The use of these sources are hereby acknowledged, and they are listed below in alphabetic order: Beck’s database of political institutions; Centre for Systemic Peace, University of Maryland for its database on war causalities; Economic and Social Research Centre for Islamic Countries for its SESRTCIC Statistical Database; European Bank for Reconstruction and Development for The Business Environment and Enterprise Performance Survey (BEEPS) and for reports of the Bureau of Economic Analysis (BEA); W. Heinsz’s dataset on political constraints;

xxiv Preface

Heritage Foundation for the Index of Economic Freedom; International Monetary Fund for Government Finance Statistics and International Financial Statistics; ISI Emerging markets for the EMIS databank; OECD for Geographical Distribution of Financial Flows to Aid Recipients, and OECD Historical Statistics; Transparency International for the Corruption Perceptions Index, CPI; Unicef-icde for Transmonee database; UN Population Division for its World Urbanization prospects; UN Public Administration Programme for data on the public sector; World Bank for the World Bank Development Indicators Database, development gateway, query, and other related data; World Values Survey Association for World Value Survey; and World Trade Organization for International Trade Statistics. The author acknowledges also with thanks the permitted use, granted by copyright holding publishers, of material from Cohen (2001), Gregory and Stuart (1999), Maddison (1971), and Cohen (2002b), in Chapters 2, 5, 8, and 9, respectively. Every effort has been made to trace rights holders, but if any have been inadvertently overlooked the publishers would be pleased to make the necessary arrangements at the first opportunity. A symbolic dedication of this book to the next generation of grand children is in place: to Sophie, Nelson, Yasmine, and Midas. Perhaps some of them some time in the future will pick up from where I have stopped. (Solomon) Suleiman Ibrahim Cohen

1 Analytical Framework for Understanding Economic Systems

1.1

The study of economic systems

Although there exists no unique, commonly accepted definition of an ‘economic system’, nor is there an objective way of delineating that part of the total social experience to be described and analysed under this topic, yet economists recognize the existence of different economic systems in their study of economic phenomena. At the national level different groups of countries, and specific countries, are seen to have different economic systems. Why are economists interested in economic systems in spite of the difficulties they face in delineating the boundaries of economic systems? The rationale for the analysis of economic systems and their comparison can be seen gathered from answering one general question: What effect does the choice of the socio-economic system have on the socio-economic welfare of the people living in that system, and those in other systems? There is much in economic theory and policy that is intended to provide macro- economic guidance to government and micro-economic guidance to firms, consumers, and other groups as they collectively or individually decide on the allocation of resources in the production of different goods and their allocation among various agents, and so on. The guidance targets high levels of economic welfare, albeit such outcomes are definable in various ways. Clearly, the particulars of the economic system are crucial factors influencing these decisions and their outcomes. Going beyond economic welfare, an economic system is essentially a means towards achieving some fundamental goals of society, such as freedom, egalitarianism, democracy, and ecological survival, next to satisfying material standards for the serving population. Although these goals cannot be valued objectively, the study of different socio-economic systems can throw light on the trade-offs between these goals. In addition to providing basic theoretical and applied foundations towards handling such as mentioned above, the study of comparative economic systems helps to acquaint agents in different economic systems and relating countries with and appreciate the understanding of economic systems of countries with which they live in and share one globe. A deeper understanding of one’s own system and other systems contributes to a peaceful and fostering whole, next to 1

2

Economic Systems Analysis and Policies

sharpening the scientific basis for the mastery of economic tools as more insights are gained into formulating institutional assumptions that come closest to world realities. Notwithstanding, the study of economic systems, in itself, has gone through ups and downs from its very start, which can be said to coincide with Adam Smith, and economics in general. The traditional approach to the study of economic systems established a collection of prototypes corresponding to the major ‘isms’ – capitalism, socialism, and communism. The initial commitment to this approach was the product of conflicting political and social ideologies, a conflict that dates to the late nineteenth century when the systems of capitalism and socialism were debated and contrasted primarily (but not exclusively) on the relative merits of their social, economic, and political implications. An important corollary of the emphasis on the ideological content of the economic system was the emphasis placed on property relations as the key element in distinguishing systems. This emphasis was rooted in the classical economics of Adam Smith, David Ricardo, and John Stuart Mill and was elevated to an ideological standpoint by Karl Marx. The traditional framework developed for the analysis of economic systems in the twentieth century reflected the ideological divide and the cold war between the two opponent regimes of capitalism and communism. This preoccupation with ideology has distracted attention from fundamental research into the phenomena and foundations of economic systems. The result is that once the choice between capitalism and communism was no more relevant by mid-1980, the subdiscipline of economic systems came to face identification crises in the past two decades. The literature on economic systems in the twentieth century was in general interested in the descriptive analysis of capitalism and communism, as by Gregory Grossman, Janos Kornai, Egon Neuberger, Frederic Pryor, and others, their comparative evaluation as by Friedrich von Hayek, compromise regimes as by Oscar Lange, and convergence and the optimal economic order as by Jan Tinbergen. Over the years, workable alternatives to capitalism have appeared, and prototypes have evolved in response to changing political and economic realities. Various thinkers have debated variations on the same basic themes: capitalism has been subdivided into ‘competitive’, ‘regulated’, and ‘welfare’ capitalism; socialism into ‘liberal’, ‘command’, and ‘market’ socialism. In contrast, little attention went to theorizing on the formation, evolution, and differentiation of economic systems, with the exception of several basic contributions by Morris Bornstein, Leonid Hurwicz, Tjalling Koopmans, and John Montias.1 The study of economic systems is currently undergoing basic changes. New issues that ask for clarification are emerging, but the traditional framework has not been helpful in addressing them. The traditional framework for the study of economic systems, based on an ideological debate on capitalism and communism, diverted attention away from fundamental questions relating to the microand macro-interactions in economic systems. The current situation for the study of economic systems can be practically described as that of a new start. There is

Understanding Economic Systems 3

recently a renewed interest in related issues partly stimulated by the recognition that next to convergence tendencies in some areas there are significant institutional diversifications among in the Organization for Economic Cooperation and Development (OECD) countries Jackson and Deeg (2006); that behavioural traits of the communist regime are re-emerging in ex-Soviet countries, Beck and Laeven (2006); and the quest for a healthy relationship between economic and political participation and progress in the developing world, Barro (1996). There are now various calls and attempts to theorize on these matters, as found in Acemoglu and Robinson (2005), and North, Wallis and Weingast (2006). The treatment of these issues is a distinct departure from the traditional framework and is genuinely new. The purpose of this chapter is to contribute to theories on the formation, evolution, and differentiation of economic systems. It shares with the last two references the purpose of developing a conceptual framework for understanding long-range changes in the economy and polity, but the unit of analysis, methods, findings, and implications differ in all three works. Our framework emphasizes the location and interaction of agents in distinct behavioural settings as the clue for understanding how agents, and the economic system they form, become aligned with a particular behavioural setting, take over the typical behavioural type that associates with that behavioural setting, and spread it to other settings via various channels. The main components of the approach pursued will be displayed, and then combined to distinguish between basically different economic systems. Country examples are added in support of the arguments. We focus on three distinct behavioural settings and behavioural types, namely those typical of the traditional household, the modern firm, and the state. We treat economic transformations within these settings, as well as inter-transactions, intercommunications, and inter-mobility of agents between these settings. We derive three distinct social regimes that associate with these settings, display the mechanisms involved, and classify countries along these regimes and their intersections. In separate sections we answer why and how different regimes evolve from different external environments and from different combinations of personal and collective needs; illustrate main arguments using a conceptual model; and recapitulate on the comparative performance of settings and regimes. We also elaborate in a separate section on the micro- and macro- interactive processes in economic systems in general. A final section describes the outline of the book.

1.2

Behavioural types and behavioural settings

We start from behavioural settings, following Fox (1984). A behavioural setting g is a physical site populated by interacting persons that became members of the setting by accident and/or choice. Behavioural settings relevant for economic analysis are those that generate for their participants added value from the transformation of some activities. Agents inhabiting such a behavioural setting engage in a value added transformation of goods and services, subject to institutional rules, information flows, and physical and technological transformation boundaries. Agents fulfil

4

Economic Systems Analysis and Policies

different roles within any setting. Some perform leader roles, the rest perform various subordinate roles. Furthermore, agents are endowed with, and acquire in the process, different attributes. A well functioning setting would allocate such roles to agents with attributes that fit most to those roles. The most common examples of behavioural settings of interest for economic analysis are household, firm, and state settings, to be denoted by g  {h, f, s}. The most common examples of household settings are a domicile, an extended family, or a kinship network; firm settings include firms, shops, and markets; while state settings include legislative chambers, government offices, public lockets, and state enterprises.2 Many more behavioural settings are not engaged in economic transformations. Some of these, that we call persuasive settings, have significant bearings for economic transformations, as will become clear later. We shall focus below on the three settings of the household, firm, and state. A distinct behavioural type characterizes each of the three behavioural settings. Transformation processes in the household, firm, and state settings are driven by intrinsically distinct behavioural motives that are typical of the given environment that circumscribes the setting. In terms of motivation, social sharing and reciprocal exchanges are the underlying motives in the traditional household settings. Profit maximization is the intrinsic motive in firm and market settings. Political returns and rent seeking are the intrinsic motives in state and related settings. In terms of coordination, the coordination mechanism in traditional household settings is typically sociologic in character, in state settings coordination is politic, and in firm settings coordination is economic. Sociologic behaviour is the basis for coordinating communal relationships in the social group. The motto of the homo sociologic here is from whom according to his ability and to whom according to his needs, resulting in social sharing and committed reciprocity. The coordination of firm settings is economic in character. The homo economic makes choices in production and exchanges such that material benefits minus costs are maximized. From whom according to his abilities and efforts and to whom in accordance with his relative abilities and efforts is the motto that is typical of firm settings. The coordination of state settings is politic in character. The homo politic brokers a settlement among insecure and/or differing parties in ways that guarantee security and resolve conflict peacefully, and with simultaneously building institutions that achieve maximum power and protective rent for the broker. The motto in state settings is best described as from whom according to maximum negotiable ability and to whom according to minimum negotiable needs. The three distinct behavioural motives can be modelled as is done in equations 1, 2, and 3, below.3 In the traditional household setting, the agents lump together their benefits and costs in an effort to make total benefits exceed total costs. In equation 1, V h stands for the value added in the household setting and it is when benefits B and costs Q of agents i and i’ are lumped together and somehow shared among all i. V h  Bi  Bi’  Qi  Qi’  0.

(1)

Understanding Economic Systems 5

The agents would thrive to distribute these benefits and costs between i and i’ in ways that contribute to a maximum value added or at least a positive result for the whole setting. The resulting income distribution among agents i and i’ can be affected by personal and relational circumstances. In the firm setting, equation 2, the value added in the firm is denoted by Vf. In the firm setting each agent i and i’ would like to realize the highest positive returns to oneself, and thereby allowing the firm to maximize its returns to capital beyond the rate of interest r at which it borrows capital. The returns to capital are defined as benefits less costs per unit of capital invested; the latter can be related to the total cost via a parameter π. Vf  S (BiQi) / pS Qi  r

(2)

The resulting income distribution among agents i and i’ is likely to show returns of one agent higher than the other. To model the state setting we attach to variables B, Q, V subscript s, as compared to the pre-state setting, subscript ps. We also employ k to represent agents with state authority. Equation 3 shows a higher value added in the state setting compared to the pre-state setting. This is due to a reorganized transformation with intervention of state agents k that results in S Bsi  S Bpsi and/or S Qsi  S Qsik  S Q psi. Part of S Qsi is a privately incurred cost and the other part is the collectively invested expenditure that allows for the higher value added transformation. Vps  S Bpsi  S Q psi  0, Vs  S Bsi  S Qsi  S Qsik  0

(3)

Agents in the state setting, k, acquire an authority to extract a remuneration from all other agents denoted by Qsik, such that the average remuneration for k is higher than the average level of net benefits left over for agents i. Distribution of incomes will manifest on the average a higher level for the authority agent k than for subordinate agents i. Given the above distinct behavioural patterns per distinct setting, the coordination mechanisms in the three settings are distinctly different. The coordination mechanism in households is typically sociologic in character, in firms coordination is economic, and in state settings coordination is political. Settings can relate to each other horizontally and vertically as organizations do. Proceeding to a higher level of organization, large numbers of comparable economic settings manifesting the same coordination mechanisms and organizational culture in resolving economic choices result in a macro frame that can be identified as a uniform economic system, denoted by m. Such a system is an integrated aggregation of a large number of similar settings. For example, an allhouseholds economic system is one in which each and all economic settings are of the household type. This is a hypothetical example, although primitive society and village communities in some developing countries resemble such cases. Other hypothetical examples are those of an all-firms economic system and an

6

Economic Systems Analysis and Policies

all-state economic system, even though some real world counterparts are not unthinkable. What are the characteristic features of each of the three behavioural settings? In particular, how do the external environments that embody these settings differ? And how do the three types of settings differ with respect to structure and conduct? The external environment is a basic determinant of behavioural settings and of the behavioural type that characterizes the setting. Different external environments generate typical coordination structures that coincide and fit with typical behavioural settings. Agent interactions in the context of the given environment reinforce the conditioning of the settings to adapt to a dominant coordination structure, mechanisms, and cultures, leading usually to a coherent and predictable socio-politico-economic structure that can be recognized as such. External environments typical of the traditional household settings h are characterized by a closed world, homogeneous population, severe scarcity of resources, and low levels of material well-being. This external environment promotes sharing behaviour and solidarity structures coinciding with and taking place in household settings. Agents in these settings are conditioned towards adopting institutions of familial altruism, brotherhood attitudes, income sharing, and reciprocal exchanges at the group level. External environment typical of firm settings f are characterized by high mobility, and an open world with many options. The f setting promotes profit maximization and commercial exchange structures taking place in firms and markets. These settings would influence connected settings to adopt institutions of profit maximization, property rights, fair competition, and open markets. External environments typical of state settings s are characterized by highly skewed human endowments, esteem, and rank among differentiated population groups. The s setting supports restricted mobility, surplus creation, and makes exploitation feasible. It promotes politicized behaviour and command structures coinciding with and taking place in state settings interactions. These settings would influence connected settings towards adopting institutions of rent seeking, asymmetric, and overlapping property rights, forced subjection, and authoritarian rules.

1.3 Distinct behavioural types determining different economic systems The three configurations of economic systems, corresponding fully with three types of behavioural settings, are hypothetical. They represent extreme prototypes, since anywhere in the real world all three types of economic settings coexist and interact together in the macro-frame of the economic system. In any country, one finds households, firms, and state settings co-existing in large numbers side to side. The same agents can be members of more than one setting simultaneously. Agents communicate with agents within their own settings and other settings. The interactions are given shape in Figure 1.1.

Understanding Economic Systems 7

Households

Firms

State

Figure 1.1

Interactions of micro settings and the macro frame

The squares, triangles, and circles refer to the three behavioural settings, each with its own members; the engagement lines linking them indicate transformation and mutual exchanges taking place among agents in or between the organizations, as well as communicated behaviours. Each engagement line can be interpreted as consisting of a large number of bits of exchanged transformations and communicated traits. Such an engagement line can be denoted by Eigi’g’. As these bits are not uniform in intensity in terms of time, effort, or effects, they can be normalized making use of some scale of the intensity of the engagement, N, in terms of time, effort or effect. The engagements weighted by intensities can be expressed by Sig (Eigi’g’. Nigi’g’). This term can be eventually divided by the sum of all engagements weighted by intensity in the whole economy to give a relative measure of the strength and dominance of the engagement lines. They can be drawn lightly or heavily to reflect relative strength, as shown in the figure. A setting generates outcomes that are distributed as rewards to its members. The distributed rewards in competing settings are crucial for an evaluation that participating agents regularly do, and which guides them in their decision to continue in the setting, voice, or exit and enter a more rewarding setting.4 The propensity to move and participate in alternative settings satiates when the marginal utility of the agent of shifting a unit of effort between settings is equal to the marginal cost of the shift. The engagement lines can accordingly be given an additional meaning: they contain agent mobility and express directions of reallocation of agents between alternative settings. Processes of exchanged transformations, communicated traits, and agent reallocations, if not obstructed by separation barriers, would lead over lengthy periods to greater concentrations of agents in related behavioural settings g than others g’, opening the way for the spread and dominance of the behavioural type G that coincides with behavioural setting g. Once a threshold is reached with regard to accepting a specific behavioural type G, this G can be expected to gain momentum in view of network externalities, and will spread further and subordinate other G’. The adoption and spread of a particular behavioural type among more agents has been studied in many contexts, and there are well-known related mechanisms in the literature.5

8

Economic Systems Analysis and Policies

A conglomeration of interacting behavioural settings having a common dominant core is very likely to evolve into, and be identifiable as, a social system. The structure, conduct, and outcomes of the social system will tend to be relatively homogeneous and reasonably predictable. Each social system has its own integral economic aspects that describe together its economic system. Similarly, each social system has its own integral polity. It is logical to expect high degrees of consistency and correlation between the economy and polity of a specific social system.6 To recapitulate, agents adopt the behaviour of the setting that they inhabit most and in which they interact most, and spread it to other settings they communicate with, or partially inhabit.7 Several points relating to the above can be emphasized. (a) Coordination mechanisms in each of the three settings are distinct and different from each other, and stand for different prototypes of behaviour. (b) All three types of settings do coexist in large numbers side to side in any country; and agents may thus interact within and between all three settings. (c) Economic exchanges between the many settings, and presence of agents in more than one setting, are crucial factors in fostering communication, integration, and convergence among the settings. (d) In any one country and over many years, complex interactions take place between people cross-inhabiting and cross-dealing with settings; these result into integrative processes that have usually ended up in a domination of one of the three coordination mechanisms (or behavioural prototypes) over the others. (e) The complex interactions involve the external environment, initial cross-concentration of agents in settings, intensity of interactions, and mobility of agents in and between settings. (f) Notwithstanding, there are thresholds conditions under which domination of one coordination mechanism over the others cannot be realized, resulting into loosely linked economic systems. Sharing common external environments among related behavioural settings, communication in and between settings, mobility among settings, and network externalities, tend to end up in a social system, with an integral economic system allied to it that would manifest one dominant behavioural type G over others G’. The general tendencies of convergence towards a dominant behavioural type have, in principle, as outcomes three distinct economic systems. The first type, and the oldest, is the economic system that circles around traditional households and in which all settings have adapted to the traditional household behavioural traits. This can be called the household intensive system, HIM, as in Figure 1.2a. In the real world, many rural regions within developing countries would qualify as HIM. At the country level, there are limited examples that fully operate along the lines of HIM. The second type, depicted in Figure 1.2b, is the economic system where agents adopt a firm-like behavioural type, i.e. maximization of material returns at least material cost. The firm intensive system, FIM, has many copies in the real world; the best example is US. The third type, depicted in Figure 1.2c, is the economic system where agents have adapted to a state-like behavioural type that is guided by rent appropriation and political returns. In the real world, there are a good number of countries that operate along the state intensive system, SIM, one example is Russia.

Understanding Economic Systems 9

(a) Households

Firms

State

(b) Households

Firms

State

(c) Households

Firms

State

Figure 1.2 (a,b,c)

Configurations of three socio-economic systems: HIM, FIM, SIM

In general, the ability to predict the structure and conduct of the economic system of a specific country depend on how uniform and integrated is the economic system in that country. For example, the modelling and analysis of the structure and conduct of the FIM along the lines of profit maximizing behaviour in

10 Economic Systems Analysis and Policies

a country like US; and similarly for the SIM along the lines of rent appropriating behaviour in a country like Russia, should be seen as workable approximations made possible by over majorities of agents behaving along these distinguished lines under the two systems in the two countries, respectively. Prediction is more difficult for loosely linked and less integrated systems that are characteristic of many developing countries. Specific conditions can exist that may delay convergence towards one dominant behavioural type. There can be barriers that separate specific groups of agents from interacting together intensively, and as a result the specific groups remain genuinely separated and convergence is substantially delayed or even not realized. Such barriers that separate agent groups can be based on significant differences in the religion, ethnic origin, or socio-economic status and living styles of the groups. A very skewed distribution of income and endowments tends to strengthen the perpetuation of upper and lower socio-economic strata in the population, create separation barriers, and hinder agent interaction and behavioural convergence. This phenomenon shows up in the context of some Latin American countries where there are significant differences in earnings and endowments by birth and origin, and high degrees of socio-economic stratification.8 In principle, convergence would occur once the separation barriers are relaxed. A more fundamental case in which convergence towards one dominant behaviour may not occur is where the absorption of agents from household into firm or state settings faces boundaries because of the sheer large numbers of agents to be absorbed, as, for example, in China or India. These countries have vast rural populations that are attached to household settings, and at the same time significant urban populations manifesting subcultures relating to firms and state. The distribution of agents on these settings has been historically stable, and given the magnitudes of agents involved the distribution may not change much in the future.9 The result is a loosely linked multipoles system that can be denoted by MPM. It can be asked how is such a system kept intact. The answer is that especially in such a system, there is a host of institutional settings that link the multiple. These include political congresses, judiciary courts, religious, and intellectual and media circles. A suited name for these settings is persuasive settings. Persuasive settings play a crucial role in the streamlining of developments among these segments. Persuasive settings are exclusive settings. Participating agents are highly talented leaders who are able to place themselves as leaders in various contexts: household, firm, state, religious, intellectual, and judiciary settings, as well as spatially, in rural and urban areas. They are the so-called ‘wise men’, and they are able to obtain the support of leaders that lead different settings. They have the natural authority to affirm the status quo and anticipated changes. Persuasive settings are usually much higher up in the hierarchy of settings. Occasionally leading persons from different settings would sit down together and forge crucial deals and endorsements that commit their fellow members in their settings, simultaneously and mutually. Such deals and endorsements can

Understanding Economic Systems 11

be interpreted to contain value added transformations conceived as such by the leading persons representing their constituent settings and usually backed by their fellow members in the concerned settings. But persuasive settings do not constitute economic transformation settings in the conventional sense. However, they can be vital for rationalizing and endorsing multipolar behavioural patterns within the same borders, for binding loosely linked settings into one whole, and for the smooth operation of the economic system in a diversified country. To the extent that agent distribution among these segments in these countries will continue to keep a stable balance in the future it can be expected that persuasive settings will increase their leverage significantly in environments of such big countries as China and India.10 The introduction of behavioural settings suggests that there can be fourth configurations of economic systems as sketched in Figure 1.2d. This figure shows location of the population in two segments: rural and urban. Agents interacting in the rural segment do that in household settings with little interaction with firms and state settings. In situations where very large numbers of agents are rural, these village agents cannot be possibly absorbed into the urban segment for a long time to come, and hence it is unlikely that they would converge to either firm or state behavioural types typical of urban areas. The figure is a fair representation of big countries such as China, India, and some other Asian countries. Persuasive settings are introduced in the figure via stars. The dashed lines are indicative of the influence of persuasion settings on other settings. These influences are most effective when there are mutual feedbacks between the persuasive and the other settings.

Urban households

Firms

Urban/rural administration

Rural households

Figure 1.2d

Configuration of a multi-poles socio-economic system: MPM

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Economic Systems Analysis and Policies

1.4 Positioning countries along behaviourally different economic systems What makes a network of interactions comprehensible as a distinct system is the prevalence of common revealed preferences and typical coordination tracts, structures, and performances as can be observed in countries considered to have adapted to that system, as compared to other groups of countries with a different behavioural focus. How is the common formed? And how is the prevalence caused? We emphasize four factors, mentioned in passing in previous sections, and which are elaborated here and later: (a) Settings with relatively greater numbers of agents and greater economic transformations are likely to become more prevalent. Over time, agents observe the transformation outcomes in alternative settings, and move to the advantaged setting or copy its behaviour, thus resulting in the prospect that the typical behaviour of the advantaged setting becoming more prevalent; (b) Highly intensive and extensive interactions and outward communications of agents belonging to a particular setting and their participation in other and more settings allows the greater prevalence of this particular setting and its associated behavioural type; (c) Network externalities enforce further convergence towards the most prevalent setting and behavioural type. Finally, and of paramount importance; (d) sharing of common external environment and history fosters convergence towards a common behavioural type. Furthermore, there is the strong association between specific given environments, behavioural settings and behavioural types. When a behavioural setting g happens to stand higher than g’ in the hierarchy of settings, then g is also able to set rules that other settings g’ would follow. And in this way, the behavioural type associated with g’ is subjugated to that of g, allowing a further dominance of the behavioural type associated with g. Finally, if persuasive settings, being the highest, affirm the socio-economic order, then prevalence of stipulated behavioural type in the economic system is complete.11 To drive the point at the cost of some exaggeration, we maintain that in US the high concentration of agent interactions in firms pushes intrinsic motivations in the household and state settings aside and they are replaced over time by profit maximization typical of the firm settings. In contrast, the same processes oblige agents in household and firm settings in Russia to follow a politicized motive typical of state settings. As a result, all three settings in US behave in ways typical of firm settings, while in Russia they manifest behaviour typical of state settings. In the extreme, a comparison between the economic systems of US and Russia is a comparison of two contrasting behavioural types that involves the political, and the whole social, system. In US, the economic motive dominates, and the polity can be described to have adapted itself to the economic motive. Next to constitutional checks and balances, and an independent judiciary system, that keep state discourse in control, profit maximizing firms and agents have installed more institutions for controlling state conduct, and in some cases bending the polity to realize economic interests. In contrast, in Russia the polity can be seen as exogenous to the economy.12

Understanding Economic Systems 13

Apart from the two examples above, it is not always easy to identify individual nations in the real world with prototype economic systems that we developed for gaining analytical insight. However, economists manage successfully to group countries that share several properties together. There are international mechanisms relating to sharing trade, politics, events, history, culture, religion, ideology, and distance that tend to attach together some countries away from others. In discussions on economic systems, economists have traditionally grouped Western industrial countries together under the labels of capitalist and/or free market economies, and the former Soviet Union and allied countries under the labels of communist and/or centrally planned economies. The rest of the world was then named the third world and/or developing countries. Our classification of countries and regions along economic systems is in terms of HIM, FIM, and SIM, and we assign individual countries and regions to these systems based on a variety of country indicators relating to structures and conducts that correspond a priori with the specific features of these systems. In the following chapters, a large number of country indicators on the structure and conduct of their economies will be displayed in support of the classification. Our classification is also more refined than traditional classifications by allowing a diversification between countries within FIM and SIM, and a varied positioning of regional groups among developing countries. In applying the classification, it is thought that it is more functional and purposeful to proceed from some established regional divisions such as those followed by the World Bank, and which are generally followed by the profession, than to introduce new regional terms and specifications with which readers are not acquainted. We add refinements on the World Bank regional divisions, by adding one more region, introducing relevant and significant subdivisions within the regional divisions and where the need arises, reflecting on specific conditions for a few special case countries. The World Bank regional divisions take the industrialized countries by their country names; these are mostly OECD countries. Then there are the former ex-Soviet republics and allied countries; commonly called transition countries. Within the industrialized countries we make a distinction between United States of America (US), Western Europe (WE), and Japan. Similarly, within the transition countries we make a distinction between Russia, the Baltic, Central and Eastern Europe (BCEE), and all other ex-Soviet Republics (EXSR). World Bank regionalizes developing countries into five groups: East Asia and Pacific (EAP), South Asia (SA), Middle East and North Africa (MENA), Sub-Saharan Africa (SSA), and Latin America and Caribbean (LAC). We follow these regional divisions too, and we add a sixth region of countries of the Arab Gulf (GCC). This region consists of six oil-rich countries.13 As a result, MENA excludes these six oil-rich countries.14 We shall elaborate also on subdivisions within developing regions in due course.15 The outcome of our positioning of the above countries and country regions in the world at large along the four economic systems is displayed in Figure 1.3. As will be apparent from Chapters 3 and 4, the analysis and ranking of a large

14

Economic Systems Analysis and Policies

South Asia SA

East Asia Pacific EAP

Japan

HIM

US FIM

Latin America Caribbean LAC Sub Saharan Africa SSA

Western Europe WE

Middle East Nr. Af. MENA

Arab Gulf GCC SIM

Ex-Soviet republics EXSR

Figure 1.3

Russia

Baltic, Central, Eastern Europe CEEE

Positioning of economies along axis of dominant systemic interactions

number of empirical indicators relating to firm and state settings shows US to be most close to FIM,16 while Japan and West European countries, also identifiable as FIM, yet showing differing inclinations towards HIM and SIM, respectively. West European countries lie on the right of US and reflect a state control-inclined economy that is characteristic of SIM.17 In Figure 1.3, Japan lies to the left of US and reflects a household sharing-inclined economy that is characteristic of HIM.18 In Chapters 5 and 6, we examine indicators that show Russia to fit most to SIM, with the BCEE and EXSR country groups also manifesting SIM but showing differing inclinations to the HIM and FIM, respectively. The East European former satellites lean slightly more to firm settings. The EXSR lean slightly more to household settings.19 Chapters 7 and 8 are devoted to examining economic systems in developing countries; their positioning is shown in Figure 1.3. Geographically seen, we start with the EAP region and move eastwards to other regions. To start with, the positioning of the EAP, consisting of China, Indonesia, Philippines, Vietnam, Thailand, Malaysia, among others and Pacific Islands, close to HIM and along the HIM–FIM axis, reflects the facts that the majority of agents in the region are still in rural areas where household settings count, despite a sizable population living in urban areas, working in commercial firms, and manifesting the impact of firm settings. We show in Figure 1.3 a special position for China, given its characteristic multipolar economic system. The South Asian region, consisting of India, Bangladesh, Pakistan, Sri Lanka, among others, is placed in the HIM corner, which reflects the relatively higher dominance of household settings in this region. The SA region, like the EAP, is also positioned along the HIM–FIM axis; but SA is much closer to HIM than FIM, when compared to EAP. We refer also in Figure 1.3 to a special position for India, based on previously stated arguments regarding prevalent multipoles structure.

Understanding Economic Systems 15

Practically speaking, the Arab countries, sharing common linguistic, historical, religious, and socio-cultural features, fall in the two regions of GCC and MENA. The oil-rich Arab Gulf countries, i.e. the GCC region, are traditionally known for a dominance of household settings. While household settings are dominant, due to various historical and cultural precedents, state authorities have a significant influence in these regions. More recently, oil exploitation, the oil booms, and the quick modernization of the GCC region resulted in the conversion of major segments of the GCC economies into firm oriented settings.20 The region is placed along the axis of HIM and SIM, and with a close distance to FIM in view of its modern segments. The Middle East and North African countries, i.e. MENA region, are placed halfway the HIM–SIM axis, in view of long histories and religious traditions by which households voluntarily entrust state leadership, whether it is led by royalty, president, military, or religious council, with authorized and extended rights and obligations. Notwithstanding, the state settings undergo other checks and balances instituted by history and tradition and are thus less intensive and dominant in MENA than in the ex-Soviet and allied countries. The Sub Sahara African countries are positioned along the axis HIM and SIM. As kinship and ethnic ties occupy a central role in agent interaction in most SSA countries, it is logical to position SSA closer to the traditional household settingsHIM corner. Because of the influential role of the state in African countries they are positioned along the HIM–SIM axis. But state institutions in SSA are not as strongly institutionalized as in the ex-Soviet and allied countries. Finally, the positioning of LAC, consisting of Latin American and Caribbean countries, is along the HIM–FIM axis, but closer to FIM than HIM, reflecting long periods of a significant impact of firm settings on the economic system, and a relatively higher degree of urbanization than other developing countries. However, separation barriers between population groups in LAC stand in the way of convergence towards a dominant behavioural type. Within the regions covering the developing countries there can be important variations. Some of these variations can be systematized by introducing subdivisions to gain more reality and comprehension. This will be done in Chapters 7 and 8. In Chapter 7, we make the basic and important distinction between small developing countries and large developing countries with large populations living and working in rural and informal settings. In Chapter 8, we attempt to accomplish a meaningful overview of regional subdivisions by developing an analytical strategy based on a few basic hypotheses that have been displayed in this chapter. We apply these hypotheses to identify leading countries within regional div isions. The basic hypotheses are as follows: Among alternative settings that setting which contains the largest number of agents and manages the largest economic transformation is more likely to dominate on other settings. Furthermore, the intensity and extensiveness of interactions of agents and their outward communication to other settings, network externalities, and a common external environment matter in the prevalence and domination of one type of setting over others. The noun country can be substituted for the noun setting in

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the above hypothesis. If a few measurable indicators can be identified at the country level regarding the size of the agent population, the size of the economic transformation, and the outward orientation of both the population and the economic transformation, countries within a regional division can be ranked to give an indication of leading country(ies) within a regional division, as will be done in Chapter 8. These are countries whose economic systems are likely to dominate the economic systems of the regional divisions. Focusing on the economic systems of these leading countries and understanding them is a richer alternative than reviewing the complexities and differences within the regional divisions. An application of the above strategy results in focusing on ten major countries that constitute poles of attraction likely to dominate neighbouring countries in the identified regional group. These ten countries are also the focus of further treatment in Chapters 7 and 8. The countries are China and Indonesia (EAP), India and Pakistan (SA), United Arab Emirates (GCC), Egypt (MENA), Nigeria and South Africa (SSA), and Brazil and Mexico (LAC). Certain aspects in two countries, Indonesia and Pakistan, belonging to SA and EAP, respectively, will be treated at some length in Chapter 7, the other countries in Chapter 8. A closer look will detect that in some developing regions there are outliercountries that can be characterized as having a state intensive economic system, very close to the sense used for the ex-Soviet Union and present Russia.21 Notwithstanding these exceptions, the positioning of the six developing regions along the indicated planes of HIM–FIM and HIM–SIM meets global and average criteria and contributes to a rational and anticipated distinction between the developing regions and other world regions that distinctly lie in or along the axis of FIM and SIM.

1.5

Outline of the book

This first chapter gave the basic components of a conceptual framework for studying economic systems and went some way in applying it. The application gave a positioning of countries and country groups along four identified economic systems and their intersections, and relating motivations. Chapter 2 elaborates on the analytical framework. It elaborates on the micro behaviour of agents in the short run, and the convergence of agent behaviour into distinct economic systems in the long. We make use of simple conceptual models to illustrate the involved mechanisms in the short and long runs. The chapter then examines the structure, conduct, performance, and attitudes in different economic systems. Each system carries with it particular social attitudes. Making use of results from the World Values Surveys (WVS), the chapter checks on how attitudes with regard to household, firm, and state settings differ in countries that associate with HIM, FIM, and SIM, respectively. The check supports our specific positioning of countries and country groups along the axis of HIM, FIM, and SIM. Chapters 3 and 4 study the economic systems in FIM relating countries, in particular, US, Western Europe, and Japan. While Chapter 3 focuses on the economy, Chapter 4 treats the polity.

Understanding Economic Systems 17

Chapter 3 reviews the economic principles of the pure firm intensive system. The optimal performance of the perfect market economy centred on firms depends on the fulfilment of four presumptions; that is absence of indivisibilities, uncertainties, externalities, and collectivities. Non-fulfilment of underlying presumptions in the real world results in inefficiencies that may be remedied by firms and market solutions and/or state interventions. A fifth presumption towards reaching highest welfare relates to income distribution. Market failures occur in the five areas. The chapter treats each of the five market failures by reviewing the problem, and examining and assessing the response of affected firms and state intervention in resolving the problems. We make use of FIM-related country data to illustrate the problems and illuminate country differences. Chapter 4 turns to the treatment of the polity in the FIM and relating countries. In a FIM economic system, profit maximization is the underlying common behavioural pattern of all actors, thus both firms and state. The political process in such a system can be described as an exchange process subject to instituted constraints that serve the FIM system. The functioning of state institutions, and state agents, i.e. voters, political parties, governing politicians, bureaucrats, interest groups, public sector employees, is equivalent to that of a marketplace. The chapter addresses several questions. Who are the main actors in this polity and how do they function and interact in the FIM nation state in relation to their two main activities in the economy: public regulation and public spending? What are the consequences of their functioning for the size of the public sector versus the private sector, and for the economic and social welfare of the nation as a whole? The chapter uses comparative country examples from US, EU, and Japan, among other FIM relating countries, to illustrate the extent and variety of the political influence of the executive branch on the economic system and its economic performance. Chapters 5 and 6 study the economic systems in SIM relating countries, in particular, Russia and the ex-Soviet republics and allied countries. Chapter 5 examines how the polity dictated its rules and policies on the economy in the past communist era. Chapter 6 turns to the transition period and studies the transitional problems, reforms and progress in the transition countries. Chapter 5 demonstrates the point that state settings in SIM are all-dominant and all-political in their behaviour, making the economy a by-product of the polity. The main features of the communist regime of the Soviet Union are reviewed with more attention given to the state as the sole coordinator and driver of the economy via a system of central planning and monitoring. We treat procedures, methods, forms, and the practical operation of central planning. System reforms and state policies will be reviewed and the failing results evaluated. The chapter looks at the past economic growth and distribution performances of the Soviet Union and its allies, and compares them with those of FIM relating countries to obtain a grasp into the missed opportunities of communist countries to achieve more. Not only did most of the reforms, policies, and performance fail, but the whole regime fall short of achieving the announced objectives which it promised for its people. The chapter reviews alternative explanations for the failure of the

18 Economic Systems Analysis and Policies

communist regimes. The explanations rely, to different extents, on economic, social, and political theory. Chapter 6 starts from where the communist regime collapsed. A heavy recession, which endured from four to ten years depending on the SIM relating economy, wiped on average about 40 per cent of the GDP. The chapter examines the magnitudes and causes of the transitional recession in the ex-Soviet Union and European associates. It then gives a review of transitional reforms and their phasing into what is called short transition and long transition. A SIM relating country undergoing the long transition is confronted with economic failures that appear also in the FIM countries. These are economic imperfections due to the presence of indivisibilities, uncertainties, externalities, collectivities, and inequalities. The responses of firms and state settings to these economic challenges are different in the two systems. In contrast to FIM countries where firms orchestrated the remedies, the responses in most of the transition countries reflect a dominance of state agents, rent seeking practices, and disruptive consequences that are consistent with the assumptions of the state intensive economic system. The chapter displays separate empirical material on these disruptions for Russia, EXSR, and BCEE. The results show the disruptions to be highest in Russia, followed by EXSR and BCEE. Chapters 7 and 8 examine the economic systems of six developing regions. Chapter 7 discusses five to six decades of social, political, and economic developments across the six regions. Chapter 8 considers each region separately, giving more emphasis to China and India. Chapter 7 treats several groups of related questions on the changing economic systems in the six developing regions. Which mixtures of social, political, and economic structures were initially present in various parts of the developing world in roughly the eighteenth century? What are the major historical epochs, since then, through which developing countries passed and are still passing? How were the roles and significance of behavioural settings such as of the household, state, and firm affected? What can be said of the economic system in very large countries with substantial populations living apart in household settings, and in firm settings? Which macro and micro analytical and policy frameworks are able to catch multiple systemic prototypes in the same country? The chapter attempts to give region-wise differentiated answers to these questions and support the answers by empirical material from the six developing regions. Chapter 8 combines indicators of (a) country’s share in the regional agent population and (b) country’s share in the regional economic transformation, in determining countries whose economic systems are likely to dominate the economic systems of the concerned region. The analysis renders eight such countries across the third world, whose economies are studied further. The chapter devotes most attention to China and India. The chapter reviews for both countries the past background, the systemic changes accompanying economic development, and critical issues regarding system performance, future outlook, and coordination problems in multipolar social systems.

Understanding Economic Systems 19

Chapters 9 and 10 elaborate on methods and applications for the comparative analysis of economic systems. Chapter 9 develops the Social Accounting Martrix, SAM, into a comparative model for evaluating the structure and performance of countries manifesting different economic systems. The chapter explores the growth and distribution effects of state and external injections in the economy. It does this for a selection of FIM and SIM relating countries: Italy, Germany, Netherlands, and Spain as representatives of Western Europe; and Hungary and Poland for Eastern Europe. Furthermore, the chapter adds a few refinements to the SAM analysis in an applied comparative evaluation of the SAMs of Russia and China. Chapter 10 investigates long-term tendencies in the income per capita gap between rich and poor countries, and catch-up tendencies in both income per capita and the GDP. First, while most studies have relied mainly on supply side models of economic growth, this chapter offers a demand side model, based on the social accounting matrix. The SAM model, applied to 16 countries belonging to different economic systems and economic development levels predicts, after adjusting for peculiarities of economic systems, higher economic growth at lower as compared to higher levels of income per capita, which is indicative of a convergent tendency. Main causes behind this convergent tendency are dispelled. Second, taking a longer time perspective, for instance 2040, the chapter examines displacement tendencies between countries, and their associated economic systems, with respect to the country’s size of the GDP. If current trends in economic growth are prolonged some of today’s developing countries, i.e. China and India, are projected to have larger shares of the world’s GDP than today’s developed countries, i.e. US and EU. The chapter speculates on the future profile of dominant economic systems in the world at large, and the place therein of household, firm and state settings, and the related behavioural types to these settings.

1.6 Summary and conclusions The first chapter laid down basic elements in a foundational analysis of economic systems that emphasizes the prominence of distinct behavioural types in driving economic systems. Individuals behave in accordance with the settings in which they live and interact. The joint presence of individuals in several roles, and in complimentary behavioural settings, intensifies the likelihood of agents facing similar environments, develop mutual expectations, and produce a unified behavioural pattern. Interdependent behaviour and mutual influences among agents in typical behavioural settings result in typical behaviours and revealed preferences that characterize different societal orders. Our foundational analysis of economic systems distinguishes between three behavioural settings that associate with distinct behavioural motives. We focus on household, firm, and state settings. Intensive interactions of agents in such settings lead to the evolvement in the long run of the household intensive system, HIM, the firm intensive system, FIM, and the state intensive system, SIM.

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Economic Systems Analysis and Policies

The structure, conduct, and performance of the economic system in the HIM, FIM and SIM are basically different. Individuals who spend most of their day in household settings and are frequently in interaction with persons in similar behavioural settings, as is typical of village economies, develop a group and individual behaviour that is characterized by fraternity motives, group allegiance, mutual help, and sharing rights and obligations. When individuals, who strongly associate with household settings, perform ‘economic’ exchanges, these exchanges are socially coloured. Large portions of agent interaction in rural surroundings in developing countries can be described to associate with the HIM. A very different setting is that where individuals spend a great portion of their days in business settings where economic choices take place regularly, profit maximization and cost minimization hold, and entry and exit are commonplace. The interdependent behaviour between and among individuals living in the same commercially oriented settings results in a dominant economic behaviour that is typical of the business firm and the marketplace. Exchange between individuals tends to have the pure economic motivation behind it. US and many European countries associate most with the FIM. Another very different setting is that where the behaviour of individuals is coordinated for a large part via, by, and for state authorities. Political behaviour of individuals evolves over time towards taking the forms of strategic responses to use of opportunities and threat, more likelihood of rent seeking, and the accumulation of subordinating power. When individuals perform economic exchanges, these tend to be politically tainted economic exchanges. Significant portions of the populations in communist-like regimes in Russia and elsewhere lived and many are still living in politically dominated behavioural settings, characteristic of the SIM. We attempted to position major countries and regions along the axis of HIM, FIM, and SIM. The vast and highly dualistic countries of China and India would not fit in these configurations for now and for the near future. This is due to their densely populated multipolar orientation and the low prospects of absorption of these populations in any one setting. The remarkably big sizes of the segments relating to rural households, urban households, commercial enterprises, and state settings in such big countries stand in the way of an evolution of the social system towards a unified system that behaves along one dominant behavioural pattern. As a result, persuasive settings and persuasive institutions are bound to play a greater crucial role in coordinating the economic and political systems in these two countries, than elsewhere.

2 Elaborations on the Analytical Framework and Its Application

2.1

Introduction

In this chapter we elaborate on the analytical framework and its applications. Sections 2.2 and 2.3 develop a theory of changing economic systems that is based on interaction of agents in economic behavioural settings. Section 2.2 develops the premises of the theory in the process of answering several questions. Section 2.3 sketches a simple model of interacting economic behavioural settings that captures salient features. Sections 2.4 and 2.5 treat the emergence, evolution, and prevalence of specific behavioural types and economic systems over time. Section 2.4 lays out the principles. Section 2.5 makes use of a simple model to demonstrate the operation of the principles. Section 2.6 examines aspects of structure, conduct, and performance of economic systems; and it reflects on the comparative performances of economic system related country groups. Section 2.7 examines the diversification tendencies between countries that relate to different economic systems, as well as among countries that relate to the same economic system. Section 2.8 gives a summary and conclusions.

2.2

Micro and macro interactive processes in economic systems

Generally speaking, the function of positive economics in the context of economic systems is to uncover the static and dynamic properties of the (national) economic system and anticipate changes due to external and internal forces. Somehow, a system has to be assumed or identified as a well-behaving and predictable system to be studied at all, and be usefully employed. In doing that, four sets of questions are raised, which we display below. Our answers to these questions will explain our approach. The approach followed in building a theory of economic systems focuses on the interaction of agents in interactive economic behavioural settings. The building blocks of the theory will be grouped under the headings of external environment, internal structures, outcome performances, response processes, 21

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and systemic integration. Table 2.1 is a schematic presentation of these building blocks and is helpful for a quick review. The table gives the constituent elements in the left column and adds remarks on mechanisms in the right column. Let us start with listing the four sets of questions and our answers to them. First, what is the unit of analysis? What is the smallest (economic behavioural) setting that can be identified as an (economic behavioural) setting? What are the constituents of the external constraints, i.e. the external environment, which circumscribes the setting and determine its behavioural type? What are the constituents of the internal structures that allow the setting to function? Second, how do settings organize their agents in pursuing their aim, how do settings reward their agents for their efforts? Third, how do comparative rewards between alternative settings drive the agents to move from one setting to another? And what are the implications of this mobility, reshuffling, and response processes? Fourth, in which way does participation of agents in overlapping settings produce an identifiable (national) economic system and lead to systemic integration? To start with, in dealing with the first question regarding the unit of analysis, it is helpful to adopt the idea of a behavioural setting as described in K.A. Fox (1984). This is a physical site where participating agents mutually interact and generate some valued outcomes as perceived by those agents. Those behavioural settings, which have the objective of generating a valued transformation of artefacts to their participating members, would qualify as economic settings. Our focus is on economic behavioural settings, to which we refer henceforth as settings, and sometimes as organizations. We have distinguished between three main settings of relevance for the study of economic systems: household settings, firm settings, and state setting. All three settings involve economic transformations in which the values of the transformed products increase. Besides the primary forms of economic organizations at the micro-level such as households, firms, and state settings there are related types of settings at the meso-level such as cooperative organizations of households, business associations, interest groups, political parties, and various types of state governing bodies, and a vast number of different transforming markets. Each type of setting is circumscribed by distinct externally imposed constraints constituting the external environment and is characterized internally by different and distinct structural features, conducts, and outcomes. A behavioural setting is thus subjected to exogenously given external constraints, which affect and condition the internal structures of the setting. As a result, over a long period of time the external environment shapes the structural features of the setting, its conduct, and outcomes. The internal structures of an economic behavioural setting can be described to fall into four structures that can be briefly denoted by the following shortcuts: (1) the physical-technological transformation structure, (2) the transacting agent structure, (3) the institutional rules, and (4) the information structure. The following can be elaborated on each. (1) The transformation operates along physical-technological laws and restrictions, with the objective of increasing the

Elaborations on the Analytical Framework Table 2.1

23

Building blocks of the analytical framework

External constraints (external environment) An economic behavioural setting is subjected to external constraints that shape the setting’s behaviour, structural features, and outcomes.

External environment constraints are given data for the referred setting. Different external environments lead to different behavioural types.

Internal structures (four structures) within the setting (i) The physical-technological transformation structure is the transformation process of an economic activity, T.

The transformation process is guided by given technologies and physical restrictions.

(ii) The structure of participating agents, p  1, ... ,#, manages the transformation process.

Each participating agent has his/her own role to play in the transformation process; next to goals, endowments, and attributes. These can be denoted by indicators q, collected together in a set of personal attributes Q. So there are Q p for p  1, ... ,#.

(iii) The structure of institutional rules, I, regulates interactions among agents. Institutional rules define obligations, rights, and decision-making responsibilities for each agent based on their roles in the setting and the transformation process.

The institutional rules are driven by behavioural motives that are tied to the type of setting. Sharing oriented rules are typical of household settings. Commerce oriented rules characterize firm settings. Polity oriented rules characterize state settings.

(iv) The structure of information signals, N, which agents use communicate to each other, drives the transformation process into motion.

Information can be some times incomplete and asymmetric, involving situations with adverse selection and moral hazard.

As interactions among members of an economic setting intensify and converge over many periods, the four internal structures will tend to adjust to each other, and integrate towards a homogeneous whole.

The four internal structures will undergo unified shaping towards a homogeneous whole that reflects the conditioning influences of the constraining external environment, and the behavioural type that is typical of the setting.

Outcome performance Periodically, each setting generates outcomes, i.e. transformed value added, which are distributed on participating agents. The effort of each agent is compensated with material and immaterial rewards.

Outcomes are signalled to agents in other settings. If freely signalled, agents will know the outcome performances of comparable agents in competing settings, allowing agents to appraise alternative allocations of their efforts on competing settings. Continued

24 Economic Systems Analysis and Policies Table 2.1

Continued

Response process The dynamics within a setting are set into motion by [c] leading to potential changes in institutional rules. A setting gaining members, set into motion by [d], adapts its institutional rules to newcomers.

Agents with an overweight of socialization motives are likely to opt for [a] and [b]. Agents with an overweight of self-identity motives are likely to opt for [c] and [d].

The end configuration between competing settings is that of growing and shrinking settings, as well as a hierarchy of settings.

The power of a setting is directly measurable by number of participating agents and size of transformed value added. In case of hierarchy, an indirect measure is the extent of authority that a higher setting has in laying external constraints on the conduct of agents of lower settings.

Systemic integration Agents carry with them the behaviour typical of their setting and manifest such behaviour in interactions with other agents in other settings in which they participate, transact, or communicate with. This results in a spread of the behavioural trait, and its institutionalization on a larger scale.

Degree of systemic integration depends on agent distribution and participation across settings, interaction intensities of agents within and between settings, network externalities, and extent to which settings share the same external environment.

value of the transformed good. (2) The transformation is operated by a population of agents with varying attributes and values, whereby each agent searches for a satisfactory combination between use of his endowments (means) and fulfilment of his preferences (aims). (3) The transformation is governed by institutions, which delineate rules on the transformation, and on the behaviour, rights, and obligations of agents engaged in the transformation. (4) The transformation process is set into motion by a complex of information flows communicated by the agents on (1), (2), and (3). When taken together it can be stated that an economic behavioural setting is engaged in an economic transformation; it has its own members, who are mobile agents with varying attributes and converging values. The transformation is carried under physical and technological restrictions; the transformation takes place under a set of institutions containing behavioural rules on the conduct of the interacting members, such rules were formed in earlier periods, and they undergo changes as a result of changes in technicalities, information and profiles; and the transformation is set into motion by information flows between the members. In general, the components of the internal structure will adjust to each other to produce a consistent whole that converges with the external environment.

Elaborations on the Analytical Framework

25

The structural features that characterise a setting will undergo changes that can be secondary or primary in nature. Several examples of secondary changes include the following. (a) The transformation of artefacts may undergo upgrading through technological change, investment, and scrapping. (b) The profile of the agents changes over time due to internally induced changes such as when the profile of members in different behavioural settings change in more or less predictable ways: ageing, or when endowments and preferences of members in different behavioural settings change with the phase of development. (c) The institutional rules may undergo changes through mutual acceptance by members of the setting. (d) Through contacts with other systems, new perceived information signals on alternative transformation details, institutional rules, and opportunity costs become available, or can be increased by conscious search. Primary changes are put into motion by a comparative evaluation by agents of outcome in alternative settings, a search by agents for settings in which individual agents can combine endowments and preferences to their satisfaction, and consequently, the reallocation of agents between settings. As a result, the distribution of persons among settings is adjusted and new configurations of settings and their populations are reached, which in turn make possible further major changes in the transformation structure, agent composition, institutional rules, and the information structure. The aspects of the comparative evaluation of outcomes, and the consecutive response processes belong to the second and third sets of questions. Second, how do settings organize their agents in pursuing their aim, how do settings reward their agents for their efforts? Each setting organizes itself by assigning roles to its member agents. The agents are expected to implement these roles within given physical-technological transformation boundaries, institutional rules, and information flows. The fulfilment of the transformation process allows the setting to generate outcomes, i.e. value added-s, which are then distributed as rewards to each member agent. The received rewards have material as well as immaterial contents. Knowledge about the received material and immaterial rewards of competing settings are crucial for an evaluation that participating agents regularly do, and which guides them in their decision to continue in the setting or move to another setting. Third, how do comparative rewards between alternative settings drive the agents to move from one economic behavioural setting to another? And what are the implications of this mobility, reshuffling, and response processes? A review of the situation at any moment will show that (i) some members are content with their setting vis a vis other settings and they continue with the same effort as in the past or more, there is full conformity between the values of these members and the governing institutions (ii) some have voiced objections, got no response, have reassessed alternative benefits and costs and chose to cling to the setting but lower their effort in it causing X-technical inefficiency (iii) still others have voiced, found that they are better off elsewhere and have exited, and (iv) they may have entered other settings or are searching for one. Hirschman (1970) was among the first to emphasize the notions of loyalty, voice, exit, and entry.

26 Economic Systems Analysis and Policies

Agents move from one setting to another. The movement continues until the agent reaches equilibrium, i.e. marginal benefit and costs of changing positions between alternative settings becomes the same for the participant. In other words, the mobility continues up to the point where the propensity to move satiates in the sense that the marginal utility for an individual of shifting a unit of effort between settings is equal to the marginal cost of the shift. The moment situation in which each and all agents find themselves is interpretable in terms of the concept of general equilibrium, but with focus on reshuffling of agents. The distribution of agents on settings can be seen as Pareto optimal. It is understood that the equilibrium referred to here is meant to consider both material and immaterial rewards. The specific harmonization between the two types of rewards would depend on the specific agent, and it is outside our immediate scope here. However, in household settings the immaterial may weigh more than the material rewards, while in firm settings the material may weigh more than the immaterial rewards. What is observed and measured at a time period is a search and response process. A few remarks on the implications of this response process are in place. Voice and exit in some settings lead to the relative decline of these settings in relation to competing settings. An organization that manifests such voice, little restructuring of rules and little exit possibilities for its members is doomed to decline in terms of effective outcome. It may retain members for a long time. These members will consciously minimize their utility by minimizing their effort, thus resulting in X-inefficiencies that would undermine the outcome performance for the setting and its members.1 Entry to, and loyalty within settings, lead to the relative growth of these settings. The movement of agents leads to a reallocation of the effort of individuals within and between behavioural settings to the advantage of those settings that gain in retaining their members or attracting new entrants. Fourth, in which way does participation of agents in overlapping settings produce an identifiable (national) economic system and lead to systemic integration? There is a problem here. How can the national economic system be identified as an economic system as such when it is viewed as a conglomeration of interacting and overlapping agents participating in many organizations with each having its own dimensions in terms of transformation of artefacts, rules, members, and information? How to identify a common core in the vast collection of behavioural settings? In which sense do interactions of mobile agents in and between non-symmetric behavioural settings form a distinct observable system at all? The answer is sought along the following lines. What makes a network of interactions observable as a typical system is prevalence of mutual behaviour, common revealed preferences, and typical coordination tracts among the population for a nation as compared to other nation states. How is the ‘typical’ formed? And how is the ‘prevalence’ caused? We emphasize several factors. (a) Settings with more agents and greater value added transformations have a greater prospect of their typical behaviour becoming more prevalent. (b) Greater intensive and extensive interactions and greater outward communications of agents belonging to setting g and a greater outward communication with and participation in

Elaborations on the Analytical Framework

27

other settings g’ will extend the prevalence of the behavioural type associated with g, call this behavioural type G. (c) Once some thresholds of prevalence are achieved for setting g, network externalities enforce more convergence towards and extended prevalence of settings and behavioural type G. Last and not least (d) there is horizontal and vertical interaction among settings. In the horizontal interaction between settings, the sharing of a common external environment causes convergence and if the external environment is characteristic of a setting type g, it is more likely that behaviour characteristic of setting g prevails. In the vertical interaction, if setting g is higher in the hierarchy of settings, it may be able to set rules that other settings g’ would follow; and thus influence the other settings to follow behavioural type G. If persuasive settings, being the highest setting, affirm the existing order, then the prevalent behavioural type G, its structures and outcomes are strengthened furthermore. The above lines can be elaborated further. To start with, (a) the relative size of agents and the relative size of economic transformations that characterize a setting are major determinants of the relative influence of a setting. Agents move from what they see as a less attractive setting to a more attractive setting. The direction and extent of this mobility depends on the information they get and collect, and on mobility restrictions. If in settings g and g’, outcome performance of g  outcome performance of g’, this leads to tension in g’ (voice and exit) and pressure on g (entry). As more agents move from the g’ settings to the g settings, the behavioural type associated with the g settings gains more followers at the cost of g’. Ultimately, the relative sizes of settings in terms of the number of agents and of the value added transformations become basic determinants of the relative dominance of competing settings. (b) Communication between agents matters. In spite of the vast variations among organizational settings, it is the joint presence of agents in several roles in various organizational settings intensifies the likelihood of agents facing similar environments, and developing mutual expectations and realizations in linked organizational settings. Interdependent communications and mutual influences between agents normally result in synergetic profiles and revealed preferences that characterize the system as a whole and its development over time as a separate entity. Such synchronization mechanisms are sometimes termed socioeconomic conditioning. The importance of communication was illustrated with the help of Figures 1.1 and 1.2 in Chapter 1, which described in general terms the communication and transaction lines within and between the three most frequently encountered forms of economic organizations: households, government, firms, and markets. (c) Once a threshold is reached with regard to the acceptance of a specific behavioural type, this behavioural type can be expected to gain momentum in view of network externalities. Besides intensively experiencing a particular behavioural type, adopting it and spreading it to others, there are related mechanisms that lead to the same convergence and concentration around specific behavioural types. These mechanisms may overlap but we mention them as additional forces that cause the spread and dominance of particular behavioural types. These

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mechanisms include imitation, convention, focal points, information cascades, reciprocal behaviour, group learning, Markov chain inversions, melting pot, and power of dominant shares, among others.2 The contribution of social networking to the formation of uniform norms and commonly expected behavioural rules has associations with the notion of small world phenomena, where interconnections between a minimal number of persons are sufficient to secure interconnectivity for a much larger population. 3 (d) Finally, a typical behavioural pattern among the members of many organized settings is the result of the sharing a common external environment over many years. The operation of an organization is constrained by the environment external to it. Participating members in an organizational setting tend to mutually adjust their behaviour, technology, institutions, and information to the external environment that they commonly face. Organizations subjected to the same external environment will ultimately converge in their behavioural patterns. A shared external environment integrates settings in more subtle ways too. Tendencies towards a unified culture, associated with one dominant setting, are bolstered by the presence of external constraints enforced by the dominant setting, higher up in the hierarchy, on other settings lower down. The external constraints imposed by one setting on other settings are often in the form of checks and balances. While many institutional rules that agents observe in setting g’ are endogenously created by agents themselves to assure the well functioning of the agents collectively in setting g’, there are usually other checks and balances on agents inhabiting setting g’ that are exogenously imposed by agents of setting g higher up in the hierarchy. The extent and intensity of these exogenously imposed checks and balances, and how heavy they are, are indications of the degrees of dominance of agents of g on agents of g’.4 Persuasive settings, see Chapter 1, can be seen as belonging to the highest level in the hierarchy of settings. The consensus that is reached, proclaimed, and disseminated from these persuasive settings usually play an important cementing role in endorsing and propagating the dominant features of the socio-economic system.

2.3 A conceptual model of economic behavioural settings featuring the building blocks A model of participating persons p  1, ... ,# in setting g can be written in three sets of equations using the following notations. Notations Eg Tg Ig Ng Qp

Exogenously given external environment Transformation structure Institutional structure Information structure Set of personal attributes q belonging to person p

Elaborations on the Analytical Framework

Vpg Dpg

29

Value added received by person p from participation in setting g Decision of p to move, or not, from setting g to g’

Equations (T,I,N,Q p)g,t  ø{d(T,I,N,Q p)g,t  1; Eg,t} Vpg  s (T,I,N,Qp)g Dpg  m(Vpg:Vpg’)

for g  1,2 p  1, ... ,# for g  1,2 for p

(1) (2) (3)

Equation 1 shows the changing profile of the four structures in setting g as dependent on the exogenously changed environment circumscribing setting g, and similarly for g’. Equation 2 shows the value added in utility accruing to the agent in setting g as dependent on the four structures of setting g, and similarly for setting g’. Equation 3 is a general function that determines the decision of the agent p to stay in g or move to g’. Among the arguments in this decision is the relative relation between the value added utility in g and that expected in g’. Equation 3 allows the decision Dpg to be conditioned by the behavioural features that are typical of behavioural setting g. ‘Value added utility’ is differently conceived in the behavioural settings of the household, the firm, and the state. In firm settings, Dpg is guided by the following: p continues to participate in g if Vpg defined in terms of material benefits  opportunity cost of p in g’. In firm settings p leaves g and participates in g’ if the material benefit Vpg is below opportunity cost, thus causing the movement of agents, and hence resulting in changes in the profile compositions in settings dQ pg.5 In household or state settings agents are less motivated by material benefits. The arguments in the decision functions in the household and state settings take other forms. For the sake of simplicity, taking for the moment the variables T, I, N, and Q as given, the model is reduced to 2 times equation 2 and 1 time equation 3, in total three equations; and three unknowns of Vpg, Vpg’ and Dpg ; giving thus a determinate model that solves for the three unknowns. The model can be extended to make the four structures fully endogenous over time. The model can also be extended to solve for the optimal allocation of effort in terms of the agent’s participation between two settings. The greater the degree of integration between T, I, N, and Q p in setting g, the greater is the transformation surplus and the value added accruing to the person Vp, and the attractiveness for the person to allocate more effort (participate) in the particular setting at the cost of the other setting. Once the participation and integration between T, I, N, and Q p in setting g, have reached certain levels, one can then speak of the setting as an integrated economic system with predictable economic behaviours and outcomes. A behavioural setting, which is purely economic in nature such as a pure commercially operating firm, will produce an economic system which behaves in purely economic terms, indeed the more so if T, I, N, Q are fully integrated and adapted to each other. In contrast, a predominantly social or political setting is bound to produce a diluted economic system.

30 Economic Systems Analysis and Policies

In summary, and turning to the applied side of contemporary economic systems, it has been stated that when agents share common external environments, are unrestricted in their mobility between settings, and when there is direct and indirect communication between agents in different settings that take place frequently and over long periods of time there is a tendency for the structures of technology, rules, information, and agent profile at the micro behavioural settings to be extrapolated to all settings and create common traits at the macro national level. There is also the tendency for these structures to converge into each other at a macro level so that technology, institutions, information, and agent preference reflect each other. It has been stated furthermore that over long periods of mobility and interactions several distinct economic systems are likely to emerge reflecting the features of distinct settings and the associated distinct behavioural types with them. We have distinguished between three such distinct prototypes: (a) HIM, the traditional household intensive system that takes place in and among households, and which is characterized by familial solidarity; (b) FIM, the firm intensive economic system, which is allied to commercial firms that buy and sell their inputs and outputs in open markets, driven by monetized commercial motives; and (c) SIM, the state intensive economic system, which takes place in governmental circles, and which is characterized by seizure of political opportunities and rent appropriation. Each of the three economic systems display distinct and alternative patterns of institutions, preferences and information backups, which fit into each other, as was demonstrated in Chapter 1, Figure 1.2 (a, b, c), respectively. The above assumes convergence of behaviour towards the behavioural type of the dominant setting. Notwithstanding, it was also concluded earlier that there are some large developing countries, such as China and India among others, where the process of convergence is far from reaching any conclusive end, and that their socio-economic system would suggest the treatment of a fourth prototype of socio-economic systems which we called MPM, for multi-poles system. It was also concluded that persuasive settings play a crucial coordination role in the context of the MPM.

2.4 Evolution of differing behavioural types into different economic systems It is helpful to postulate the development of the three prototypes of economic systems as an outgrowth from some common origin, which is by definition the household setting. If at the end of the road three, or four, broadly defined economic systems show up, then how did each start at all at the very beginning and developed further? The external environment is a basic determinant of behavioural settings and the behavioural type that characterizes the setting. Different external environments generate typical coordination structures that coincide and fit with typical behavioural settings. A closed world, homogeneous population, strong kinship, severe

Elaborations on the Analytical Framework

31

scarcity of resources, and low levels of material welfare characterize the external environments of household settings described here. This external environment promotes sharing behaviour and solidarity structures. Agents in these settings are conditioned towards adopting institutions of familial altruism, brotherhood attitudes, income sharing among households linked by kinship and location. Similarly, households unrelated by kinship or locations tend to be excluded from the sharing tradition. Group altruism is double edged, with inclusive and exclusive dimensions. The external environment typical of value maximizing settings is materially better off, and is characterized by an open world with frequent changes, product discoveries, and choice opportunities, and a high mobility of agents. The external environment typical of state settings is also materially better off, but is characterized by highly skewed endowments and rank among differentiated population groups, often generating conflicting interests and requiring authoritarian rules to resolve them. The external environment contains also barriers that obstruct openness, choice, and mobility. The starting point is conveniently the situation where household settings are already there. It can then be asked which settings followed: firm settings or state settings? Hicks (1969) is among the many economists who contend that tribal, feudal, army and state settings historically preceded firm and market settings. Most anthropologists, like Firth (1967), maintain that economic organization and the transformation and exchange of products within and between neighbouring primitive societies came first and preceded political organization. There is documented history that can be used to support both views in different regions in the very past. The way we shall model the introduction of a new setting would make both scenarios possible, next to the simultaneous emergence of economic and political organization in a predominantly household intensive system. The model is basically microeconomic, and it is based on several premises. (1) Agents inhabiting household settings, and interacting with each other in a communal environment, experience specific needs, or can be attended to uncovered needs, and they are ready to embrace these needs. Agents are also innovative and capable of finding solutions and creating new transformation settings that satisfy these needs. (2) The needs of an agent can be personal or collective. Personal needs of one agent can be directly satisfied by the innovative and responsive transformation offered by another agent; opening ways for exchange and firm settings. Collective needs are indivisible and their satisfaction would require a joint effort of agents and a third party intervention to coordinate the task at a higher level; which opens ways for authority and state settings. (3) In communities where personal needs happen to have overweight, firm settings will emerge and prosper. In communities with an overweight of collective needs, state settings will emerge and prosper. (4) The above premises assume other things remaining the same; in particular, the external environment is kept constant.6 Communities where personal needs had overweight would push the economic system towards adopting a firm-like behaviour. These communities happen to be

32 Economic Systems Analysis and Policies

more of the open type. In an open economy, agents search more frequently for new personal products. Eventually, these demands for new products are matched with talented and skilled agents who are capable of innovating and achieving a value added transformation in the form of a new product that satisfies some felt personal need. The newly introduced transformation is by itself a new setting in formation. The larger the community and the more open it is, the greater is the probability that more personal needs, talented transforming agents, and new transformation settings emerge in the form of firms and markets. As demand for personal goods diversifies and increases, more agents reallocate from households to transforming firms and markets. The income sharing behavioural type would tend to decline in favour of the profit maximization behavioural type. In contrast, communities where collective needs had overweight over personal needs would promote the emergence and prevalence of state settings. The development can be displayed along the following lines. Collective needs consist of urges to curb uncertainties and externalities that the agents experience. Unable to resolve their uncertainties and externalized divisions agents i and i’ call on a ruling agent k to organize security and to execute public actions to satisfy collective needs. In all societies there are talented agents who are well equipped to take the role of ruler k, lead politically, find compromising solutions to collective needs, and govern effectively towards realizing these solutions. Having a governing monopoly, agents k pursue an economy of measured exploitation in fixing their compensation for the services they provide to agents i, i’. If all the counteracting i,i’ agents calling for collective action count I and each produces y, and the production is liable to fall down to x if no collective action is taken, but may increase to z if the state intervenes, whereby x  y  z, then I (z  x) represents the maximum amount that agent k can collect from agents i, i’ for the collective actions rendered, including the bureaucratic apparatus required to implement these actions. If the number of agents involved in the collective actions is K, then their average reward per agent k is I (z  x)/K. Under crude but realistic assumptions agent k can be shown to end with about double the income of agent i, i’ or more.7 Under leadership of politicians and bureaucrats, governments have evolved overtime into natural monopolies.8 Anywhere, there is only one government to run state affairs. This monopoly position is likely to seduce state officials to appropriate rent in the process of organizing and executing collective actions in the future. State officials are also politically motivated to create and expand community needs for collective goods. In this way, the received rent is extended to more activity areas, and the monopoly is sustained and broadened. To create community needs for collective actions, political man would take measures to discourage private solutions to emerging needs. The above does not mean that all state agents behave along rent appropriating motives. Many, or most, state agents will pursue benevolent motives as when the state is embedded in a household intensive system, HIM; since they are conditioned to behave accordingly in a HIM environment. Similarly, many or most state agents will seek no more than their opportunity cost if they are embedded in a firm intensive system, FIM; since they are conditioned to behave accordingly in the FIM environment. But

Elaborations on the Analytical Framework

33

if they function within a system that is intensively dominated by the state, SIM, then state agents will excel in rent appropriation and political behaviour, and cause this behavioural type to spread to other settings in the context of a SIM environment.9 Finally, persuasive settings play an important role in affirming the principles of a newly installed socio-economic order, whether it is one where firm settings dominate or one where state settings dominate. If persuasive settings, being the highest, affirm the socio-economic order, then prevalence of stipulated behavioural type in the economic system is complete.10 To summarize, alternative scenarios are feasible regarding sequence of regimes. It follows therefore that it is perfectly plausible that the state (firm) settings emerge first and firm (state) settings follow later if collective (personal) needs were felt to be more urgent than personal (collective) needs. Therefore, both routes are possible, and these can vary over time and place. The breakthrough towards a predominance of the firm or state settings would then depend on the cumulative relative weights of personal vis a vis collective needs. We have abstained in the above from various complications. In the real world, the external environment undergoes basic changes that particularly promote FIM or SIM. A few examples suffice: (a) the age of discovery has allowed a major diversification in demanded products at the personal level, a huge jump in personal needs of the newly settling migrating populations and a push for firm settings, and (b) technological advances enhance demand for new personal products and their divisible production encourages firm settings. Both examples can explain the early inclination of US and Europe towards FIM. On the other hand (c) military conflicts with neighbouring countries promote growth of state settings, while (d) frustration with the social order leads to calls for authoritarian rule. Both examples explain the inclination of Russia to SIM after WWI, and a stronger state in Germany between WWI and WWII, and in WWII. In principle, there are conceivable conditions under which the two orders can temporarily (or permanently) reverse. If in specific circumstances, collective needs overshadow personal needs there will be a strong demand for state settings. Similarly, disappointment with achievements of state settings and rising demand expectations based on better attainments in firm settings can shift the overweight from collective to personal needs, giving some push towards firm settings. A pronounced example is that of Russia that experienced both reversals in the twentieth century. Other examples of modest realignments between the two orders are inherent in deregulation and regulation waves in US and other FIM related countries: deregulation of the utilities and communication sectors in the 1990s, and regulation of the finance and banking sectors following the financial meltdown of 2008.

2.5 A conceptual model of the emergence and prevalence of behaviourally different economic systems With the above as background, the emergence and prevalence of specific behavioural types in response to satisfaction of personal and collective needs can be

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conceptually modelled. This is a specific model of social interactions, inspired by the more general models of social interaction in social groups such as by Becker (1974) and Simon (1952). The probability that a behavioural type identifiable with setting Vg prevails over all other Vg’ can be expressed as in equation 4. Vg prevails if (v1 Ag  v2 Cg)  v

(4)

In this equation, two share parameters affect prevalence. Ag is the share of agents in setting g, with respect to all agents in all settings. Cg is the share of goods and services, say commodities, demanded that are most suitably transformed in setting g, with respect to all demanded commodities. The personal commodities are most suitably transformed in firm settings. The collective needs are most suitably transformed in state settings. The greater the shares of those agents and commodities associated with a particular setting the greater is the probability that the behavioural type underlying this setting prevails over other behavioural types. v1 and v2 are weights applying to these two shares, whereby v1  v2  1.11 In this equation, n is a proportion, this represents a critical mass. Once the practice of a particular behavioural type reaches this critical mass, this behavioural type can be expected to benefit from network externalities and to extend its maintenance to practically the whole population. There are different views concerning the likely value of the critical mass. Values of 2/3rd and 3/4th are among the most quoted in the literature relating to a critical mass.12 There is thus justification for fixing the value of n at around 0.7. The network externalities can be interpreted by adding to the term of the direct effects of the agent shares in equation (4), a term for the indirect externality effects. This latter can be conceptualized by introducing a squared term that is meant to emphasize a scale effect in this process of induced interactions and spin offs. For example: (v1 Ag  v2 Cg)  vo (v1 Ag  v2 Cg)2 . In this expression, giving thus the direct and indirect effects of relative agent participation on behavioural prevalence, the squared term should have a lesser weight, than the non-squared term, 0  vo  1. If (v1 Ag  v2 Cg) reaches the value of v, say, 0.7, and if vo is set at say ½, then the direct and indirect effects would result in a full-fledged prevalence tending towards 1.0. The shares of agents and transformations by setting, Ag and Cg, as combined in equation 4, form an Index of Interactive Influence, which is indicative of the relative assertive power of setting g over the other settings. Quantification of this index for types of settings for individual countries would give the systemic orientation of the individual country as to which setting is most dominant. A value of the index for a setting type g of around and above 0.7 is a strong indication of the dominance of that setting type. We shall apply the index in Chapter 7 to that end, and later on in Chapters 8 and 10 to explore, respectively for the world regions and the world at large, the relative dominance of prospective economic systems that associate with leading countries.

Elaborations on the Analytical Framework

35

Attention can now be directed to examining the likely paths of the share of demand for commodities, Cg, and the shares of agents Ag for each setting g. To start with concentration of commodities, define Cg as the proportion of demanded commodities D most suited to be transformed in setting g, in the total demand for commodities, Cg  Dg / D. Applied to the three settings we have the share of demanded personal commodities that happen to be most suitably transformed in firm settings Cf  Df / D, and the share of demanded collective commodities that happen to be most suitably transformed in state settings Cs  Ds / D, so that the share of demanded domiciled commodities that happen to be most suitably transformed in household settings becomes Ch  1 – Cf – Cs. For the evolution of the shares of commodity types transformed in alternative settings, Cg, introduce Dho, Dfo, Dso for the initial demand for goods whose transformation is related to the domicile, personal and collective types h, f, and s, respectively. In equations 5.1 and 5.2, the evolution of the commodity shares of Cft and Cst over time t is described in terms of the initial Dho, Dfo, and Dso, and the growth rates of per capita demand for the f and s commodities: gf and gs; which are assumed for convenience of presentation to grow at constant rates but this is not a necessary assumption. As we stated earlier the shares can shift abruptly due to exogenous changes in the external environment. In equation 5.3, commodity share Cht becomes a residual in terms of the initial values of goods by the three types and the growth rates gf and gs. Cft  Dfo (1  gf )t / {Dho  Dfo (1  gf )t  Dso (1  gs)t} Cst  Dso (1  gs)t / {Dho  Dfo (1  gf )t  Dso (1  gs)t} Cht  Dho / {Dho  Dfo (1  gf )t  Dso (1  gs)t}

(5.1) (5.2) (5.3)

The following can be noted on the evolution of the commodity shares. Ch tends to fall over time in favour of Cf and Cs. However, these effects are tempered if the per capita growth rates of demand for commodities gf and gs are low, due to a high population growth and/or low economic growth. Next, considering the concentration of agents, define Ag as the proportion of the population L in setting g, in the total population, Ag  Lg / L. Applied to the three settings we have therefore the share of agents in firm settings Af  Lf / L, and the share of agents in state settings As  Ls / L, so that the share of agents in household settings becomes Ah  1 – Af – As. For the evolution of the agent shares in alternative settings, take first the case of firm settings f. In equation 6.1*, future agents in firms Lft are determined by the initial labour input/demand output ratio Lfo / Dfo, and the evolution of this ratio as depicted by the future growth of labour productivity lf ; and the future level of the demand for commodity f. This is the initial demand Dfo multiplied by the future growth rate of per capita demand for this commodity (1  gf )t. The result of the above gives Lft. This is divided by the future total number of agents Lt to give the share Af, where Lt is the initial Lo multiplied by the future growth of the labour force, or the population at large, (1  p)t. By substitution and elimination, equation 6.1* is simplified to its final form in equation 6.1. Similar results are shown for the case of state

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settings s, in equation 6.2. In equations 6.1 and 6.2, the evolution of shares of agents in firm and state settings Aft and Ast over time t is described in terms of their initial values of Afo and Aso; the growth rates of labour productivity in firm and state settings lf, ls; the growth rates of per capita demand for commodities that relate to personal and collective needs and that are most suited to be transformed by firm settings and state settings, gf , gs, respectively; and the growth of the labour force. In equation 6.3, the share of agents in household settings Aht becomes a residual. Aft  Lft / Lt  [(Lfo / Dfo) (Dfo (1  gf )t (1  l)t)] / Lo (1  p)t Aft  Afo (1  lf )t (1  gf )t / (1  p)t Ast  Aso (1  ls)t (1  gs)t / (1  p)t Aht  1  Af  As

(6.1)* (6.1) (6.2) (6.3)

The following can be noted on the evolution of the agent shares Ag. (a) The effective share of agents in household settings Ah tends to decline, and those of Af and As tend to increase. However, if the per capita growth rates of demand for commodities gf and gs are low, due to a high population growth and/or low economic growth, then the effects just mentioned are tempered. Thus, high population growth and/or low economic growth sustain the prevalence of Ah, while low population growth enhances the shares of Af and As.13 (b) There is disputed evidence that gf  gs. To the extent that this is true then firm settings have a greater probability to spread than state settings. However, these growth paths are frequently interrupted and there are periods when collective needs dominate personal needs, and other periods manifest the contrary. (c) It is generally established that the growth rate of labour productivity is higher in the transformation of personal goods as compared to collective goods lf  ls; this tendency favours a relative rise in the agent share of state settings as compared to firm settings. Finally (d) a high population growth rate p sustains the prevalence of Ah, while low population growth enhances the shares of Af and As. The conceptual model in this section can be elaborated further to consider additional interactions between settings. A behavioural type associated with a setting type g can extend to and determine behaviour in setting type g’ via two channels that can be called (1) horizontal, and (2) vertical. (1) In the horizontal channel, agents in setting g are many and have a high intensity of interaction. These agents participate as well in setting g’ and interact with agents in g’, and thus transfer their behavioural type to g’, so that in time agents in setting g’ take over the behavioural type characteristic of setting g. The conceptual model in this section treated the horizontal channel. The model identified two key variables in the transfer of behaviour: the relative share of agents in g and g’, and the relative share of transactions in g and g’. (2) In the vertical channel setting g stand higher up than g’ in a relational hierarchy. Binding rules of conduct are imposed by setting g that setting g’ should observe, resulting in behaviours and outcomes of g’ that are consistent with those of g. The conceptual model in this section does not incorporate binding rules of conduct by g on g’, though they can be readily introduced.

Elaborations on the Analytical Framework

37

Channel (1) is direct. It can be more enduring in its effect as it is generated via experiencing, learning, and adoption. Channel (2) is indirect. The origin of the vertical channel lies in the ability of higher settings (usually state allied agencies) to impose binding rules of conduct on the lower settings. Such binding restrictions belong to the control sphere. The effect of vertical channels of interaction on the distribution of power and decision-making between settings can be very significant. For instance, the accumulated strong power of state authorities over centuries of agent interactions in SIM related countries have been acquired through vertical and not horizontal interactions. In contrast, FIM related countries have relied in their adoption and evolution of the FIM system more on horizontal than on vertical channels of assimilation. It is sometimes observed that the contribution of vertical channels of interaction towards unified behavioural formation across settings is less permanent than that of horizontal channels of interaction. In the case of vertically acquired behavioural attitudes, these can terminate after some time if the control mechanisms become too demanding due to technological loopholes, or the rationale for the binding restrictions disappears, or the balance of power between g and g’ reverses. On the other hand, the appreciation of how vertical channels of interaction determine the balance of power between settings and how behavioural conduct is transferred from higher to lower settings is important for understanding the management structure of the socio-economic system in a specific country, as well as the emergence of international institutions and binding restrictions for interacting firms and states of different countries. The role of vertical channels in the context of persuasion settings is of special relevance. Vertical channels and persuasion settings are vital for the streamlining and coordination of differing attitudes and interests in multipolar social systems.

2.6 The structure, conduct, and economic performance of different economic systems In this section we examine the structure, conduct, and performance of the HIM, FIM, and SIM economic systems. We start with the HIM. The work by Becker (1981) on a treatise on the family is a major breakthrough. It deals with modern household in a firm intensive system. It explains family behaviour in terms of the principles of the FIM, i.e. profit maximization and cost minimization. The intrinsic principles that hold for the household family before intrusion of the FIM, often called traditional, peasant, or primitive households, constitute a different set of principles than that which operates in the household family after its integration in the FIM setup. In the context of the HIM, the traditional household is the relevant unit of analysis. With a few exceptions, notably advances in prospect theory and neighbourhood economics, economists give little attention to the study of structure and conduct in the traditional household intensive system.14 This is understandable in view of the diminishing role of traditional household settings as compared to

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firm and state settings, and is furthermore to be expected since traditional households behave along sociological rules that are far fetched from economics rules and the economics discipline. In contrast, the social anthropology literature of primitive economies deals at great length with the economic structure and conduct of societies centred on traditional households, kinship relations, and social groups.15 There are several salient economic features of the household intensive system that are worth mentioning. (i) The household units are engaged in the process of production with the aim of ensuring the reproduction of their customary consumption levels and the stability of their living and working conditions from one cycle to another. The household unit is always a part of a larger social grouping of households that are related by kinship, obligations, or land tenancy arrangements. Household behaviour is accommodated to the larger social grouping to which it belongs. The reference base of utility is the social grouping, as prospect theory asserts. (ii) Household behaviour is non-economic: it is guided by a survival algorithm and would avoid risk even if it is profitable, it would go for maximum total product commensurate with the customary consumption levels even when average productivity falls and costs rise. (iii) Products are transacted within and between households via reciprocity and redistribution. The guiding rule is from each according to his status obligations in the social system and to each according to his status rights in the system. (iv) Exchange between households at the market place is restricted to essential products and the feedback that links market values to production decisions is absent because factors of production are not marketed. (v) The economy in the HIM is embedded in social relations in the sense that the economic system functions as a by-product of social institutions. Economic relations can be understood only as part of a scheme of social relations.16 We turn now to examining the FIM and SIM economic systems. In contrast to the HIM, there is a vast economic literature on the structures and conduct of free market and state controlled regimes. A discussion of the structure and conduct of FIM and SIM would come close to a traditional review of the economics of free market and state controlled regimes, though with a different focus. We shall save the reader such a review and focus instead on how the underlying behavioural principles of SIM and FIM, these are respectively rent appropriation and profit maximization, tend to shape the structure and conduct of the respective systems. It is important to underline that while rent appropriation and related political motives are central in the behavioural patterns of the state intensive economic systems, profit maximization and economic motives are central in the behavioural patterns of the firm intensive economic system. This contention is valid when the reference points are the whole systems of SIM and FIM. Of course, these two associations cannot be all inclusive for all instances of state agents in all state settings, and respectively all firm agents in all firm settings, in all places and all times. There are instances where firms are engaged in rent seeking, as well

Elaborations on the Analytical Framework

39

as many instances where states are performing their transformation tasks with opportunity cost as the purpose in mind. In the light of the above, it is important that the border lines between the two motives of rent appropriation and profit maximization be carefully delineated to avoid overlapping and allow for distinct behavioural types that identify distinct economic systems; without denying an apparent co-existence of both motives in the distinct systems. We shall examine below the differences between rent seeking and profit maximization and expand on their application in institutionalized socio-economic systems such as the SIM and FIM, as well as to their application to individual instances of state settings and firm settings. We shall then make a conceptual review of the comparative outcome performances of the rent appropriation based SIM and the profit maximization based FIM. Rent seeking is a premium an agent appropriates due to the agent’s monopolistic advantage. Rent is receipt in excess of opportunity cost in a competitive setting. Rent seeking, therefore, covers calculated and institutionalized acts by the agent towards realizing such an appropriation now and later. Rent seeking contains political coercion. In profit maximization the agents seek to extract the highest economic value by engaging in mutually beneficial transactions. Critics point out that in practice, there may be difficulties distinguishing between beneficial profit seeking and detrimental rent seeking. J.M. Buchanan (1980) postulates that the difference between profit maximization and rent seeking can be only determined ex-post. Where there is monopoly the result is described as the outcome of a rent seeking behaviour. Where there is competition the result is described as the outcome of profit maximization. So formulated, the impression is created that there is no genuine difference between the two motivations. The difference is shifted towards the circumstances in which the two motivations take place. This point of view does not go far enough since it does not answer the question why monopoly would exist in one setting while competition would come about in the other setting. However, the point of view suggests as well that one can speak ex-ante of rent appropriation in societies and socio-economic systems where monopoly of power is strongly rooted, i.e. SIM, and rather of profit maximization in societies and socio-economic systems that are more competition oriented, i.e. FIM. Our standpoint sees the significance of the difference between the two motives to lie in their applied integration into distinct whole systems with different institutional set-ups. Intensive interaction of agents within state settings and ruled-ruler like settings broil rent seeking behaviour, and generates monopolistic outcomes as contrasted with intensive interaction within firm settings that promotes profit maximization behaviour and bring about competitive outcomes. The standpoint can be elaborated further. Strictly speaking, the basic feature of the rent appropriating behaviour is in drawing out rules and erecting institutions that bind the ruled to the rulers, and thus constrain the mobility of the ruled to other options than those offered by the ruler. In this way, an institutional monopoly is artificially created in the first round, and is substantiated by

40 Economic Systems Analysis and Policies

practice, custom, and acceptance in subsequent rounds. In an insecure society facing significant collective needs, and where most agents are least enabled and a few are highly enabled a ruled-ruler regime is very likely to emerge in which counter expectations and obligations between ruled and ruler are prescribed, and regularly revised to assure continued rent appropriation. These often go together with modes and boundaries of interaction between the common and the elites. State settings, if they are unchallenged in their growth, are able to transform the social system into a state intensive socio-economic system with an institutionalized monopoly of the state, a ruled-ruler regime with a maintained rent appropriation. As state agents, in a SIM context, have an unchallenged monopolistic advantage in running state affairs and related economic transformations, they are in a position to purse appropriating rents with success. The rent seeking act takes different calculated forms: for example, extending the authority of government and size of the public sector, political campaigning to govern and job queuing by aspiring candidates for state positions. The rents appropriated can be monetary payoffs, legal as well as illegal, job amenities, executive power, and prestigious status. Given their monopoly in running state affairs, state settings in SIM are natural breeders of the rent appropriation motive. More generally speaking, state agents in state settings are politically motivated to create and expand community needs for collective actions. In this way, the received rent is extended to more activity areas, and the natural monopoly is sustained and broadened. To create community needs for collective actions, political man would take measures to discourage private solutions to emerging needs. The measures used are subtle. They include restrictive rules, distorted information, and strategic policies with the objective of increasing indivisibilities, uncertainties, and externalities. It is in the interest of the politician to display a greater disagreement between opponent private actors than genuinely is, this raises the private demand for state intervention. It will be incorrect to assume that all states in all SIMs at all places and times were or are of the rent appropriating type. History contains benevolent state leaderships in SIMs that were exemplary in terms of ideal governance and away from self-enriching. The same history shows that such benevolent episodes were followed by rent appropriating regimes that are institutionally built-in in a SIM with an absolute monopoly for the ruler on the ruled. Power spoils. In contrast, in a firm intensive economic system, FIM, agents take over the profit maximization behaviour typical of a firm. It is in the interest of each and all agents to secure free entry and exit, and to create and maintain institutions that promote competitive outcomes. The more competitive agents are in relation to each other the greater is the probability of having fairly distributed opportunities and equitably distributed endowments. In turn, pursuing profit maximization by all agents reinforces institutions that promote competitive practice and profit maximization. It will be also incorrect to state that all firms at all places and times behave competitively throughout. Innovative firms come with their products as first in

Elaborations on the Analytical Framework

41

the market and naturally obtain some surplus profit, as a reward for their innovative investments; but the surplus disappears gradually as more firms enter and compete. There are also bigger firms that are engaged in erecting entry barriers and spending resources towards excluding competitors. These firms try to build artificial monopolist positions and appropriate a monopoly rent, and are as such seeking rent, in the sense of the short term; but they do not have the authority or capacity to institutionalize this rent seeking permanently; which is the crucial feature of what constitutes rent appropriation. It is commonly agreed upon that profit maximization in the presence of many competing firms excludes in the longer run the presence of surplus or abnormal profits due to monopolistic positions. Given the large number of competing firms in a market economy, most firms are eventually inclined to behave competitively; and in the long run, tend towards making normal profits, and thus, no rents. Firms have an economic motive and not a political motive, and this makes firm settings distinctly different from state settings. A few more questions remain to be answered on many instances of rent seeking firms in the context of SIM-countries, say Russia, in spite of the intrinsic orientation of firm settings towards profit maximization. Similarly, there are many observed instances of benevolent state settings in the context of FIM-countries, say US or EU, in spite of the intrinsic orientation of state settings towards rent seeking. In explaining this phenomenon, we refer back to the external environment, including the hierarchy of higher settings that circumscribe specific settings. In general, while any transforming setting A has its own regulating institutions to assure the well functioning of agents A collectively, there are other checks and balances on agents A that are externally imposed by agents of a higher setting B, call them agents B. The extent and intensity of these exogenously imposed checks and balances, how heavy they are, is an indication of the degree of dominance of agents B on agents A. How extensive are rent seeking and political behaviour, or how extensive are profit maximization and economic behaviour in contrast in a specific system/ country, depends on checks and balances that constrain state power relative to those constraining firm power. It can be reasoned that systems/countries where the checks and balances on the conduct of firms are heavier than those on the state can be described to have a quasi form of state dominance. The state is thus able to impose more and heavier checks and balances on firm behaviour than is feasible the other way round. In other words, the institutional structure that the state settings have established is at a higher level of authority than the institutional structure that the firm settings have established. Contemporary Russia is an example of a quasi form of state dominance. In the past Russia, firms were public enterprises and had operated as such in the full realm of state settings. In the present Russia, most firms are privately owned. Although intrinsically these private firms can be expected to pursue profit maximization behaviour, yet the mix of past and present state checks and balances that circumscribe all firms in Russia drives most of the firms to pursue a rent seeking behaviour in their strategic operations.17

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Economic Systems Analysis and Policies

In contrast, countries that are characterized by heavier checks and balances on state agents and relatively lighter checks and balances on firm agents can be described as having quasi-firm dominance. In these countries, firm agents, and citizens at large, are able to institute checks and balances on the functioning of the state that make state conduct accountable to these agents. In other words, the state is subjected to institutional structures that are meant to limit the authority of the state. Contemporary western democracies can be sited here. Take the firm focused system of the US. Checks and balances keep the rent seeking and political behaviour of state settings within very limited boundaries. Behaviour of agents in state settings is commonly analysed in terms of income maximization, very much similar to the economic behaviour in firm settings. The acclimatization of agent behaviour in state settings towards that of firm settings is the result of many years of interactions with dominant firm settings and strong checks and balances that are externally imposed on the functioning of state settings. The quasi dominance of firms in US has been highlighted by Stigler (1971), who was first to maintain that state regulation of business activities and related state legislations were initiated in the first place by strong firms and interest group lobbies to allow these groups to earn a rent. Government, it is argued, is an instrument in the hands of firm lobby, to legitimize and channel the rent to the interest groups. This does substantiate the standpoint that the US is a firm intensive and firm dominated economic system. Stigler interprets the regulations as evidence of short run rent seeking behaviour of the regulations initiating firms, yet given the operation of the FIM in the longer run; the interpretation of Hayek (1971) is more consistent with the functioning of the FIM. Hayek sees the regulations as driven more by competing firms, and they are meant to enhance competition, earn a normal profit, and minimize rent. Firms in a FIM succeed ultimately in endogenously installing checks and balances on their own functioning and that of the state, to support sustainable exchanges and competition between firms with a minimum intervention of the state.18 Next to discuss is the economic performance of economic systems. It was mentioned earlier that a household intensive economic system is less capable than firm centred or state centred economic systems in producing larger valued transformations. The main reason for that is that the traditional range of household products is much smaller than modern personal and modern collective needs and products (that satisfy these needs). The question whether the economy in a firm intensive system or in a state intensive system would perform better in the above sense has been controversial for more than a century. There is the abstracting view that if the two systems would operate under the right conditions there is no reason to expect one system to perform better than the other. Under optimal conditions, firms in the firm centred economy would maximize their profits to the point where inefficient profits would be eliminated by more entry and exit of firms; and if this is realized the maximum economic welfare will be obtained. The state in a state centred economy can achieve the same maximum economic welfare, if it succeeds in obtaining the right information flows and coordinating them; very crucial here

Elaborations on the Analytical Framework

43

is the ability of the state to calculate its exploitation margin right: that is to say, it will not impose a too high inefficient margin that, to say, may reduce the size of the cake and the ultimate margin as well. Apart from the difficult task of underpinning and coordinating decentralized information flows at a highly centralized level, there is the crucial question of deciding on the right exploitation margin. In the real world there are no pure forms of FIM or SIM, and the two systems are confronted by market failures and polity failures, respectively. The validity of either of the two standpoints depends on the conditions that market failures due to indivisibilities, uncertainties, externalities, and mal-distribution are collectively remedied under FIM, and the conditions that polity failures due to uninformed or exploitative rulers are collectively avoided under SIM. Both sets of conditions are violated. There are more pragmatic views that base the evaluation of economic systems on the opposite motives of rent appropriation versus profit maximization. These views would argue that economic outcomes of a system dominated by rent appropriation, political motives, and state settings can be expected to be inferior to that of a system dominated by profit maximization, economic motives, and firm settings. Six arguments are put forward. First, when artificial scarcities are created, thereby opening the way for rent seeking, the efficient allocation of resources is distorted. Second, when there is a rent to be captured, contenders often over invest in material resources and human efforts in seeking the rent. The competition involves a social waste of resources. Rent avoidance causes similar wastages. Third, incapable contenders for state positions may gain the rent seeking competition and obtain a payback and more for the investment they incurred; and if they were incapable they would strive to collect the rent and leave, in search of the next rent seeking activity. Fourth, although officials come and go in state settings, the accumulated authority and activity areas of the state are maintained and expanded in state settings. The effort of bureaucrats to expand the government share of economic activities is likely to have negative effects on economic growth. Fifth, If the powerful persons are privileged with rent seeking and realization, whereas subdued agents are excluded, people’s perception of the economic system, and their actions, are negatively affected.19 They are likely to follow and practise rent seeking and political tactics at lower levels, call for greater state interventions, and therefore lead to a spread of rent seeking behaviour at all levels. A political vicious circle often develops causing greater uncertainty overall, and hidden transactions and corruption among some, and passiveness and distrust among others. These effects hinder social progress and economic growth. Sixth, any economic system faces economic limitations that reduce its economic performance. These limitations relate to indivisibilities, uncertainties, and externalities.20 The state tends to intensify these limitations in an initial round to enhance the role of governments in resolving such conflicts in later rounds. Political gains involve economic losses. This is the opposite of the response in firm dominant systems. Firms here attempt to find least cost economic solutions to the limitations. Where feasible they cooperate in fixing new structures of technology

44 Economic Systems Analysis and Policies

and governance that reduce indivisibility, uncertainty, and externality, or enlist minimal state interventions as a last resort. There is one systemic feature of the FIM that can be at times a major drawback for the FIM performance. This is the greater uncertainty characterizing financial markets in contrast to real markets in the FIM economy. A financial market failure in a FIM can cause loss of confidence and a financial meltdown that wipes accumulated economic gains and cause recession. The financial meltdown of 2008 is such a case. SIM is less prone to such financial risks. While financial institutions and risk-taking markets are indispensable for economic growth, the response of the market system and state intervention falls short in periods of financial uncertainties and instabilities. Taking the above arguments into consideration it can be maintained that there is a conditional edge for FIM related economies to perform better than SIM related economies over longer periods of financial stability and sustained growth. The empirical evidence on economic growth for the years 1950 to 1990 for FIM and SIM related countries does show that the growth in FIM countries was higher than in SIM countries, with the exception of the first ten years. Chapter 5, Section 5.7 will examine these trends. The empirics do not allow supporting the same judgement that favours FIM over SIM when periods of heavy financial turmoil are involved. The contrary judgement is in place in periods of heavy financial turmoil. The empirical analysis of issues of catching up, convergence, and displacements will be treated at some length in Chapter 10. Notwithstanding, it can be stated here that the contributions of empirical analysis to the debate on the relative economic performance of alternative economic systems have been limited. Empirical observation may not always establish superiority of system related country examples on others due to a host of intervening changes and related external and internal disruptions that affect the country examples. The impact of these disruptions is empirically not easy to isolate. There are significant non-systemic factors that affect economic performance and the catching-up tendencies of countries with different economic systems. These factors are often interrelated, and thus make it difficult to establish with rigour which system would realize a higher economic performance. For instance, if for one reason or the other, FIM related countries have become richer, and more expensive than others, the ensuing income and price effects in a trading world would favour higher growth in the lower income countries, which are mostly non-FIM. And, as high levels of richness are reached in FIM related countries, the scarcity problem tends to give way to an abundance phenomenon, the economic motivation loses gear and economic performance in FIM related countries could slow down. The ageing composition of the population is a reinforcing consideration. In a non-FIM country at a lower level of economic development, the economic motivation works in the opposite direction, and favours economic growth. Because economic systems cannot be isolated from the countries that adopt them, and because there are frequent disruptions at the country levels unrelated

Elaborations on the Analytical Framework

45

to the economic system, these disruptions distort the comparative performance of alternative systems as they prevent agents from making a rational choice between genuine alternatives, discourage agent mobility across settings, systems and countries, and tend to reduce convergence between countries featuring different systemic behaviour. Where nationalist sentiments are high, the real gaps in comparative performances between competing systems related countries tend to be ridiculed if the gaps appear unfavourable to own nation. This instinctive attitude to defend one’s own distorts the transparency of comparative system performance. In principle, if performances of competing systems were fully transparent and agent mobility is assured between fully interacting competing systems, then this would permit convergence of the systems over time. But as noted above, various complexities intervene, disrupt genuine evaluations and choice, and prevent convergence. Moreover, there are indications21 that while interacting systems contain some general dimensions that tend to and can be predicted to converge, the same systems contain also other beholding specific dimensions that accentuate identity and divergence. One other question that remains to be raised is what are the future prospects of what can be called a synthesis-system? The historical development of the three societal systems of HIM, FIM and SIM can be interpreted in terms of an original, a thesis, and an antithesis, respectively. HIM is the original state. FIM can be viewed to constitute the thesis in which the individual agent strives towards his/ her individual maximum economic welfare. This thesis supports the free mobility of goods and factors of production in space and time. SIM can be viewed as the reaction to a privatized economy, as the antithesis where the individual’s self-interest is substituted by a collective satisfaction of needs that is defined and ruled by state authorities. In this context, regulations on the free movement of goods and factors of production and aspirations of nationhood and protectionism are likely to prosper. Are there grounds for expecting an evolvement towards a synthesis of the three systems? Or would there be new elements entering in a synthesis-system? The answer to this question is not independent from the future economic outlook for the countries that embody the alternative economic systems. In particular, the future outlook for economic systems may be significantly influenced by the expected larger sizes of the economies of China and India compared to US or Russia. Because all countries interact in an increasingly globalizing world, the rapidly expanding economies of China and India would raise the relative influence of their economic systems in relation to the FIM and SIM economic systems of today. If the contemplated future outlook were realized, some of the new elements in a synthesis system would come forth from the social systems of China and India. Both countries have configurations of behavioural settings that lean more towards household settings, i.e. the traditional and sharing behavioural type, than firm settings, i.e. the modern and maximizing behavioural type when compared to US. Their version of state settings is also different from that in Russia. Furthermore, and more important, persuasion settings in China and India are

46

Economic Systems Analysis and Policies

much more active in coordinating and streamlining the social system than elsewhere, which is justified given the demographic dynamics and the multi polar differentiation of the social system in these two giant countries. It is likely that a synthesis system would manifest a more frequent and substantial occurrence of persuasive settings.22 More on these aspects will be treated in Chapter 10.

2.7 Dominance and diversification tendencies across countries and systems: Some applications We have emphasized in this chapter systemic tendencies towards dominance of one type of settings over others, but we gave also attention to the occurrence of disruptions at the country level that obstruct the systemic tendencies towards dominance from taking place fully. Instead, the disruptions show up in diversification tendencies across countries, within broadly defined economic systems that apply for country groups. This section reflects on the fabric of dominance and diversification in our economic systems and the various country groups that associate with these systems. We have already positioned countries along the three axes of economic systems: HIM, FIM, and SIM, in Chapter 1, Figure 1.3. How does this positioning of countries across systems fare with the observed dominance and diversification tendencies among the countries? In other words, how do agents in the various countries perceive their systems and the positioning of their countries in these systems? The answer to these questions requires an investigation of the variance in attitudes of agents towards the three distinguished settings: the family-household settings, business settings, and the state; and the implications of these attitudes for the system. It can be expected that in countries close to the household intensive economic system, HIM, agents would show preference for strong family ties and a greater role of the family in the agent’s life. Likewise, in a country leaning towards the FIM system, agents are likely to have more trust in business firms in conducting activities, and hence give preference for firms over state in managing the economy. Along the same reasoning, in countries leaning towards the SIM system, agents are likely to have relatively more collective than private needs. They would prefer a greater role for state bodies and a lesser role for business firms in managing the economy and producing the required goods. Of course, due to the diversification tendencies, it can be expected that not all agents will have the same systemic focal point no matter how integrated that system may be. An important source on agent attitudes is the World Value Surveys (WVS). The survey is a compilation of national surveys on values and norms on a wide variety of topics. It started in 1981 and was carried out in 1981–84, 1990–93, 1995–97 and 1999–2004.23 We use the last survey, and where necessary compliment it with the previous survey for missing country data. The WVS contains relevant information relating to the importance of the household family in an agent’s life, as well as information on preferences for business firms contra preferences for state bodies in managing the economy. The concerned question on the household family asks how important is the family, and the answers are ranked into ‘very important’, ‘rather important’ and

Elaborations on the Analytical Framework

47

decreasingly down to ‘not important’. Table 2.2 and Figure 2.1 display the percentage results of the above alternatives for the reported countries; and the results are in conformity with our positioning of countries along the HIM axis. It is recalled that we placed the OECD countries in the FIM corner and the transition

Table 2.2 Importance of household settings: Percentage of responses to varying ranks of importance of the family in one person’s life FIM related countries

Country

SIM related countries

Very Rather important important Country

FIM US+ US Australia Canada

87.7 93.1 95.3 90.2 93.9

10.4 5.7 3.8 8.0 5.3

WE Austria Belgium Denmark Finland France Germany Greece Ireland Italy Norway Portugal Spain Sweden Switzerland UK

85.9 88.5 86.5 87.0 79.6 87.5 81.0 82.3 90.6 89.8 87.8 84.1 85.4 89.4 80.9 88.2

11.8 9.2 9.7 11.1 16.2 10.6 15.4 15.3 7.7 8.6 10.6 14.4 13.4 8.5 16.2 9.6

Japan+ Japan Korea Singapore

90.9 91.3 89.6 91.8

8.0 6.4 10.0 7.7

Developing countries and regions

Very Rather important important Country

SIM Russia

67.9 75.0

13.4 19.0

CSEE Czech Rep. Estonia Latvia Lithuania Hungary Poland Slovakia Slovenia Albania Bosnia Bulgaria Croatia Macedonia Romania

76.9 84.5 67.5 70.5 64.7 88.6 91.5 87.3 81.9 95.9 98.7 82.3 78.4 97.5 84.5

13.5 13.5 27.9 22.1 30.1 9.1 7.8 10.5 14.9 3.1 1.2 14.5 20.3 1.8 12.7

EXSR Armenia Azerbaijan Belarus Georgia Kyrgyzstan Moldova Ukraine

85.2 86.0 84.7 77.7 94.6 87.2 85.0 81.4

12.3 12.0 13.2 18.2 4.3 12.1 12.1 14.4

Very Rather important important

EAP China Indonesia Philippines Vietnam

89.0 76.5 98.6 98.6 82.2

10.5 22.5 1.0 1.3 17.0

SA India Bangladesh Pakistan

93.7 91.9 96.7 92.6

5.2 6.0 3.3 6.4

MENA Egypt Algeria Iran Jordan Morocco

95.0 96.4 94.4 94.1 96.6 93.4

4.2 3.3 4.7 4.5 3.1 5.4

GCC S. Arabia

94.7 94.7

4.8 4.8

SSA S. Africa Nigeria Uganda Tanzania Zimbabwe

94.4 95.2 98.9 91.0 89.6 97.3

3.8 3.0 0.9 6.9 5.6 2.6

LAC Brazil Mexico Argentina Chile Colombia Dominican El Salvador Peru Uruguay Venezuela

90.6 92.6 90.6 90.2 96.4 84.0 85.1 96.6 96.6 82.4 91.3

8.5 6.6 8.5 8.4 2.8 15.5 14.4 2.5 2.2 16.7 7.1

Source, note: Compiled from World Value Survey 1999–2000, at http://www.worldvaluessurvey.org. Results are for national sample surveys, around 2000. The figures for China refer to 1995. The table gives percentage of the responses ‘very important’ and ‘rather important’. The reply ‘not important’ accounts for the residual of a 100 percent. Figure 2.1 displays results for the reply ‘very important’ at the country group level. The country groups average is 89.1, and is indicated by the average line in Figure 2.1.

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Economic Systems Analysis and Policies

FIM

87.7 67.9

SIM EAP

88.9 93.7

SA MENA

95.0

GCC

94.7

SSA

94.4

LAC 0.0

90.6 10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

Percentage respondents reporting family as very important, average dashed line = 89.1 %

Figure 2.1

Importance of household settings: Country ranking of importance of family

Source: Table 2.2.

countries around the SIM corner. In contrast, we placed the six developing regions along the intersecting axis between household and firm intensive economic systems, HIM and FIM, and household and state intensive economic systems, HIM and SIM. This means that there is a greater alignment of the developing regions with household settings. This is not surprising since the development of the three prototypes of economic systems can be postulated as an outgrowth from some common origin, which is by definition the household setting; and in terms of economic development the developing regions are closest to the common origin. Table 2.2 confirms that the developing regions rating of household settings, the family and kinship as very important is higher than the FIM or SIM related countries. Figure 2.1 shows the average line for all countries for this question at 89.1%, with the developing regions above the average and FIM and SIM related countries below.24 The table shows a higher prominence of family settings and family related attitudes in the FIM related industrial economies than the SIM related transition countries, suggesting that firm settings are more accommodative to familial institutions than state settings. Especially in the context of the ex-communist rule in transition countries, the state appears to have specially undermined household settings.25 What are the implications of a strong preference for familial institutions? Alesina and Giuliano (2007) studied the influence of the above indicator of the family importance and related indicators on economic behaviour in a crosssection of 70 countries. They found strong family ties to associate with greater reliance on the family as an economic unit for production and exchange and less reliance on the market and the state as income providers. Furthermore, strong family ties go together with a higher home production reduced labour participation, less geographical mobility, and a larger size of the household. An interesting point of discussion is whether attitudes of agents determine the orientation of the

Elaborations on the Analytical Framework

49

socio-economic system, or that such attitudes are accommodated to the existing socio-economic system. It is likely that both causality chains exist, representing active and passive behaviours of actively oriented agents and passively oriented agents, respectively. The agent mix of the actively oriented agents and the passively oriented agents would then determine the degree of dominance of new attitudes on new facts, and the pace of change. The World Value Survey is relevant in the context of economic systems in another respect. It gives national results around 2000 on attitudes towards the FIM and SIM axes. The set of questions asked that is of specific concern here was the following: {‘How would you place your views regarding the following statements on the following scale?’ The respondent is requested to mark the statements with which he/ she completely agree. There are ten statements numbered 1 to 10 that range from one extreme to the other. For example, 1  Private ownership of business should be increased; 2  ....; 3  .... ; etc ....; 9  ....; 10  Government ownership of business should be increased.} Table 2.3 sums the results of the responses from 1 to 5 as favouring private ownership, and responses from 6 to 10 as favouring government ownership. In countries that we classified as being oriented towards the firm intensive economic system, the dominant response is that favouring private ownership of business. The score for US is 83 per cent, with Western Europe and Japan at 76 per cent and 70 per cent, respectively. In the transition countries, which we indicated as relatively close to the state intensive economic system, the response becomes less favourable to private ownership. In the BCEE group, the preference towards private ownership dwindles to 64 per cent. Countries that were part of the ex-Soviet Union, the EXSR group show an equal preference for public and private ownership at 50 per cent. The majority of responses in Russia are seen to reverse, and favour government ownership, i.e. 55 per cent. Figure 2.2 shows a pattern of diminished preference for firm settings and a rising preference for management of the economy by state settings as one moves from US to Russia. The developing regions show a mixed picture with SSA as the region that favours private ownership of business most, followed closely by SA, MENA and GCC. On the other hand, the majority of responses in EAP and LAC favour state ownership over private ownership. These outcomes can be interpreted in various ways. One way of interpretation is that the private versus public attitude in a specific region is consistent with the respectively dominant FIM or SIM regime in the specific region, as was argued with respect to the developed and transition countries. This is a weak interpretation since the developing regions are undergoing processes of extensive socio-economic change and there is as yet no one economic system type that can be assigned as the dominant regime. This point is explored further in Chapter 6. The other way of interpreting the outcomes is to look at the private versus public attitude as a short-term reaction to disappointments with the occurring

50 Economic Systems Analysis and Policies Table 2.3 Importance of firm and state settings: Pro-firm and pro-state attitudes

FIM related countries Country

% for % for private public Country

FIM US+ US Australia Canada

76 82 83 82 80

24 18 17 18 20

WE Austria Finland France Germany Ireland Italy Norway Portugal Spain Sweden Switzerland UK

76 89 78 83 80 76 78 77 67 54 76 86 71

24 11 22 17 20 24 22 23 33 46 24 14 29

Japan+ Japan Korea Singapore

SIM related countries

70 76 67 68

30 24 33 32

Developing countries and regions

% for % for private public Country

SIM Russia

59 45

41 55

CEEE Czech Rep. Estonia Latvia Lithuania Hungary Poland Slovakia Slovenia Albania Bosnia Bulgaria Croatia Macedonia Romania

64 67 47 58 65 57 55 39 75 79 72 59 70 78 68

36 33 53 42 35 43 45 61 25 21 28 41 30 22 32

EXSR Azerbaijan Armenia Belarus Georgia Kyrgyzstan Moldova Ukraine

50 56 44 62 51 46 37 55

50 44 56 38 49 54 63 45

% for % for private public

EAP China Indonesia Philippines Vietnam

43 34 41 39 57

57 66 59 61 43

SA India Bangladesh Pakistan

60 49 60 72

40 51 40 28

MENA Egypt Algeria Iran Jordan Morocco

55 36 57 56 53 71

45 64 43 44 47 29

GCC S. Arabia

49 49

51 51

SSA S. Africa Nigeria Uganda Tanzania Zimbabwe

62 56 49 76 59 70

38 44 51 24 41 30

LAC Brazil Mexico Argentina Chile Colombia Dominican El Salvador Peru Uruguay Venezuela

47 58 52 52 45 36 42 42 40 56 47

53 42 48 48 55 64 58 58 60 44 53

Source, note: Compiled from World Value Survey 1999–2000, at http://www.worldvaluessurvey.org. Results are for national sample surveys, around 2000. The following definitions hold: (% for private)  accumulated percentage of respondents in the interviewed sample that believes private ownership of business should be increased. Results of responses ranked in terms of five degrees of conviction are summed. (% for public)  accumulated percentage of respondents in the interviewed sample that believes government ownership of business should be increased. Results of responses ranked in terms of five degrees of conviction are summed.

Elaborations on the Analytical Framework

82%

US+

30%

64%

CEEE

36%

50%

EXSR

50%

45%

Russia

55%

43%

EAP

57% 60%

SA

40%

55%

MENA

45%

49%

GCC

51% 62%

SSA

38%

47%

LAC

Figure 2.2

24%

70%

Japan+

0%

18%

76%

WE

10%

51

20% 30% % for private

53% 40%

50%

60%

70% 80% % for public

90%

100%

Importance of firm and state settings: Pro-firm and pro-state attitudes

Source: Table 2.3.

socio-economic changes. For example, in Sub Saharan Africa, South Asia and the Arab countries, a pro-private attitude can be seen as a logical reaction to dissatisfaction with the increasing role and the development performance of the state. In contrast, in EAP and LAC, i.e. China and Brazil among others, the pro-state attitude can be seen as a logical reaction to dissatisfaction with firms and markets in rapidly changing economies with significant displacements. There is another plausible interpretation with a more endurable character. Country groups that tend to have pro-business attitudes were shown to assign a very high importance to familial institutions and household settings, while country groups that favour pro-state attitudes tend to assign low priority to familial institutions. This is generally true for the industrial and transition country groups, and applies also to the developing countries.26 The association at the country group level suggests the presence of a synergy between pro family and pro business attitudes; and an affinity between indifference to familial sentiments and support of pro-state attitudes. Finally, our positioning of countries along the systemic axis recognizes diversification within the dominance tendencies, with respect to FIM and SIM related countries. This is present in out positioning of US closest to the firm intensive economic system, and Japan and Western Europe to the left and right, respectively. This reflects the sharing-inclined economy in Japan, and a control-inclined economy in Europe. Taking an index for 2006 based on ten indicators of firm competitiveness, Table 2.4, left part, shows a greater ability of agents to compete in the US than in Europe, which can be seen as evidence of a more firm intensive economic system in US than in Europe. The indexes show Japan to be closer to

52 Economic Systems Analysis and Policies Table 2.4 Indexes of Firms Competitiveness and State Appropriation (Rule of Law) for FIM and SIM related countries, respectively Firm competitiveness in FIM related countries (a) US 82.4

Rule of law in SIM related countries (b) (10 = best, 0 = worst)

EU

Japan

Russia

BCEE

EXSR

70.9

74.5

3.7

7.2

4.4

Sources: (a) The Heritage Foundation (2000): Index of Economic Freedom, published by The Wall Street Journal and The Heritage Foundation, New York. See also Chapter 3 Table 3.3. (b) Wall Street Journal. The figures are also quoted in Hoff and Stiglitz (2002). See also Chapter 6, Box 6.3.

US than Europe. Chapters 3 and 4 will elaborate more on the diversification tendencies in the FIM country group. Among SIM related countries, Russia was positioned at the core, with former European satellites leaning to firm settings, and the other ex-Soviet republics, especially some Asian, leaning to household settings. This orientation is shown in Table 2.4, right part, which reflects on the extent of institutionalization of the rule of law versus state discretion, or in popular terms, rent appropriation by the state. The Rule of Law Index shows Russia as closest to state appropriation, with the Baltic, Central and Eastern European countries (BCEE) and the Ex-Soviet Republics (EXSR), as more free from state appropriation. The topic is revisited in Chapters 5 and 6.

2.8 Summary and conclusions The distribution of agents in contrasting behavioural settings, such as household, firms, and state settings, and their interactive participation, produce over long periods highly contrasting economic and political systems that coincide with distinct behavioural types. The three systems associate with dominance of households, firms, or the state and are identified as HIM, FIM and SIM. The chapter laid down a micro-macro conceptual framework that is useful for tracing the evolution and the internal consistency of the economic system and the polity towards focal behavioural types and settings. Making use of differing compositions of personal and collective needs, and a conceptual model to trace the mix of needs, the chapter explored the paths of different economic systems since early development that associate with satisfaction of personal and collective needs. The economy–polity configurations of countries like US and Russia are outcomes of firm-intensive and state-intensive economic and political transformations, with overweight of personal and collective needs, respectively. The chapter compared the structure, conduct, and performance of the three economic systems. Economic performance in the state intensive system, SIM,

Elaborations on the Analytical Framework

53

being subjugated to the state polity, is likely to be inferior to economic performance of the FIM, which is oriented towards economic objectives, granted that firm competition is not hindered by monopoly power. However, in FIM the financial market is inherently less transparent than the real market and is a cause of uncertainties and instabilities that cut in the economic performance of FIM. Financial turmoil is less common in SIM. A preliminary discussion of the future configuration of economic systems pointed out to the inevitability of assigning greater roles for sharing and persuasion mechanisms in coordinating future systems. Finally, the chapter reviewed agent attitudes on economic systems by country groups. The World Values Surveys gives results on affiliation to households that are consistent with the positioning of country groups along the HIM axis. Differences among countries in attitudes towards business (personal) versus state (collective) solutions in the provision of goods and management of the economy are shown to support our positioning of countries between the firm intensive system, FIM, and the state intensive system, SIM.

3 The Firm Intensive System: Economic Challenges and Agent Responses in US, EU, Japan

3.1 Economic principles of a pure firm intensive economic system Historically, the rise of economics as a science about two and a half centuries ago in Europe coincided with the beginning of the firm intensive economic system (FIM). This coincidence is not an accident. It is a natural outcome of scientific reflection on emerging realities. While economics started as, and continues to be, the study of transformation processes that result in a value added at a lower cost, economic thought usually focuses on profit maximizing firms and allied markets as the main behavioural economic settings. It is in these firms and markets, where most transformation processes take place, where economic agents inhabit most and where economic behaviour is displayed, learned and spread by the agents to other settings. The industrial revolution in Europe made an end to home production as a major economic setting and opened the way for firms and markets to dominate the economic system. The firm intensive system can be described as one in which profit maximizing firm settings are the focal points. Firms, led by entrepreneurs, invest capital, hire labour and transform goods into higher values at lower cost, and exchange the goods in allied markets for real money – that is used to realize more exchanges. Firms strive towards maximization of profits, and agents labouring in the firms take over this economic behaviour and follow suit by maximizing their utility in their role as consumers. About a century ago, European and American economists started theorizing on the properties of this economic system in its purest form. They specified the conditions and presumptions, which must be satisfied by producers/firms and consumers/households in a model of the perfect market economy to achieve economic efficiency in the sense of Pareto optimality.1 Where there is a deviation from Pareto optimality, and given their goals, firms (and other agents), will reallocate and act to remedy the situation, and achieve more gain at lower cost. If for various reasons, firms (and other agents) cannot coordinate their actions purposely, they may call on collective action in the form of state intervention, which will mean that the government enters the stage as an explicit outsider. 54

Firm Intensive System: Economic Challenges 55

Economists have studied (a) ways in which real market economies deviate from the model of the perfect market economy, the response of firms, households and government to these deviations; and (b) how state intervention take place and the consequences of these state interventions for the economic system. This and the next chapter are guided by the insights gained in (a) and (b). This chapter will focus on issues relating to (a), the next chapter will deal with (b). Together, the two chapters aim at displaying the mechanisms and outcomes of the firm intensive economic system and the accommodation of the state in such a system. Our approach to examining the firm intensive economic system and its evolution is best done along the lines of considering the firm intensive system in its pure form and proceed to examine market failures and subsequent state interventions. We shall assess the FIM in terms of these issues, and in that order. Such an assessment is helpful in determining how responses of firms and government combine and evolve to the mixed forms observable in industrialized countries. We shall use examples from national economic systems that are closest to representing the firm intensive economic system; these are the US, the EU and Japan. We recall that while there are major differences between the three national economic systems they share together a primary role of the modern firm in shaping their economic systems. In relative terms, the US stands for the context where the role of the modern firm and free markets are paramount in determining the character of the economic system. In comparison, the EU allows for a greater influence of collective features typical of state settings, while the Japanese economic systems manifest elements of sharing typical of kinship settings. In this section, we review the economic principles of the pure firm intensive economic system. The firm intensive system can be seen to consist of firms (and individuals) who are motivated by commercial self-interest. The firms maximize profits subject to technological and budget constraints. Individuals follow suit and maximize their utility subject to budget constraints, which are the incomes the individuals earn from the firms for work done in these firms. The firm intensive system relies on the competitive price mechanism, which is characterized by indirect exchanges between many independent sellers and many independent buyers. The firms are sellers and buyers of output and input, respectively. The individuals can be owners and hired labour of firms (these being the input of firms), and buyers of consumption goods (this being an output of firms), respectively. All agents take note of the relative prices at which the market settles for competing goods, and agents react by buying or selling, without getting involved in a direct exchange. There are no exchange costs in place or time. If all agents (firms and individuals) behave competitively, there will be free entry and exit, there will be no barriers whatsoever to exchange, all agents will be price takers at the same price for the same commodity, and a simultaneous equilibrium will be obtained by all agents in all markets – hence the term general equilibrium. For example, Figure 3.1 shows how the maximizing firm x decides on uses of labour l in the production of commodity i (or j). The firm employs labour to the

56 Economic Systems Analysis and Policies

Pi MPi1 (marginal value)

wage rate w0

l0 Figure 3.1

labour input

Firm decisions on use of factors

x3 Quantity i

x2 x1

Qi Pj Pi Qj Figure 3.2

Quantity j

Firm decisions on production of goods

point where the value of marginal productivity of the worker MP equals the wage rate he faces.2 Equation (1) obtains when all firms, x and y, so that x

y

MP i l = MP i l =

Pl Pi

(1)

Figure 3.2 deals with the choice of firm x between production of commodities i and j. Firm x faces profit lines x1, x2, x3 in an increasing order. The slope of these lines is given by the relative market prices for the two commodities. Firm x will choose an allocation between commodity i and j where the highest point is attained. The firm will equalize the marginal rate of transformation MRTij to the relative prices P of competing commodities i and j he faces, giving equation (2). The same applies to firm y. y x MRT i j = MRT i j =

Pj Pi

(2)

Firm Intensive System: Economic Challenges 57

Similar figures can be drawn for individual consumers, making use of their marginal rates of substitution MRS, to demonstrate how they determine efficient choices in consumption between commodities i and j, and between consumption and work, all occurring under the same prices mentioned above. It can be shown that under perfect market conditions the marginal rates of transformations within and among firms and the marginal rates of substitution within and among households will coincide to give equation (3).

MRSija

MRSijb

...

MRTijx

MRTijy ....

(3)

In the prefect market economy, market prices carry significant information. Each commodity price would reflect the buyer’s marginal valuation relative to other commodities. Moreover, the price of a commodity must be equal to its marginal costs. Each price, therefore, expresses the lowest possible costs that society is ready to sacrifice for the commodity concerned. Furthermore, the market prices are equilibrium prices which go with an equilibrium position from where it is impossible to make a change without making someone worse off, hence competitive markets are Pareto optimal. The First Theorem of Welfare Economics thus states that if the marginal conditions in equation (3) will hold then the resulting competitive market equilibrium is Pareto optimal. Guided by equilibrium prices the self-interested decision of the economic agents lead to a social optimum in the Paretian sense. This is another way of viewing Adam Smith’s notion of the invisible hand mechanism. The optimal performance of the perfect market economy centred on firms depends on the fulfilment of four presumptions; that is, absence of indivisibilities, uncertainties, externalities and collectivities. There are technical and behavioural dimensions to these presumptions. The optimal performance of the market economy would require fulfilment of the technical presumptions as well as absence of behavioural bias in the four directions. The presumptions can be stated as follows. (1) Consumers’ preference ordering should satisfy non-satiation, continuity and strict convexity. Producer’s technology sets should satisfy boundedness, regularity and strict convexity. Factors of production, labour and capital are homogeneous and divisible. Commodities produced are homogeneous and divisible. Hence, there are no indivisibilities. (2) Perfect and same information given to all consumers and producers; no uncertainties. (3) The economy does not encounter external economies or diseconomies in consumption or production. Preferences and utilities of agents are independent of each other; no externalities. (4) All potential production of commodities and use of factors have been considered in the optimal allocation. Preferences and utilities of agents are genuinely revealed in market transactions; no collectivities. Non-fulfilment of underlying presumptions in the real world results in inefficiencies that may be remedied by firms and market solutions and/or state interventions. The model of the perfect market economy contains presumptions that are mostly difficult to maintain in the present-day market economies. Such situations are often called market failures, which possibly call for corrective market

58 Economic Systems Analysis and Policies

responses and/or state interventions. Table 3.1 is a summary presentation of failures and responses. Because of technical barriers the four presumptions stated above fail to be realized in all real economic systems; hence, the label of market failure used by many, exaggerates the market context of the failure. Notwithstanding, imperfections in the profit maximizing behaviour of firms may aggravate the technical barriers. For example, not only does non-convexity create barriers and pave the way towards monopoly, but also monopolistic behaviour of firms may lead to intensifying indivisibilities in the production function. Similarly, while uncertainty exists on technical grounds in any economic system, asymmetric informational behaviour of firms in a market economy increases uncertainty faced by other firms. Again, while externalities exist on technical grounds in any economic system, it is likely that the emphasis on private benefits and costs in the market economy aggravates the gap between social and private benefits and costs and, with the presence of interdependent behavioural patterns among agents, will moreover strengthen the recurrence of externalities. Finally, the problem of collectivities is aggravated by non-revealed and intentionally distorted preferences in the context of free-riding behaviour. There is a Second Theorem of Welfare Economics that states that any Pareto optimal state is equilibrium for some initial distribution of endowments. It was thought at one time that if the initial distribution is sub-optimal, this could be easily reset ex-ante by lump-sum transfers without distorting work incentives. Mirrlees showed that this is not feasible. Then Kaldor-Hicks introduced the compensation principle, by which gainers compensate the losers from a gain made by the gainers. However, this compensation mechanism, which is ex-ante, is not operational. Arrow and Sen have shown furthermore the impossibility of the Paretian liberal. Bergson has shown, at the other end, the necessity of assuming the benevolent ruler in a discretionary regime as the way out. 3 In which ways can the actual working of the firm intensive economic system be interpreted to resolve the public choice dilemma in such a system? The economist’s rationalization of the system’s consistency tends to see the real world as consisting of a benevolent ruler who reviews the income distribution situation at the end of the year and resets this ex-post, giving due consideration to the perception of a desirable initial distribution and unintended differential outcomes during the year. Transfers are then affected in consistency with the resetting. If the resetting is well-done and duly implemented, then the outcomes of the firm intensive economic system can be described to be in harmony with the desired equity perspectives, even though this happens with a lag in time. And should the ruler be non-benevolent, it can be argued that via the parliamentary process his replacement by a benevolent ruler who could correct the distribution ex-post, and perhaps also in real terms, is again a matter of more time lags. Reasoning along the above lines, the regular and lagged implementation of ex-post redistribution policies in industrialized market economies can be seen as remedies that fit well within a general framework of applied welfare economics

Firm Intensive System: Economic Challenges 59 Table 3.1

Problem areas leading to market failure, and the subsequent responses of firm and state

Problem areas

Manifestations

Resulting market failures

Firm responses

State responses

Monopoly and imperfect competitive behaviour in a static context

Increasing returns to scale show up in indivisibilities in production, non-competitive behaviour of producers, market power taking, price setting, entry barriers etc.

Natural monopoly and imperfect competition: deadweight loss managerial slack rent seeking like practices

Contestable markets

Nationalization, privatization, regulation, and deregulation. Legislation on dominant position and restrictive practices

Monopoly and imperfect competitive behaviour in a dynamic context

Weak incentives for firms to invest in technology when benefits are nonexcludable.

Retarded growth

Joint ventures

Technology policy with focus on innovating firm and/or on perspective technology

Imperfect information

Markets do not clear over time because of coordination failure, mobility costs etc.

Coordination weak under uncertainty Discouraged exchange Deadweight loss

Future markets

State legislation and information banks to clear markets and stimulate exchange

Distorted information

Asymmetric informational behaviour

Adverse selection, moral hazard, market barriers

Signalling

Governance policy: transaction restructuring

Interdependence of individual utilities

Diverging private interest behaviour avoids realization of positive externalities

Social and private benefits diverge leading to deadweight loss

unitization

Example of positive externality: industrial policy

Interdependence of individual utilities

Diverging private interest behaviour accentuates negative externalities

Social and private costs diverge leading to deadweight loss

unitization

Example of negative externality: environmental policy

– Non-rivalry and non-excludability – Free riding

Unattended public goods and merit goods

Cooperative provisions

Social provisions insurance schemes

No consensus Compensation principle not operational, not neutral

Trade-off efficiency and equity unresolved

Fair pay and provisions for income maintenance

Ex-post distributional policies Continuous necessity to revise distribution of income and wealth

Indivisibilities

Uncertainties

Externalities

Collectivities Genuinely revealed preferences Distribution No consensus over socially desirable initial distribution of endowments

60

Economic Systems Analysis and Policies

for the firm intensive economic system. The presumption of a benevolent ruler, which may not materialize in the short run but is more certain through democratic processes and substitution of governments in the long run, is a basic condition for resolving the dilemma of public choice in these economic systems. A stylization of market failures showing unfulfilled assumptions, resulting manifestations and problems as well as areas of self-regulated market corrections and areas of public policy are found in Table 3.1. Of course, these aspects are not always symmetrically encountered in real life as the table may suggest. For example, competition policy is in reaction to imperfect competition and imperfect information, but overlaps with policies relating to monopoly, technology and industry. Even though the main thrust of industry policy lies in externalities, it involves other market failures. Environmental policy is mostly related to externalities, but contains collectivities as well. While health and education sector policies are responses to imperfections in competition, information and externalities, they represent collectivities. It is also important to note that while the table may give the impression that firm responses and state intervention stand opposite to each other as competing alternatives in remedying market failures, the usual case in FIM is that of a cooperation in which firms and state act in concert. In this cooperation, behavioural expectations consistent with intrinsic firm settings dominate over those typical of intrinsic state settings. Furthermore, as will be shown later, in most cases of market failure firm responses have overshadowed state interventions. In FIM, state interventions in firm economics are constrained to a minimum and subjected to various juridical and parliamentary controls. The following sections will treat each of the five market failures in Table 3.1: indivisibilities, uncertainties, externalities, collectivities and distribution, Sections 3.2 to 3.6, respectively. In each section we review the problem, and examine and assess the response of firms in remedying the problems and state intervention to resolve the problems. We make use of FIM related country data to illustrate the problems and illuminate country differences. The chapter ends with summary and conclusions.

3.2 Indivisibilities: Problems and firm-state responses 3.2.1 Problems Conditions of perfect competition require free entry and exit of firms leading to a large number of companies producing competitive goods. Through free entry and exit, a situation is created in the long run where price of a good is equal to the average total cost, so that monopoly profit is eliminated. In the real world, technological indivisibilities in some vital industries persist and translate in increasing returns to scale (or decreasing costs) so that average total costs of the firm are decreasing over a large output interval. If demand is small in relation to the output volume produced by the firm the activity will end up with one single firm offering the minimum costs for each desirable output volume. Even if a natural monopoly does not arise, the presence of indivisibilities

Firm Intensive System: Economic Challenges 61

gives an advantage to incumbent firms, which could restrict entry, promote noncompetitive practices and result in imperfect competition. Because of indivisibilities the incumbent firm is able to fix a high price and receive a monopoly profit. Aspiring firms cannot enter because there is little space for more producers. This creates tension between incumbent and aspiring firms. Also existing firms that deliver or receive inputs from the monopolistic firm may not be content with lack of competition. Moreover, monopolistic practices have deadweight loss next to technical inefficiencies. Hence, there is mounting pressure to restrain monopoly power not only from business but also from the whole community. Because of the inability of the participating agents to act collectively towards that end, the government is called upon to render regulatory and monitoring services towards promoting competitive practices. The discussion below treats the static and dynamic consequences arising from indivisibilities, namely, natural monopoly and imperfect competition in the static context; and technological bias and growth limits in the dynamic context. We shall examine firm responses and state interventions relating to these contexts. 3.2.2 Natural monopoly and imperfect competition 3.2.2.1 Natural monopoly Natural monopoly appears when economies of scale are important. With huge economies of scale there is only one single producer. Familiar examples of monopolistic industries with a significant degree of economies of scale are telephone, postal and railway services, and public utilities such as water, gas and electricity. This is also true in particular for certain services sold on a limited local market. In the case of natural monopoly, the very nature of the decreasing cost of technology precludes perfect competition. With a natural monopoly, average costs are declining, and marginal costs are below average costs. Hence, if price were set equal to marginal cost, as in the case of perfect competition, it would be less than average costs and the firm would be losing money. If the community wanted a natural monopoly to produce at the point where marginal cost equals price, it would have to somehow support the industry to offset these losses up to the point of nationalizing the industry and fully regulating it. The opposite alternative is that the industry is privately owned and run but that the production and price of the product are regulated in some degrees. These two alternatives, nationalization versus regulation, are found in various combinations in FIM countries. The nationalized industries are basically the part of government production that covers the provision of private goods for sale through the market. Thus the nationalized industries in a typical country include railways and electricity, but not the army or the provision of education or housing, which are not sold commercially. There are several reasons why nationalized industries were entrusted to state ownership in the past. As was stated above, the first and foremost is the natural monopoly problem emanating from indivisibilities. The presence of large capital costs and economies of scale turn some industries into natural monopolies such

62 Economic Systems Analysis and Policies

as electricity and railways. As in these industries marginal cost lies below average cost, they cannot meet the social efficiency criterion that requires that prices be close to marginal cost for otherwise they will incur losses. Private investors are furthermore discouraged to enter these industries. An entrant would have to enter on a large scale and incur costs comparable with those of the existing firm, and this is unlikely. The entrant worries too that should it enter, the existing firm will compete sufficiently keenly so that what promised to be high profits will disappear. Entry is even less inviting when there are large sunk costs: if the existing firm does compete and the entrant is forced to exit, the entrant will be unable to recoup much of its investment. Since private shareholders cannot be expected to initiate such enterprises, public ownership and/or public management may then become inevitable, and they are eventually endorsed by existing and aspiring firms. Nationalization has been supported for other reasons than indivisibility, such as externality. This is the case when the social gains from an economic transformation, i.e. air, road or rail network exceed the private benefit for which direct users are prepared to pay. Furthermore, some public services can be seen as merit goods that should be made available to all.4 Even though inescapable, state ownership of monopolistic industries is looked upon with scepticism in FIM. Several problems accompany nationalized industries. It is hard to ensure that the industry does minimize costs. The regulatory public body has the difficult task of trying to ensure that the management of the natural monopoly is as efficient as possible. This is a problem of information access and mechanism design between agent (management) and principal (ministry). The managers of nationalized industries often lack adequate incentives to cut costs and modernize vigorously, particularly given the fact that government is frequently willing to subsidize the industry when it loses money. In addition, the nationalization of natural monopolies subjects them to a number of political pressures and employment interests from regional and central politicians. Innovating firms, driven by a genuine demand by the business community to eliminate indivisibilities and minimize state responses, have responded in the past two decades with introducing new advances in production divisibility and distribution technology. The innovations succeeded in introducing contestable markets and enhanced potential competition. Transport and communication are typical examples of contestable markets where entry and exit is relatively cheap. In many case of contestable markets, the threat of entry is sufficient to keep prices from rising above average costs. Thus, potential competition is all that is required for FIM to operate efficiently, not actual competition. The technological innovations, directed towards reducing indivisibilities, have led in FIM countries to a gradual withdrawal of state ownership, management and regulation of economic activity, and the further enhancement of deregulation, privatization and competition. In addition, recent technological advances in telecommunications and energy supplies demonstrate that the national markets for any of these services are linked worldwide and are sufficiently large enough for three or more suppliers. This has

Firm Intensive System: Economic Challenges 63

lead to more drives in the past two decades towards privatization of nationalized industries, and the greater enforcement of the FIM regime. In countries where privatization programme of nationalized industries were launched, and firms were tendered to take over the natural monopolies from the state, both parties have collaborated in developing a consistent and phased privatization strategy, followed by liberalization and greater competition within the national market and across the border, as well as adequate incentives and monitoring provided by regulatory public agencies.5 This was and is necessary in view of the diverse objectives, conflicting interests and specific restrictions involved. It is worth mentioning that there are empirical investigations regarding the choice between nationalization and privatization. These focus on determining whether public or private sector firms are more likely to attain the lowest possible cost curve. An evaluation of the results of 30 studies conducted in different industries in different countries by Yarrow (1985) lead to the general conclusion that there is not much difference in cost between government enterprises and large private corporations, particularly when both are subjected to the same degrees of competition and regulation. For particular cases, it is difficult to determine empirically how much more or less efficient the government is as a producer than if the same company is run by a private corporation. Many economists agree that the key issue is not the difference in ownership but rather how effective the monitoring of management and the forces of market competition. It is generally known that privatization leads to a better performance if it drives managers to act in more transparent and competitive ways. In the regulation alternative the dominant firm persuades other firms, and the community at large, to accept the firm as the sole owner of the natural monopoly, with the condition of entrusting the government with the role of ensuring that price is kept at the lowest possible level, commensurate with the monopolist’s obtaining an adequate return on its investment. In other words, the regulator tries to keep price equal to average costs – where average costs include a ‘normal return’ on the firm’s capital, on what the firms owners have invested in the firm. If the regulators are successful, the natural monopoly will earn no monopoly profits. From the start, prospects for the regulatory system in FIM were constrained by two levelled objections. The first objection is that regulations often result in inefficient practices. For instance, prices are set so that firms obtain a ‘fair’ return on their capital. For the firms to make the highest possible level of profit under the circumstance, firms respond by increasing their amount of capital as much as possible, which can lead to too much or too costly investment. Or, the structure of prices is set so that some groups, often businesses, may be charged extra-high prices to make it possible to subsidize other groups. Furthermore, firms’ incentives to innovate are greatly attenuated if every time they succeed in lowering costs, the regulators quickly force them to lower their prices as well, giving all or even most of the benefits to consumers. This problem is exacerbated when regulators require the shareholders to absorb all the costs of unsuccessful attempts at

64

Economic Systems Analysis and Policies

cost reduction. More recently, the problem has gained recognition and utilities are increasingly permitted to retain much of the increased profits they obtain from improved efficiency, at least for a period of a few years. The second objection relates to regulatory capture, which implies that the regulator gradually comes to identify with the interests of the company it regulates. Regulators tend to be pulled into the camps of those they regulate, so that they give way to bribery, corruption and lobbying. Regulators depend on executives of the regulated industry for the information necessary to regulate the industry, and tend to develop personal friendships with them. Regulatory agencies – the principal – come to rely more and more on the experts, expertise and judgement of the regulated industries – the agent. Furthermore, there are instances in which regulators who show enthusiasm towards a particular industry are promised and get good jobs in that industry after leaving government service. The two objections on the regulation alternative gained momentum in US, EU and Japan in the past three decades, paving the way for a deregulation process. Deregulation focused on industries such as airlines, railroads and trucking, where there were thought to be, at most, limited increasing returns to scale. It sought to distinguish between parts of an industry where competition might work and parts where competition was unlikely to be effective. More recently the telecommunications industry has undergone the same fate and the sectors of railways, electricity and water are under discussion. What is the country experience in the FIM context? Whereas European countries tended to acquire public ownership of assets of natural monopolies, US handled the same problems through public regulation of industries whose assets were left in private ownership. Regulatory agencies set prices and specify quality and quantity of output. Hence, when countries concluded that the public sector was too involved in the economy, the initial policy priorities differed in Europe and US. In Europe, privatization came first and deregulation later. Having few nationalized industries, the US emphasis was on deregulation, starting with airlines in 1978. Empirical investigations of the economic effects of regulation preceded those of deregulation reflecting the historical path of policy orientations in most countries. Joskow and Rose (1989) offer a comprehensive review of the methods used and results obtained on the economic effects of regulation. As the term economic regulation covers many different types of control with a variety of objectives, they found the nature and magnitude of regulatory effects to vary substantially depending on the structure of the regulatory process, the industry examined and the economic environment. Several common themes emerge, nevertheless. The ‘public interest’ model is not borne by the regulation effects, but ‘producer capture’ models are seen to be too simplistic to account for the obtained picture. The structure of prices and revenue in public utilities reflect more political than economic efficiencies. And, regulation tends to increase costs and lower service quality. Winston (1993) provided empirical evidence on the economic effects of deregulation in US. Winston found for nine sectors in US mainly over the 1980s, and in

Firm Intensive System: Economic Challenges 65

Box 3.1 Changing patterns of nationalization and privatization in FIM countries: 1980–2005 US policy tended to keep ownership of infrastructural activities in the hands of the private sector, but regulate it. In US local utilities, for instance, remain private, but their rates are regulated by the individual states. At the national level, federal agencies regulate interstate telephone services and prices charged for the interstate transport of natural gas and oil. In contrast, European countries were more for nationalization of infrastructural activities. The following figures show for 1980 the scores of the extent of nationalization/privatization for 11 infrastructural industries that are characterized by high indivisibilities. The figures show also the changes in these scores by 1990 and around 2000. An average score is calculated in the last column. The average for US in 1980 was .14, falling down in 1990 to .09, and in 2000 to practically zero. Canada follows US closely. The average score for European countries in 1980 was about .74, and falling down in 1990 to .61 and in 2000 to .28. UK was the most forthcoming in terms of privatization Japan scores closer to US than Europe. Korea is inclined to follow a similar course as Japan. At the other extreme end by way of comparing, scores for non-FIM related countries such as Russia, China, or India for the reported infrastructural activities are often between 3/4 and 1.0. Telecommunication

Electricity

1.0 3/4 1/2

0

1/4

1.0

1/4

1.0

3/4

0

3/4

France 1980 Changed by 1990 Changed by 2005

1.0

1.0 1/2 0

Germany 1980 Changed by 1990 Changed by 2005

1.0

Italy 1980 Changed by 1990 Changed by 2005 Netherlands 1980 Changed by 1990 Changed by 2005

1.0 0

0

Sweden 1980 Changed by 1990 Changed by 2005

1.0

1.0

UK 1980 Changed by 1990 Changed by 2005

1.0

1.0 0

Japan 1980 Changed by 1990 Changed by 2005

1.0

Korea 1980 Changed by 1990 Changed by 2005

1.0

Country/year

Post

US 1980 Changed by 1990 Changed by 2005 Canada 1980 Changed by 1990 Changed by 2005

Gas & Rail- AirShip water Oil Coal ways lines Motors Steel Building Average 0

0

0

1/4 0

0

0

0

0

.14 .09 .05

0

0

0

3/4 1/2 0

3/4 1/2 0

0

0

0

.34 .30 .14

1.0 3/4 1/2

nr

1.0

1.0

3/4

1/2

3/4

0

3/4

0

1/4

0

.80 .67 .35

1.0

3/4

1/2

1/4

1/4 0

0

1/4

0

0

1/4

1/4

.59 .55 .14

1.0

1.0

3/4

1.0

3/4 1/2 0

3/4

.83 .80 .50

0

1.0

0 1.0

0 1.0

1.0

0

1/2 1/4 0

nr

nr

1.0

1.0

1/4

1/2

0

1/4 0

0

.67 .61 .25

0

1/2

0

3/4

3/4

nr

nr

1.0

3/4 0

1/2 1/4 0

1/2

1.0

nr

nr

1.0

1/2

0

3/4 1/2 0

3/4 0

.72 .69 .33

1/4 0

1.0 1/4 0

1.0

3/4 0

1/2 1/4 0

3/4 1/4 0

1.0 1/2 0

.84 .32 .09

0

1/2

0

1.0 1/4 0

1.0 0

1.0 0

0

0

nr

0

3/4 1/4 0

1/4 0

0

0

0

.30 .12 .10

1.0

3/4

0

nr

1/4 0

1.0

0

0

3/4 0

0

.48 .38 .28

0

0

Source, note: Figures for 1980 are from The Economist Intelligence Unit (EIU). Figures for 1990 and 2005 are the result of updating done by I. Gurkov and S. I. Cohen undertaken in 1996 and 2007 at Foundation for Economic Rotterdam and Erasmus University Rotterdam, on the basis of data from EU, OECD, World Bank, and industry study reports from EIU. Extent of nationalization  1.0, ¾, ½, ¼. Fully privatized  0. nr  not reported.

66

Economic Systems Analysis and Policies

conformity with economic theory, lower prices and significant gains to consumer welfare as a result of deregulation. Other results are price variations that arise from cost and competitive considerations. Several important improvements in provided services also occurred, especially in airline, road and motor travel; and in telecommunications. 3.2.2.2 Imperfect competition Although imperfect competition can take different forms in different markets, the origin of imperfect competition lies in the first place in the possibility of reaping an advantage from production indivisibilities; i.e., the presence of some economies of scale or scope. As most industries operate under less than full capacity they are able to set a market price that is higher than marginal costs. The advantage will not be as permanent as in the case of the monopolist but may be just sufficient to serve as a barrier for entry, which can be further substantiated by non-competitive behavioural practices such as predatory pricing or cartel formation. Seen from the point of view of competing firms non-competitive practices by monopolistic firms limit the gains and perspectives of the competing firms. Seen from the community viewpoint the results are a restricted output with a higher price, managerial slack, and rent seeking like practices. Therefore, many participating agents have an interest in mobilizing the state to restrict imperfect competition. This section reviews the effects and the remedies. We shall examine first the restricted output effect. A perfect competitor will accept market price equal marginal cost and the result will be Q0 of output in Figure 3.3. A monopoly that maximizes profits produces and sells a volume of output at which marginal costs and marginal revenue coincide, leading to a market price above marginal costs. This means that the output Q1 will be less than optimal in a competitive market. The shaded area in Figure 3.3 will then express the deadweight loss. The reduction in output and the consequent higher prices makes the owner of the monopoly better off (than he would otherwise be) and makes consumers worse off. Consumer surplus is cut down and producer surplus is increased. There can thus be a large transfer bias of purchasing power from consumer to the producer.6 It is difficult to quantify precisely how much worse off society as a whole is as a result of the deadweight loss and the transfer bias. Lower production levels mean less use of society’s resources within an industry. Thus resources that the monopoly might have used are deployed elsewhere and production of other goods increases. From society’s point of view the cost of the monopoly’s reduced output is only the net difference in the value of how these resources are used. There may be as a consequence a significant production shift from one sector to another with unknown transfer effects. Managerial slack refers to the situation where monopolistic firms are insulated from the pressures of competition there is a lack of incentives to economize resulting in a loss of efficiency. In the absence of the discipline provided by

Firm Intensive System: Economic Challenges 67

Price MC

a P1

b

c e

P2 d

D MR Q0

Q1 Figure 3.3

Quantity

Deadweight loss from restricted output

Price

MC0 MC1

D MR Q1 Figure 3.4

Q0 Q2

Quantity

Deadweight loss from managerial slack

competition, resources are often not utilized efficiently. The discipline provided by competition limits the extent of managerial slack. High profits and other consequences of limited competition can be expected to give rise to a wasteful use of available resources and hence to an unnecessarily high level of production costs. The result is that the marginal costs curve MC0 in Figure 3.4 may turn out to be too high. On the contrary, in a situation of active competition the marginal costs might be reduced to the level indicated by the MC1 curve. The monopoly would thus lead to a second form of efficiency loss as shown by the shaded area in Figure 3.4 (reduced by the costs, if any, for reorganizing production). Figures 3.3 and 3.4 imply that the total efficiency loss from monopoly behaviour will equal the sum of the shaded areas in both figures. The empirical evidence of the size of the efficiency losses from restricted output with higher price and managerial slack is both fragmentary and open to criticism. It is sometimes argued that the first effect - underproduction due to monopolistic pricing policy – is of no practical importance. The efficiency loss that stems from this effect, it is suggested, amounts to much less than one percent of the value of the GNP. It is clear, however, that even small percentages of the GNP in a long

68

Economic Systems Analysis and Policies

run context might be important from a policy point of view. It is often assumed, however, that the loss from limited competition is due primarily to the second effect of the managerial slack. The association between monopolistic practices and low growth is not fully established, however. While competition motivates firms to develop new products and less expensive ways of producing goods, a monopolistic firm, by contrast, may let the profits roll in, without aggressively encouraging technological progress. Nevertheless, there are cases where monopolists have pushed hard for technological progress. The issue is controversial in the sense that a large firm may be more able than a small one to invest in R&D, build up cost advantages of economies of scale and end up with a lower MC curve than otherwise in a competitive market. Rent seeking like practices are situations where competing firms take various measures to improve their chances of winning the contest for the monopoly position.7 The cost of these measures might be quite large. For example, the individual company would obviously be willing to accept costs, if necessary, all the way up to the level of the expected value of future monopoly profits, if measures taken would guarantee victory over its competitors. In particular, society loses when monopolistic firms devote resources to obtaining or maintaining their monopoly position or deterring entry. In competitive markets, the profits earned by a company would ordinarily serve to encourage competitors to enter the business. However, in a non-competitive setting, rent seeking firms can use entry-deterring devices to discourage such entry, and make payments to lobbyists and politicians to maintain regulations that restrict competition so that they can keep their profits high. These lobbying and political activities are, for the most part, socially wasteful. The waste from rent seeking like practices can be much larger than the loss from the restricted output and managerial slack. While technological indivisibilities are a primary cause of failures of competition in the economy, other imperfections are the result of sharp business practices that deter the entry of competitors and promote collusive behaviour among the firms in the industry. Just as with natural monopolies, it was seen above that this restricted competition results in higher prices and lower output than would prevail under monopolistic competition, managerial slack and rent seeking like practices. Competing firms, as well as the community as a whole, would gain if dominant position legislation and restrictive practice legislation were monitored by the state. We review below these two state interventions. Dominant position legislation becomes applicable when one firm or group of firms controls, say, one-third or one-quarter or more of a market. A monopolies and merger commission, MMC, is asked whether the monopoly or merger at hand is acting against public interest, i.e. is not against (a) promoting effective competition, (b) interests of consumers and users, (c) reducing costs and (d) raising quality. If it does and is accepted as such by parties concerned, then negotiations are started which would lead to actions to curb the monopoly. In general, dominant position laws are particularly concerned with horizontal mergers, that is, with competition within a market. These are distinguished from

Firm Intensive System: Economic Challenges 69

vertical mergers, in which a firm buys a supplier or a distributor, amalgamating the various stages in the production process within a firm. In practise, the question of whether a firm is too big is usually put as ‘What is the size of the firm relative to the market?’ Thus, the debate centres on the question of defining the relevant market. One generally talks of the market for steel or the market for aluminium. But when the government sets out to enforce a policy of competition within a certain market, it must have a concrete way of defining that market. In general, the problem of defining markets and a firm’s market power is related to two factors: the concentration of firms in the industry and the extent of product differentiation. Regarding firm concentration, respect to industry concentration policy analysis in the past was done in terms of concentration measures at the national level. More recently, international trade has increased in significance appreciably, and this has affected defining markets and measuring the extent of competition in product markets. Today, the degree of competition in a market must be assessed from a global viewpoint, rather than looking simply at how many firms produce a good in the country. Regarding product differentiation, while all firms that produce the same good and sell in the same location are clearly in the same market, when the goods produced by different firms are close but imperfect substitutes, there may be problems of defining the boundaries of the market. How do the courts work in practise? First, in defining market boundaries courts consider the extent to which the change in prices for one product affects the demand for another. If an increase in the price of aluminium has a large positive effect on the demand for steel, then steel and aluminium may be considered to be in the same market, the market for metals. Second, if a firm can raise its price, say by 10 per cent, and lose only a relatively small fraction of its sales, then it is ‘large’; that is, it has market power. (In a perfectly competitive market, a firm that raised its price by 10 per cent would lose all of its customers, so this is a natural approach to measuring the degree of competitiveness in the market.) Furthermore, the law sees to it that before one large company can acquire a competitor or merge with another, it must convince the government that the acquisition would not seriously interfere with competition. Dominant position legislation has a history that determines its evolution. Concern about business size and related manipulations has first led to the enacting of antitrust policies in USA as far back as the Sherman Antitrust Act of 1890. This outlawed every contract or conspiracy in restraint of trade or commerce. The Clayton Act supplemented the Sherman Act in 1914, which forbade any firm to acquire shares of a competing firm when that purchase would substantially reduce competition. The act also outlawed interlocking directorates among competing firms, on the presumption that they would naturally lead to reduced competition. These anti-merger provisions were further strengthened in 1950. Similar but less restrictive legislation started in Europe after the Second World War. Evaluations of past policies in developed economies show that the policy trend has been shifting towards favouring mergers, this under an increasing understanding that government intervention should be left to a minimum as

70 Economic Systems Analysis and Policies

market behaviour is more efficient in the long run and is constantly expanding in a global economy. Furthermore, in much country legislation it is not dominance but its abuse that considered as incompatible with the spirit of dominant position legislation. Restrictive practice legislation. Another permissible intervention by the state in the firm intensive economic system is to limit restrictive practices between firms and their distributors or suppliers which may take such forms as tying, exclusive dealing, description (quantity and price setting) and price discrimination. In many OECD countries, restrictions accepted by two or more parties with regard to the above aspects have to be registered and are to be referred to a Restrictive Practices Court, RPC, which passes a judgement on whether the practice is against the public interest. Because of the existence of unwritten price agreements the RPC is empowered to call up any such arguments for registration.8 The RPC is usually helped by lay experts to assess the applicability of these gateways. Turning to restrictive practices legislation, this can be also privately enforced as it allows any firm that believes it has been injured by the anti-competitive practices of another firm to sue the latter, and if successful, the first firm can receive from the second firm several times the value of the damage claimed and attorney fees. There is the advantage here that the private firm – and not the government – is the best-motivated party to take initiative to sue. But there is the shortcoming that a suing firm may tackle its competitor unfairly to secure strategic gains. It is also true that the prospect of legal suing may hinder innovative actions by a daring firm. The assessment of restrictive practice legislation and its application has not been exclusively positive. Part of the legislation is unnecessary since other legislation exists to protect the public against injury. It is not possible to debate complex economic arguments in a court since many judges lack the technical knowledge. Penalties for registration may not be sufficiently severe to prevent the formation of secret cartels. After many costly negotiations, many practices become nevertheless legalized. The attitude towards application of restrictive practice legislation differs from country to country. With increased globalization and cross-country trade, competitors may sue multinational firms for non-competitive practices in more than one country. Given the extent of the phenomena it is more often that American multinationals are assessed by both the US and EU competition authorities than EU multinationals are subjected to American and EU testing of competitive conditions. Recent engagements of US and EU in competition assessments of common cases show that the US authorities are more lenient than the EU authorities. Such examples relate to proposed fusions of American Airlines with British Airways, which were not opposed by US but were refuted by EU. Another example is the prolonged EU case against Microsoft. The stricter attitude of the EU authorities vis a vis American multinationals is likely to be related to effective lobbies of EU competitors at the EU headquarters. There are academic calls for a streamlining of assessment criteria and applications in both camps and in Japan, but the business

Firm Intensive System: Economic Challenges 71

Box 3.2

Firm intensity and open competition in FIM countries, 1995, 2000, 2005

While dominant position and restrictive practice legislation go a long way to combat imperfect competition among firms there are more areas of imperfect competition that can be jointly exploited by collaborating agents, i.e., firms and the state. The Heritage Foundation publishes annually an Index of Economic Freedom that ranks a large number of countries in terms of descending perfect competition. A most-perfect competitive country scores 100. The index is based on ten indicators covering competitive bias in the (a) state regulations, (b) foreign trade, (c) fiscal sphere, (d) government practices, (e) monetary sphere, (f) foreign investment, (g) banking sphere, (h) property rights, (i) black market, and (j) labour market. The table below shows a greater ability of firms to compete in the US than in Europe, which can be seen as evidence of a more firm intensive economic system in US than in Europe. The indicators also show that while Japan and Korea used to closer to US and Canada than most EU countries they have come over time below the EU average. The EU average remained stable. To compare, the scores in 2005 for China and India were 52 and 54. In contrast, Hong Kong and Singapore were most competitive with scores of 90.2 and 90.1. The scores are shown for 1995, 2000 and 2005. The score is disaggregated in the various components for 2005. Country

1995 Score

2000 Score

2005 Score

Regulation

Trade

Fiscal

Government

United States Canada

76.6 72.6

77.9 71.4

79.6 75.6

70 70

74.8 77.8

79.1 83.4

67.9 59.6

France Germany Italy Netherlands Sweden United Kingdom

65.6 68.8 64.3 75.0 63.9 79.1

61.7 65.2 65.7 71.5 67.6 77.9

62.9 69.0 63.5 72.7 70.9 79.9

50 50 50 50 50 70

75.2 75.2 75.2 75.2 75.2 75.2

63.2 72.3 66.4 63.8 54.1 74.9

32.0 43.8 41.9 42.1 30.6 55.7

Japan Korea

73.9 70.3

73.8 71.2

65.7 65.0

50 50

75.6 68.6

80.5 79.7

66.4 79.8

Country

Monetary

Investment

Financial

Property rights

Corruption

Labour

United States Canada

85.7 84.8

70 50

90 70

90 90

75.0 87.0

93.8 83.2

France Germany Italy Netherlands Sweden United Kingdom

86.0 88.0 84.7 84.9 86.0 85.0

70 90 70 90 90 90

50 50 70 90 90 90

70 90 70 90 90 90

69.0 77.0 53.0 89.0 93.0 87.0

63.5 53.7 54.1 52.2 49.9 80.8

Japan Korea

90.7 83.3

50 70

30 50

70 70

70.0 43.0

74.1 56.0

Source: Index of Economic Freedom, published by The Heritage Foundation, http://www.heritage.org/ research/features/index/downloads/2007PastScores.xls

72 Economic Systems Analysis and Policies

sectors and allied governments in these countries are not keen to take action in this area.9 3.2.3 Technology bias and growth limits It is the expectations of large profits in a future monopoly position that make companies invest and introduce new goods and new methods of production. If the management of a company believes that large profits simply cannot be obtained in the future, it is likely to be more reluctant to undertake pioneering investment efforts, thus curtailing the growth rate of the company. Moreover, entrepreneurs facing strong competition may simply lack time for long-term planning and for undertaking more elaborate projects of research and development. Besides, in a situation of heavy competitive pressure, profits are usually so low that little room is left for the internal financing of research and development activities. Hence, in contrast to the previous sections, a more balanced opinion has developed in FIM asserting that restricted competition creates conditions favourable to rapid growth of cost efficiency in the long term, on the condition that the restricted competition does not lead to a monopoly power that eliminates competition. The rationale can be elaborated further as follows. Suppose a company X invests in developing a product or process, which it markets later, with the objective of reaching a calculated profit. If other firms Y will immediately imitate the new invention, and enter the market, the profits to X will fall down much below the stipulated return. Since any firm can foresee that this will occur, few firms will invest in searching for inventions. As long as investor X cannot privately appropriate the benefits – since imitators Y cannot be excluded – there is no incentive to invest significantly in technological development. The problem is partly due to the fact that innovations, ideas and technological change contain positive externalities that allow competitor Y to benefit from action of X without contributing to the cost incurred by Y. However, there is an opposite danger. Firms orient their investment, research and development efforts towards seeking a monopoly position. Supposing company X takes the risk and succeeds in innovating. It can use the advantage strategically for purpose of securing a rent seeking gain, in which case conditions of perfect competitive behaviour will not be realized. Here is a collective call for state interventions to foster the combined goals of technological growth and competitive behaviour. Theoretical insight is still lacking in the resolution of the trade-off between competition and monopoly in the context of state interventions to foster technological growth. For instance, up to which extent should the effort of firms in technological innovations be protected or regulated? Absence of a technology policy at the national level may retard company investment in technological development and growth because of the presence of positive externalities, full protection of the innovating firm may lead to monopoly formation, while imposing a strict short run competition policy may achieve short run competitiveness at the cost of retarding growth.

Firm Intensive System: Economic Challenges 73

Box 3.3 Business and state resources in Research & Development in FIM countries, 1970–1980, 1990–2000 The figures below show that the funding of R&D has shifted over the years towards a greater share from business than from the state. By the turn of the century business funding exceeded state funding by 17 and 12 per cent in US and EU, respectively. In contrast, in Japan, business funding of R&D is more than three times that of state funding. Countries

Share of business in R&D funding

Share of state in R&D funding

1970–1980

1990–2000

1970–1980

1990–2000

US

.45

.54

.55

.46

EU

.51

.53

.49

.47

Japan

.70

.73

.30

.27

How large are the R & D inputs and the outputs in firm intensive economic systems? As a share of the GDP the US has been spending more than the EU. In recent years, Japan climbed to a higher share; this is reflected in a steep increase in patents in Japan. Caution is required in interpreting patents as an output indicator of R&D for the reasons that patents can vary significantly in importance and because firms with innovative discoveries may prefer not to patent them for strategic purposes. This is usually taken as the likely explanation of the drop in patents in US during the 1990s. Countries

Input indicators Per cent of total R&D expenditure in GDP

Output indicators Patents per million population

1970–1980

1990–2000

1970–1980

1990–2000

US

2.1

2.5

236

158

EU

1.3

1.9

37

51

Japan

1.1

3.0

10

79

Source: Oxford Review of Economic Policy, 1988, Vol. 4 no. 4, and 2002, vol. 18 no. 4. OECD Main Science and Technology Indicators, OECD, Paris, biannual.

The responses of firms and governments in the context of possible failures of technology and growth can be stylized in two approaches: the single company approach and the perspective synergy approach. In the first approach, individual firms are seen as technology leaders and the state would focus on the innovating firm and attempt to find the right balance between firm behaviour that capitalizes on innovations and sufficient incentives to motivate development and application of innovations.

74 Economic Systems Analysis and Policies

The second approach focuses less on firms and more on industries. It accepts the presence of market imperfections but puts more emphasis on the future perspective of alternative technologies at the industry level. In this approach an evolutionary framework is followed which seeks to find the right balance between the knowledge cycle and information synergies, and suitable forms of cooperation between industries and the state. In countries where the firm intensive economic system is well established it is the firms rather than the state that take the initiative to bolster technology and growth, and this can take the form of the first approach or the second approach. Historically, the first approach that focuses on innovating firms appeared first in FIM countries. More recently, the first approach has given way to the second approach in which more firms belonging to more industries are linked, allowing more and new economies of scope and scale.

3.3 Uncertainties: Problems and firm-state responses 3.3.1 Problems Imperfect information creates uncertainty. In reaction to this uncertainty agents will search for better information as well as for its transmission. Yet there are technical limits to perfect information. In addition, there is intended behavioural distortion of information by agents. The shortcomings open the way for remedies by private and public institutions. Imperfect information can have two type sources, depending on whether the source is technical or behavioural, resulting in incomplete information and asymmetric information, respectively. It can be argued that because information is valuable, one might expect the emergence of a market for it – a place where consumers and producers could purchase, sell and exchange information. This does not happen fully, however. The nature of information makes it more allied to a public than to a private good. Information is not easily tradable since information, by definition, is indivisible in its use; and it is very difficult to appropriate. With regard to indivisibility, it pays a large-scale producer to acquire better information than a small-scale producer, hence causing a departure from the competitive economy. Regarding non-appropriation, an individual who has some information can never lose it by transmitting it. If the information is transmitted to one buyer, he can in turn sell it very cheaply, so that the market price is well below the cost of production. But if the transmission costs are high, then it is also true that there is non-appropriation, since the seller cannot realize the social value of the information. Both cases occur in practice with different kinds of information. The non-appropriation of a commodity means that its production will be far from optimal, or otherwise the firm will be induced to implement costly protective measures to obstruct entry. The firm’s objective to maximize profit, which is a basic premise of the firm intensive economic system, is also adversely affected under uncertainty. Uncertainty upsets this objective. In essence, the demand for and the price of the product that the producing firm face are random. As a result, profit is also

Firm Intensive System: Economic Challenges 75

random, and strictly speaking, is difficult to set at a maximum. As a substitute for profit maximization, optimal decision-making theory perceives the objective function of the firm to consist of the firm’s attitude towards risk, and the firm’s perception of the likelihood of various outcomes. The greater the uncertainty the greater is the departure from risk neutral attitudes. Furthermore, the more incomplete the information on expected outcomes, the greater is the randomness of profits and the less is the validity of the profit maximization objective. Firms dominate the search for information. They spend resources on engineering and market research and on acquisition of information on the behaviour of other economic agents, including competitors, customers, workers and governments. Households also engage in search for information by looking around for the lowest price, the best deal, the highest quality and so forth. Thus, information is not merely a good that is desired and acquired but is to some extent a marketable commodity like others, but not fully so. 3.3.2 Incomplete information When information is incomplete or unequally distributed, there are market incentives not only to acquisition of information but also to the emission of signals and exchange of information among agents. In some instances, the buying and selling agents are pulled to each other in a collaborative search for information, which often results in changes in governance structures. Because searching is expensive, firms look for other, cheaper sources of information. Brand names and acquired reputation convey information about quality. If the consumer finds a brand of superior quality at a given price, he no longer needs to search for quality. He simply purchases the product with the brand name attached. Reputation, based on past searches, is attached to something easily identifiable like a label or name. If the consumer notices that the quality declines or the price increases when the quality does not, the consumer will need to search again. Firms do take advantage of the economizing behaviour by consumers to identify previously obtained information with a brand name; by differentiating the products they sell, thereby creating markets with characteristics of monopolistic competition. The costs of searching are also reduced when products undergo standardization and recognized circles monitor their quality accordingly. The technical limits to the endogenous creation of efficient information via business actions open the way for sponsoring a role for the state in the assessment and dissemination of information; though this is allowed to happen up to the point to which the firms consent. This cannot be otherwise given the fact that the firms are the basic suppliers of the information on their transformation activities and products. 3.3.3 Asymmetric information Akerlof (1970) was among the first to draw attention to asymmetric information. In the market for sale of used automobiles, the seller will in general have more

76 Economic Systems Analysis and Policies

information about the properties of the cars sold than the buyers. Initially, buyers might think that the odds are 50–50 that a car they buy will be of high quality. When making a purchase, buyers would therefore view all cars as being of ‘medium’ quality. (Of course, after buying the car, they will learn its true quality.) As a result, fewer high-quality cars and more low-quality cars will be sold. This shifting continues until only low quality cars are sold. At that point the market price would be too low to bring forth any high-quality cars for sale, so consumers correctly assume that any car they buy will be of low quality. Because of adverse selection, low-quality goods drive high-quality goods out of the market. Moral hazard would occur when for instance the car buyer causes car damages due to his bad driving, chooses to shirk and claims guaranteed costless repair from the seller. Moral hazard on the seller’s side can also occur where the seller attempts to escape from the agreed upon terms and avoid genuine repairs. Risk and uncertainty due to asymmetric information, and their implication for the functioning of the economic system, often discussed in the framework of principal–agency theory, can be placed more generally in the framework of property rights theory. Barzel (1989) defines ‘property rights of individuals over assets’ as ‘rights, or the powers, to consume, obtain income from, and alienate these assets’. To obtain income from an asset and to be able to alienate it, exchange is necessary (usually through contracts). People’s rights are not constant. Property rights can change as a result of people’s own effort at protecting these rights, other people’s capture attempts and government protection. A commodity or service that is subject to exchange has many attributes. Some belong to the private property domain, others to the common property domain. The comprehensive or accurate measurement and monitoring of all these attributes of a commodity is too costly for the exchanges. In other words, transaction costs are very high. Transaction costs are defined here as costs associated with the transfer, capture and protection of rights between the exchangers. Since it is costly to measure all attributes of commodities fully, exchangers will never find it worthwhile to gain the total potential of their owned assets. Only in the case of perfect knowledge would transactions costs be zero, because everybody would know exactly all the properties of an asset, making it easy to transfer a right from one person to another. Because property rights are never completely delineated the opportunity for wealth capture arises. Whenever an exchange is taking place, some wealth will spillover into the public domain. An attribute of a commodity is said to be in the public domain if it is not charged for on the margin. The buyer and the seller mobilize, each on his own, to capture this public domain wealth. The maximization of the net value of an asset involves an ownership pattern that can most effectively constrain uncompensated exploitation. When the income stream from an exchanged property is subject to random fluctuations and both parties can gain by affecting that income streams the delineation of ownership poses some problems. If only one party can affect the income stream, then making him bear full responsibility for his actions will ensure that ownership will be secure. This person is called the ‘residual claimant’. However, when

Firm Intensive System: Economic Challenges 77

both parties can affect the income flow generated by exchanged assets, ownership becomes insecure. In the property rights model individuals are assumed to maximize the value of their rights. This implies that whenever individuals perceive that certain actions will enhance the value of their rights they will undertake these actions. What is the economic solution in case of commodities with common property attributes? The general principle determining the maximizing allocation of ownership is that the greater a party’s inclination to affect the mean income an asset can generate, the greater is the share of the residual that party assumes.10 Coase’s theorem, Coase (1960), states that when property rights are well defined and transacting is costless, resources will be used where they are most valued, regardless of which of the transaction makers assumes liability for his effects on the other. A necessary condition for liability is variability. Only in the presence of variability that is too costly to eliminate does liability pose a problem. If property rights are to be well defined, a person who benefits another must be fully rewarded by the beneficiary, and a person who harms another must pay full compensation to the harmed person. By this criterion, a contributor to variability must assume the full effect of his actions if rights are to be fully delineated. In general, both parties to a contract can contribute to the variability in outcome. Since the individual effects cannot be isolated without incurring costs, property rights, as a rule, are not well defined. As a party’s effect on the value of the outcome increases, rights will be better defined if that party assumes a larger share of the variability of outcome, thereby becoming more of a residual claimant. The property rights approach provides a more general foundation for principal– agent theory. In principal–agent theory, the agent has the potential to act contrary to the interest of the principal. The property rights approach can explain why the agent is able to shirk. Because some attributes of every asset are in the public domain, someone will try to capture these. This is also the case for the assets of a firm. The manager, perceiving some attributes of these assets to be in the public domain, will try to capture these. This explains why there is a principal–agent problem. The property rights approach can be used to explain a wider range of economic phenomena in the firm intensive economic system, as will be shown below. Property rights do not only refer to the ownership aspect of an asset but also can include rights and obligations in managing the asset and deciding on its use. Governance relates particularly to these rights and obligations in management and use. Hart (1995) sees governance structure as a mechanism for making decisions that have not been specified by the contracting parties in the initial contract. For governance issues to arise two conditions should be present: (a) there should be a conflict of interest between different members of the organization or of the contracting parties; and (b) dealing with this conflict of interest through a contract involves very high transaction costs. Condition (a) states that there is a problem of defining property rights between principal and agent. This could, in theory, be dealt with through a contract. If everything were specified in the contract there would not be residual rights to be

78

Economic Systems Analysis and Policies

decided on. However, if transactions costs are very high it is not efficient to write a contract in which everything is specified. Therefore the usual contract will not be complete. Condition (b) refers to the eminence of transaction costs, which can also be analysed in the frameworks of both property rights theory and principal agent theory. Efficient governance structures succeed in resolving incentive incompatibilities that are typical of principal–agency problems. Stated otherwise, governance deals with allocation of residual rights of control that were not specified in the initial contract. The more efficient governance structures are able to achieve the more efficient allocations of residual rights and a better performance of the economic system. In most product markets and factor markets, leading firms tend to respond to uncertainty problems by developing market solutions and institutions that other firms abide with. In these contexts, there is only a minor and indirect role for intervention by the state. This is usually limited to disseminating information and keeping an eye on disputed governance issues via the judiciary. For example, in the product markets firms combat consumer uncertainties by developing signals and transmitting them with the objective of eliminating adverse selection and moral hazard, firms redesign transaction technologies and reduce their costs, while ethical codes can evolve among firms and occupations, and be instituted to control ill behaviour. In the factor markets, firm-driven solutions to problems of uncertainty focus on corporate governance and profit sharing. Both topics will be reviewed below. Corporate governance in large firms can be approached as a response to agency problems and property rights problems. Large companies typically have a large number of small shareholders. Although these shareholders have residual control rights, they are too small, and there are too many of them, to exercise this control effectively. In practice, management takes everyday decisions. Small shareholders have little incentive to monitor management. Monitoring involves costs. The benefits of monitoring (e.g., higher efficiency) however accrue to every shareholder. Hence every shareholder is inclined to free ride. Very little monitoring will take place in such a situation, giving managers an opportunity to pursue their own goals at the expense of the goals of the shareholders (usually profit maximization). Corporate governance deals with this situation by designing mechanisms to constrain management of a company. In general, when capital is treated as a single asset, then shareholders are the residual claimants to the profits that are generated by this asset. Since property rights are never fully delineated due to high transaction costs some attributes of this asset are in the public domain, other people will capture these attributes, because these are not charged for on the margin. Managers can use the firm to increase their own status by investing in large, but may be unprofitable projects. Because this attribute of the firm is not priced, it will be overused, at the expense of the shareholders. Corporate governance deals with these issues, trying to make use of these attributes costly to managers. Corporate governance will constrain managers, for them to act in the interest of the shareholders. Mechanisms that are designed to combat managerial

Firm Intensive System: Economic Challenges 79

slack and control management can be listed under the headings of installing a board of directors, proxy fight, large shareholders, hostile takeovers, financial debt structure, statutory rules, business reorganizations. The general conclusion is that corporate governance structures change when economic conditions change. Firms themselves are very well capable of creating a governance structure necessary for profit maximization. The case for statutory rules is weak. Government intervention with respect to governance issues is not to be welcomed, because it will limit firm’s capability to adapt to a changing world. Firms are restructuring when it is necessary. These general conclusions may require modification depending on the specific country corporate culture and the specific sector. At the country level, Anglo-American capital markets are known to emphasize exit, which refers here to the ease of selling stocks. In these markets there is usually little incentive to monitor management, because of freerider behaviour of small shareholders. Shareholders are more mobile and they can let a company go dead by withdrawing from it. In EU and Japan, there is more of an investor voice of large shareholders in corporate decision-making. In these countries the concentration of equity voting power, active participation of large investors and the important position of banks provide an incentive for monitoring management. At the sector level the applicability of corporate restructuring transactions seems to be restricted to low growth industries. Industries, which experience rapid technological or market change, may require greater managerial flexibility. Profit sharing is another major area of firm responses to uncertainty. The property rights theory argues that it may be advantageous for the workers to become residual claimants where their actions are especially costly to supervise. Otherwise, suppliers of labour are severely restricted in their insuring ability. Owners of labour are more likely to enter into contracts in which they are required to guarantee the difference between their market wage and their actual wage than they are to enter into contracts that require them to guarantee other possible effects of their behaviour. Equity capital is a factor specializing in guarantees. A firm may be seen as a set of contracts guaranteed by equity capital. There are a few empirical studies that used relatively small samples of profit sharing firms and found that the average rate of return on capital is considerably higher in profit sharing firms than in non-profit sharing firms, but more recent work by Bhargava (1994) shows that the rise in profitability is limited and is a one period rise when the firm shifts from non-profit to profit sharing. Another investigated relationship by Jensen and Murphy (1990) is that between base salary and bonus for top executives and stock market performance: this is found very weak in both the United States and United Kingdom, suggesting that incentive mechanisms are not very strong. Furthermore, the link between wider measures of compensation and performance does not seem strong. This weak link generates the widely expressed concerns about designing appropriate compensation of top executives and related issues of mechanism designs in the context of corporate governance. These concerns have led to discussions within business and state circles to set up guidelines and limits for the remuneration of top executives. There are no business codes

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Economic Systems Analysis and Policies

Box 3.4

Corporate governance patterns in FIM countries, around 2000–2004

US and UK stand apart from other countries with respect to corporate governance. There is no significant control of any one-shareholder party. In principle, all shareholders have equal control based on their degree of ownership that is no way particularly concentrated in some. The chart below shows these countries to have overwhelmingly outside governance in their top ten firms. The chart gives the fraction of top ten firms with different types of controlling shareholders. Other countries show higher incidences of insider governance. In continental Europe business family owners, industry groups and financial institutions have major stakes and a controlling power. The state may also be a major player. Corporate governance in Japan has some similarities with Germany such as the dominant role of business groups, but the state is a weaker stakeholder. In contrast, corporate governance in countries like Mexico and India, not reproduced here, show wealthy family owners to have 100 to 80 per cent control of the top ten firms in the country. US

OG

Canada

OG

France

OG

Germany

BF

Italy

BF BF BF

BG OG

Netherlands

BF

BI BF

Hong Kong

OG

Scale

BI

BF

ST BI

ST

OG BF

BG

OG

ST

BF

Korea Singapore

ST

ST BG

UK Japan

BI ST

BG

OG

Sweden

BG

BG

OG OG 10%

BF

BF 20%

30%

BG 40%

50%

BI 60%

BG

BI

BI

ST ST

ST 70%

80%

90%

100%

Source, note: National Bureau of Economic Research. The primary data appearing in Morck, R.K. and Steier, L., The global history of corporate governance, NBER, WP 11062, 2005, were indexed and adapted to fit to our presentation in the box. Control by a particular stakeholder type is assumed if any shareholder type controls 20% of votes in a company’s annual shareholder meeting. The stakeholders are OG  no one controlling shareholder, this is the case of outside governance; BF = Business families (wealthy) in control; BG  Business groups (industrial) in control; BI  Business institutions (financial) in control; ST  State controls.

emerging on this issue yet among the concerned firms. There is even less in terms of parliamentary legislation and state intervention in this area yet. It was stated above that in most product markets and factor markets, leading firms tend to respond to uncertainty problems by developing market solutions and institutions that other firms abide with. Emphasis is laid on most and not

Firm Intensive System: Economic Challenges 81

all markets. While market solutions to uncertainty problems have evolved voluntarily in the case of real products and factors, this is not the case for financial products and factors that are usually much more complex, less open and less transparent. Given the nature of the products, sellers, buyers and a host of intermediaries in the finance and banking sectors are generally more protective and secretive regarding information on their transactions. The information gap and moral hazard are also the reasons why it is more difficult for the state to regulate and monitor the financial sector. Uncertainty failures in the financial market are the areas that pose the greatest systemic challenges to the FIM. The governance failure in the financial sector is vividly demonstrated by the financial crises that started in the US in 2007, took the proportions of a financial meltdown in October 2008 and spread globally to other linked financial markets economies, with a likely global economic recession in 2008 and 2009. The main cause is an overexpansion of lending activities from 2001 much beyond the ability of borrowers to meet obligations to pay back. Although the overexpansion was highest in US, other countries followed suit. Reckless borrowing, complex securities and a vast unregulated shadow market became nearly worth US$ 50 to 60 trillion; which is about four times the size of the US national debt. The overexpansion was facilitated by the use of very risky, dubious, undisclosed and complex newly introduced financial products and credit default swap insurance contracts that defy monitoring and regulation, and a relaxed attitude towards regulation by the state central bankers who embraced a blind eye attitude as long as asset prices kept rising. Credit default by homeowners in subprime mortgages in US in mid-2007 triggered much bigger defaults among the mortgage lenders who are borrowers from other higher-up lenders, and so forth upwards. Speculative short selling on the expectation that security prices would fall further caused more falls. It is in the nature of a credit crunch confronting bankers to spread to producers causing a decline in production, layouts, spending and eventually recession. The governance failure described here has led to state interventions in the US and other FIM related countries ranging from the temporary nationalization to capital injections in exchange for state ownership stakes and bailouts of troubled investment banks, in an attempt to restore financial confidence and rescue the economies from a threatening downturn. An important issue in economic system that can be raised is whether this state intervention would affect the basic firm-driven orientation of the FIM. While the stipulated state interventions constitute a deviation from FIM, they are not estranged enough as not to be accommodated within the FIM and embedded in it.

3.4 Externalities: Problems and firm-state responses 3.4.1 Problems In general terms, an externality can be said to exist when a decision variable on buying or selling of one producer or consumer cannot be excluded from entering directly into the utility or production function of some other producer or consumer. This can be expressed by the following expression U A U A ( x1A,... xnA, y B )

82 Economic Systems Analysis and Policies

where utility U of agent A depends on excludable goods x ranging from 1 to n, produced and/or consumed by agent A, as well as some non-excludable activity y carried by agent B. In real life, producers depend upon other producers and upon consumers in their attempts to maximize their profits and thus their behaviour via the goods they produce and consume can hardly be described as without having side effects. Since great deals of these economic interdependencies are incorporated in the exchange economy and these results in the market prices and resource allocations that are observed, they are accounted for and cannot be called externalities. The policy concern of externalities relates to economic interdependencies, which are not incorporated, or to say not effectively internalized in the exchange economy. So, which side effects should fall under externalities? These are side effects, which are conventionally recognized as economically relevant, and which are not internalized and uncompensated. Externalities are, therefore, those conventionally recognized gains and losses that are sustained by others as a result of actions initiated by producers or consumers or both and for which no internalization takes place as yet. It must be noted that interdependence alone is not sufficient to constitute an externality. In the above equation yB must be conventionally recognized as economically relevant for UA and also be shown that there has been as yet a failure to internalize it in the decision-making process via payments or otherwise on account of any gains or losses. The notions of recognition and internalization are closely related. Recognition means that the inter-property rights of parties involved in a side effect are made explicit. Once made explicit, internalization mechanisms will develop which can be applied later. Internalization takes several forms: (a) unification or merger of the parties involved; (b) private contracting, covenants and arrangements whereby each producer pays for the externality rendered by other producers private contracting; (c) creation of new markets in which the property rights are exchanged; for example, a market for environmental property rights in which emitting and affected agents can trade damage for compensations; and (d) when the above remedies do not succeed in eliminating the externality problem, a final solution lies in state intervention. When to recognize an effect as external or not? Figure 3.5 is helpful in tracing an answer. An economically legitimate side effect may, for some reason, not be recognized as an externality. The reasons can be many: (a) imperfect information, (b) higher incomes over time and place may lead to higher valuations of well-being and recognition of environmental pollution as a negative externality, whereas elsewhere it is not recognized as such, (c) transaction costs that go with the recognition of a side effect can be too high for the time and place, and (d) since recognition requires a specification of the property rights of the transacting parties and such a specification has as a consequence a redistribution of property and income, it follows then that if the group which is to be disadvantaged has sufficient coercive power this group may not permit recognition. Take, for example, air and water pollution which were a common day experience already from the

Firm Intensive System: Economic Challenges 83

Internalization mechanisms absent as yet

externality persists

recognized

potential externality arises

Internalization mechanisms exist in the form of (1) unitization (2) private contracting (3) creating markets (4) state intervention Mechanisms unused Realization status of mechanisms due to imperfections Mechanisms used

externality persists externality eliminated

not recognized due to one of the following reasons (1) relevant and implementable but obstructed by powerfull party (2) relevant, but not implementable due to excessive transaction costs

externality persists indeterminate

(3) considered as irrelevant, given preferences

no externality

(4) considered as irrelevant since both parties undergo the same sideeffect

no externality

Figure 3.5 Scheme for tracing the conditions under which a side effect can be identified as an externality and justify a policy measure

early days of industrialization, but the externalities involved were not recognized as such until recently. With rising incomes, attention goes to higher needs that increasingly take the form of merit goods. The delay in the recognition can be also reasoned in terms of imperfect information, very high transaction costs or obstacles due to a powerful position of the losers versus a weak position of the gainers. Two additional comments need to be made before dealing with state interventions. First, an externality was defined as a side effect, either good or bad, that results whenever a person or firm making a decision does not consider social costs or social benefits of the particular decision, and, as a consequence, directly affects the utility or profits of other consumers or producers. It is understood that by the activities of decision-makers is not only meant the actually materialized activities but also potential activities, which could not be possibly executed because of the involved externality effects. Second, externalities can be positive or negative. A common example is air or water pollution; this is an output of one producer that enters into the utility or production functions of other consumers or producers. This example is a negative externality since the consumption of pollution reduces the utilities or profits of consumers or producers, respectively. An example of a positive externality is the development of the railway system and seaports, which allows industry and commerce to flourish, or the setting up of an iron and steel industry that allows the exploitation of many forward and backward linkages.

84 Economic Systems Analysis and Policies

Concerned firms, unable to take voluntary collective actions to internalize externalities are inclined to mobilize the state to intervene. The remainder of this section will consecutively deal with state industrial policy as an example of reaping positive externalities, and state environmental policy as a response to curbing negative externalities. 3.4.2 Positive externalities A positive externality is a side effect that exists whenever the social benefits associated with a particular decision are not fully considered by the person or firm making the decision. In Figure 3.6 the demand curve, D0, summarizes the market participants’ individual willingness to pay for road extension, that is, the private marginal benefit (MBp) obtained from road extension. (It is the horizontal sum of each individual’s willingness to pay for additional roads.) However, D1 summarizes the social marginal benefit of roads (MBs), including the benefit to others when other firms are connected to the road. Hence, (MBs)  (MBp). In the presence of the externality, the market equilibrium is Q 0 and P0. If consumers of roads, inoculations or education were compensated for the utility they rendered to other producers and consumers, the market equilibrium would be Q1 and P1. The market price would be higher and more of these goods and services would be both produced and consumed. The situation can be analysed in terms of its efficiency and equity effects. First, we deal with the efficiency effect. If the use, consumption or enjoyment of a commodity creates benefits for those who do not purchase it, the marginal social benefit of additional use (MBs) is greater than the marginal private benefit (MBp) that those who pay for the commodity receive. The social optimum is at (Q1, P1), but the market equilibrium is at (Q0, P0). At market equilibrium, the market price, P0, is less than the social value of the commodity, which can be measured by [MBs at Qe]. That is, the marginal cost of producing additional commodities is less than

Price

S = MC Deadweight loss

MBS at Qe P1 P0

D1 = MBS

D0 = MBP Q0 Figure 3.6

Q1

Deadweight loss from positive externalities

Quantity

Firm Intensive System: Economic Challenges 85

the marginal social value that those commodities provide. The market outcome is inefficient: the market price is too low, too few scarce resources are being devoted to this activity and too little is being produced. Compare quantities Q0 and Q1. This inefficiency has a deadweight loss of the shaded size indicated in the figure. Second, the equity effect cannot be fully traced in Figure 3.6 because the transfer between producers and consumers is not as relevant in this context. The transfer effect would have to be analysed with two states and two parties in mind. The two states are the current state in which too little is produced and a prospective state in which Q is increased to its social optimum. The two parties are consumers and producers alike of the commodity who pay for it, and consumers and producers alike who do not pay, but could become payers in a prospective state. Note that if the positive externalities are exclusive there will be always some non-payers who benefit. Industrial policy. Positive externalities form the rationale for industrial policy. Commonly, industrial policy would refer to government actions which aim at growth and change either via (a) a general shift of productivity and/or enhanced activity across the board or via (b) a reallocation of means in the economy in such a way that current and new activities with better perspectives (high rates of social benefits to social costs) get higher weights at the cost of other activities which are less attractive (low rates of social benefits to social costs). The first channel is often called the neutral approach; the second channel is the targeted approach. OECD countries show differences in how they combine the two approaches. The neutral approach to industrial policy in the sense of a stimulation across the board takes the form of generic instruments such as standardization, provision of information, investment in science, technology, human and physical infrastructure, and the setting up of financial institutions and judiciary systems. The targeted approach to industrial policy in the sense of influencing consciously reallocation of production among activities makes use of four broad policy areas: (i) exploitation of positive economies of scale and/or economies of scope; (ii) strategic trade and investment policy in relation to sunrise industries11; (iii) economic restructuring in response to sunset industries and regional development; and (iv) encouragement of business clusters of linked technologies, industries and firms. How do the neutral and targeted approaches combine in FIM related countries? Although the United States is known to avoid industrial policy, technology policy in the United States is active and has not been neutral. The approach adopted by the US government can be described as a ‘mission- oriented’ approach to promoting industrial, technological change in the post-war period, cf. Ergas (1986). The goal is to achieve a technological breakthrough in specific areas, so that entirely new industries using this technology come into being. The mission-oriented approach is associated with activities that carry a high cost for the first mover; compared to the relatively low cost of diffusion (copying) once the innovation has been made. This approach has led to the creation of

86

Economic Systems Analysis and Policies

prestigious projects with disproportional high costs, especially in the area of the military and aerospace. Civilian applications of related innovations came much later and in a limited extent. Another example with a mixed performance is the development of the semiconductor industry, cf. Audresch (1993). In the beginning of the 1960s, the contracts for integrated circuits came from the government. By the end of the sixties, as the technology spilled over, the computer industry replaced the government as the major buyer of semi- conductors. The government has not been able to capture the rents accruing from the investments made, and it is no longer in a position to influence the future direction of technological research in this area. Industrial policy in Western Europe is mixed. British industrial policy is based on a liberal philosophy, that industrial performance is best left to the private sector, assisted only at the margin by state activity. As a result the British industrial policy fits best into the neutral approach. It is difficult to assess the performance of British industrial policy, since one needs to know how the economy would have fared otherwise and no material of this kind is present. Germany has applied both approaches to industrial policy. Declining industries were targeted for support, either to maintain the current level of output, or to adjust to new conditions in the industry. Examples are agriculture, the railroad sector and housing. On the other hand, the most successful sectors (in terms of export performance), like the moderate technological intensive industries, have in general not received governmental support. The success of these sectors is mainly due to the neutral industrial policy of investment in industrial infrastructure and workforce. So, the success of Germany does not reflect targeting policies but rather the policies of investing in a skilled workforce and infrastructure, which can be considered as an indirect form of industrial policy, leaning more towards a neutral approach. Japan has mostly used the sectoral approach to industrial policy. In the mid1950s industrial policies focused on the heavy and chemical industries, whereas in the early 1970s the attention shifted to knowledge-intensive industries. Throughout the years the Japanese government has given special assistance to small- and medium-size enterprises. Under pressure of the US and the EU in the 1980s, Japan withdrew supporting measures to prevent trade conflicts with foreign governments. Economists are divided over whether Japanese industrial policies have been successful or not, but most argue that the Japanese targeted approach has not contributed to the Japanese growth.12 In contrast to FIM countries, industrial policy of Russia and Eastern Europe has been heavily targeted. Industrial policy here was characterized by state ownership of economic assets, centralization of these assets and a planning system to allocate their use. Furthermore, large-scale production (mass production) was regarded as the only efficient way of production, leading to a high concentration of industries. These factors allowed a temporary comparative advantage for Russia and Eastern Europe in some heavy industries in the past. However, the policy has not been useful for promoting their international competitiveness in heavy industries over the longer period, and barred them from entering high

Firm Intensive System: Economic Challenges 87

technology and information intensive markets, where frequent entry and exit is conducive to innovative behaviour. What can be concluded from country experiences? The evidence emphasizes importance of enhancing factors of production in gaining competitive advantage. While capital, technology and raw material can be replaced, this is less true for labour skills. Labour quality has been the focus of a successful neutral industrial policy. The evidence on the targeted approach shows that sectors that have received support have not always been successful, and similarly successful sectors have not been targeted by industrial policy. The case for state support of infant industry, typical of early phases of positive externalities, is functional if it is able to launch the protected industry towards a sustainable competitive advantage. Continued protection beyond that point will be detrimental to competing firms and will be opposed by them. How are industrial and trade policies changing under globalization? Under the auspices of the General Agreement on Tariffs and Trade (GATT) the first steps were taken by member countries to extend and harmonize trade liberalization policies and eventually achieve a shift towards neutral industrial policies. The initiatives can be seen to be set into motion by business forces that are eager to introduce more competition and secure mutual gains, supported by expertise analysis and enforced by governmental authorities. The initiatives gained momentum with the formation of the European Common Market and the Kennedy Round of mutual tariff cuts. In the Tokyo Round, governments attempted to reduce both tariff and non-tariff barriers, next to agreeing on codes of conduct relating to government purchases from firms, export subsidies and dumping practices of multinational firms. The slowing down of economic growth and the rise in unemployment in US and EU in the late 1970s and early 1980s, encouraged protectionist measures. In the US and EU, import competition from Japan and Korea among others impacted established firms and trade unions in textiles, steel, shipbuilding and the car industry. Trade adjustment assistance to impacted firms and labour and limits on imports of related manufactured goods were instituted. Although these measures benefited the incumbent firms and labour transition in the short run, they did not solve the problems of sunset industries in US and EU. Other complex developments as a consequence of the import limits were the increasing numbers of trade disputes between trading nations. This together with the greater integration within the European Union, establishment of the North American Free Trade Agreement (NAFTA) and other regional trade arrangements increased the complexity of resolving inter-trade policies within the GATT framework. The Uruguay Round of trade negotiations in the 1990s led to large cuts in tariffs in manufactured goods, inclusion of farm products via limits to export subsidies, lesser interference with prices and restrained use of compensatory transfers to farmers. It led also to replacement of GATT by the World Trade Organization (WTO) with additional tasks of liberalization trade in telecommunications and financial services, and as the undisputed non-veto forum for the settlement of trade disputes between member trading countries.

88 Economic Systems Analysis and Policies

Box 3.5 Response to liberalization initiatives of the World Trade Organization in FIM countries The WTO plays a central role in the promotion of greater competition between firms in member countries and enhancing international trade via encouraging neutral industrial policies and trade liberalization. Among the developed countries, industrial protection at the turn of the century was highest in EU, less in US and least in Japan. In contrast, protection of the agricultural sector is highest in Japan with subsidies reaching 55 per cent of off-farm prices, quite significant in EU at 34 per cent and less significant in US at about 14 per cent. Liberalization effects over the reported period for both industry and agriculture were relatively higher in US and Japan than in EU, reflecting the relative lobbying pressures of incumbent producers. Countries

Industrial protection as measured by tariff rates on imports of industrial goods, %

Agricultural protection as measured by producer support estimate as % of gross farm receipts

Before Uruguay Round 1986

At eve of Doha Round 2000

% change

Rank in protection. Highest = 1

United States

4.6

3

35

2

22

European Union

5.7

3.6

37

1

41

3

64 38

Japan

3.9

1.7

56

All OECD

6.3

3.9

38

1986–1988 2004–2006

% change

Rank in protection Highest = 1

14

36

3

34

17

2

55

14

1

29

24

Source, note: OECD: Agricultural Policies in OECD countries: Monitoring and evaluation 2007, OECD, Paris; Appendix Table III.1. Column 3  (col. 1  col. 2)/col.1. Column 7  (col. 5  col. 6)/col.5.

It is important to emphasize the distinction between monopolistic practices of a multinational firm and the industrial and trade policies of a national government, even though there are many instances in which the two coincide. The WTO focuses on government policy and does not have the authority to question or prohibit monopolistic practices of trading firms.13 3.4.3 Negative externalities Negative externality is a side effect that exists whenever the social costs associated with a particular decision are not fully borne by the person or firm making the decision. Pollution is an example of a negative externality. Land degradation, overgrazing or deforestation, polluted air, acid rain, garbage deposited along roadsides, trash blowing in the wind or toxic wastes leaking into water supplies, all exist because particular consumers and producers do not fully account for the

Firm Intensive System: Economic Challenges 89

Price

S1 = MCS

MCS at Q0

Deadweight loss

S0 = MCP

P1 P0

D = MB

Q1

Figure 3.7

Q0

Quantity

Deadweight loss from negative externalities

costs associated with their decisions. The costs are external to their decisions and the result is a negative externality. Figure 3.7 illustrates the market effect of a negative externality. In this figure, it is assumed that, although producing the commodity has a negative externality, there are no externalities associated directly with consuming it. That is, the willingness to pay for additional output accurately reflects all the benefits associated with consuming a good. On the other hand, disposing of by-products without paying for their disposal (by dumping them into the water or into the air) implies that private marginal cost (MCp) – that is, the marginal cost that firms actually incur is less than social marginal cost (MCs) – that is, the social marginal cost of producing the commodity from society’s perspective. The difference, of course, is the cost of the externality that is imposed on someone in society but that the firms do not have to pay. A competitive market will produce Qe when the horizontal sum of the marginal cost curves over all firms is MCp. If Qe is supplied to the market, the equilibrium price will be Pe. By contrast, if firms actually paid the true social cost to dispose of their by-products, the horizontal sum of the marginal costs over all firms would be MCs, and the market would have an equilibrium output of Qe and an equilibrium price of Ph. The market price would be higher, and less would be both produced and consumed. Notice that the externality is caused by what appears to be a free method for firms to dispose of by-products. Society essentially subsidizes the producers, in this case by the difference between MC s and MCp. The situation can be analysed in terms of efficiency and equity effects. If there is a negative externality, the true marginal cost of producing Q 0 is measured by [MCs at Q0]. Consumers pay only P0 for this output, however. At the market equilibrium, as a consequence, the true marginal cost is greater than the market price, and hence, greater than the amount that consumers would be willing to

90 Economic Systems Analysis and Policies

pay for additional output. That is, consumers pay less than it costs the economy to produce this additional output, when all costs, both internal and external, are considered. Put simply, it is as if the economy was using x in scarce resources to produce y of additional satisfaction, whereby x  y. There is thus a deadweight loss equal to the shaded area. When there is a negative externality, the economy is using too much of its scarce resources in producing too many goods that are less valued. The issue of equity relevant here is not that of the distribution of total surplus between consumers and producers but between the group of consumers and producers taken together who are causing the pollution to the group of consumers and producers together who are suffering from the pollution without being compensated for. Environmental policy. The interaction between firms and government in the context of environmental policy in FIM countries is a relevant example of reinforcing responses to negative externalities. Market prices are important because they convey information. If market prices do not incorporate the correct information because of an externality, agents will be led by the market price to make the wrong decisions. The problem of environmental damage can then be seen as a problem of ‘wrong’ prices. The challenge for the economic system at hand, then, is to get the prices ‘right’. It is a search for the right quantities with the right prices, implying that there is an optimal amount of environmental damage (and environmental protection) and optimal prices to be paid for such a balance between goods and bad. It was stated earlier that the ways open for society to assure that ‘right’ prices hold are via a variety of firm-market solutions or via state measures, as would be treated below. Firm responses include creating internal markets via forcing unitization, and defining and enforcing property rights. One solution to the externality problem in some settings is unitization of the separate activities that are connected by the externality. For example, if a factory owner also owned all of the land affected by the smoke and other pollutants created as by-products of the factory’s production, any increase in by-products would lower the value of the land. Therefore, the owner of both the land and factory would have to consider the effect of a decision to produce more at the factory (that would increase his factory income) on the value of land that he owned (where pollution would tend to decrease the value of the land and the income from land sales or rentals). Unitization is the creation of single ownership and control of resources whose uses might conflict to create an externality. Unitization does pose one problem, however. Creating a single owner for the different activities may create a firm with market power. Then solving one problem – an externality – creates another problem – a monopoly. Another way out is to create markets via property rights. Externalities almost always appear when certain kinds of markets do not develop. For example, firms dispose of by-products in the air because air is a common property, and it is not

Firm Intensive System: Economic Challenges 91

easily convertible in private property. Because lack of ownership creates externality problems, an externality problem can sometimes be solved, if technically feasible, by establishing explicit ownership of previously undefined ownership of resources.14 Even if there are market remedies to some externality problems, when transaction costs are high, these remedies frequently fail. Then, property rights cannot be effectively defined, transferred from lower-valued uses to higher-valued uses or enforced against producers of externalities. In such cases, the state is called upon to pursue direct legal, regulatory or fiscal remedies. State responses include mediated negotiations, tort law and liability, regulation methods to prohibit the firm from producing more than a specific quantity of pollution and emission fees. In theory, emission fees are more efficient than regulatory measures. First, such taxes on pollution are attractive for several reasons: they not only move a market towards a more efficient equilibrium but also, if they change with changes in the quantity or type of pollution, they provide incentives for polluters to find cost-effective means of lowering pollution. Second, the cost of achieving a specific amount of pollution reduction can be minimized if the marginal costs of pollution control can be set equally for all activities that create the pollution. Third, in a sense, if firms are taxed on the basis of the pollution that they create, there is a market for pollution. Either a firm can buy the right to pollute from the state by paying the tax, or it can avoid the tax by reducing its pollution. If it pays the tax, its costs will increase and it will produce less, including less pollution. Fourth, these emission fees lead to favourable effects in the long term. Research activity will then concentrate on developing new methods of production aimed at economizing on the now more expensive factor of production. In this way, prices will ‘inform’ the consumers about the true social costs of producing. In practice, controlling governmental departments in FIM prefer physical regulations to emission charges. A policy effect that can be monitored and attained with certainty, such as in regulation, is particularly valuable, when environmental damages are expected to increase dramatically if this level is surpassed. In contrast, the effect of charges on emission volumes is less certain. One reason is that the cost structure of polluting firms, which determines the effect of charges imposed on them, may be essentially unknown to the governmental department concerned. It was seen earlier that with increased globalization there are increasing externality effects among trading countries. This has led firms and countries to push for a harmonization of industrial and trade policies so that firms may face comparable competitive conditions in competing countries. In the same globe environmental pollution in one country has negative side effects on other countries. Here too, the nature of environmental policy is changing towards a sharing of the burden of global environmental protection among producing countries. The Kyoto Protocol is a perfect example of global cooperation.

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Economic Systems Analysis and Policies

Box 3.6

Responses of FIM countries to the Kyoto Protocol

The Kyoto Protocol (KP), negotiated in December 1997, is the first international treaty to limit emissions of greenhouse gases. KP offers an illuminative example of the changing nature of environmental policy across rich countries. The table below gives a summary of emissions and targets by countries intending to participate. The US Congress, and hence the government, declined to participate and are proposing other unilateral ways to reduce pollution and meet the collective obligation. Other countries signed. KP studies, implemented by the Clinton Administration in 1998, estimate the marginal cost of meeting the Kyoto targets by the participating countries at a similar value to the global marginal damage of the emissions, about US$ 18 per ton, meeting optimal marginal conditions. The Kyoto targets are expressed in net emissions; this allows effective use of alternative instruments. Net emissions are equal to greenhouse gases emitted by industrial activity less gas removals through forestry, which is very effective in absorbing these gases. Substitution is introduced by including next to carbon dioxide other gases that cause greenhouse effects. Abatement of a ton of nitrous oxide is put equal to 315 tons of carbon dioxide. KP requires that the above targets be met over the years 2008–2012 on average, and not every year. Countries are allowed to carry forward additional reductions they achieve to a future control period, allowing trading over time. KP allows also trading over space. EU can trade its emission target with transition countries where abatement cost is cheaper. The environmental effect will be the same for the globe as a whole. This provision will help creating a global market for trading environmental burdens. KP excludes developing countries from emission reduction target until 2012, based on the understanding that for many years to come the developing world needs to intensify its industrial activities in a catching-up growth process. But KP allows and extends projectbased joint implementation by participating countries to developing countries. In this way an incentive is created for implementing abatement in the developing world and persuading countries of the developing world to endorse the protocol. Non-participating third world countries will acquire comparative advantage in the polluting industries that will tend to shift from the North to the South. Emission will increase in the South so that some leakage is unavoidable. Leakage in the South is estimated at about 10 per cent of the abatement in the North. Shifting industry can hurt some parties who will lobby for protection in the North. The agreement is greatly handicapped by non-participation of US. The burden of implementation lies on the EU given last minute commitment of a less enthusiastic Russia. Aspects of implementation and inspection are not yet worked out, which are problematic. Countries

Actual emission 1990 gigagrams CO2

Projected emission 2000/actual emission 1990

Kyoto Target 2008–12

Share in total emissions % in 1990

United States 1 country

4,957,022

104

93

36.00

European Union 15 countries

3,288,667

103

92

24.05

Other OECD 9 countries

2,065,119

109

98

15.35

SIM in transition 13 countries

3,364,259

81

103

24.60

Total 38 countries

13,675,067

98

95

100.00

Source: Cohen (2001). For a more detailed treatment, see Barrett (1998).

Firm Intensive System: Economic Challenges 93

3.5 Collectivities: Problems and firm-state responses 3.5.1 Problems If certain goods are not profitable, the firms will fail to produce them. If, nevertheless, a community collectively considers such goods as necessary, then production must be undertaken despite the negative signals of the price mechanism. Under these circumstances it is usually the government that plays an active role in the provision of public goods. A first feature of a public good is that it cannot be supplied to one consumer without simultaneously being supplied to others. It is in this sense that the public good is an extreme example of externality. When the good is provided for one agent, it will bring external benefits to many other agents. This feature is known as non-excludability. It results in the problem of ‘free-riders’. People will not like it to pay for goods that they think can be acquired free. As a consequence of free riding, the demand for a public good understates the true value of the good to the agents. The second feature of the public good is that once the good has been supplied to a single consumer there is no additional cost in supplying it to others. The supply of benefits generated by the good is in no way depleted no matter how many people use it. This feature is known as non-rivalry, implying that the cost of supplying an extra user with the good is zero. The benefit enjoyed by the second, third etc., street walker from the street lighting has not resulted in an increase in costs, nor has it reduced the amount of light available, in terms of the Pareto criterion it would be inefficient to charge a price. Indeed, when any extra user can benefit from the good at no extra cost to society, charging a price would clearly discourage some potential users and result in a loss of total benefit to society. As there are by definition no costs involved in serving additional consumers, a price should not be charged for these services. But with a zero price and non-zero production costs, output cannot be determined in the usual way by demand and supply on a market. The following example highlights the above issues and lays down basic links between general equilibrium theory and game theory in treating the problem of collectivities. Assume there are several closely located firms each denoted by a, each owning its own paved road i and they share a desire for expanding, building and using a railway line and warehousing facilities, j. Assume a marginal rate of transformation, MRT, of 2 units of paved roads to 1 railway line. To obtain ‘general’ Pareto efficiency it is not necessary that the marginal rate of substitution, MRS, between road and railway for each firm should be 2. If there are 20 firms, it is, in principle, sufficient for each to give up 0.1 of road to have full use of the common railway. For ‘general’ Pareto efficiency to be realized in the context of MRSia, j MRTi , j . public goods it is not necessary that MRSia, j MRTi , j , but rather a The efficiency problem is, therefore, transformed to one of reaching a satisfactory distribution among the firms. Whether it is feasible or not to reach agreement on the allocation of costs and benefits to the individual firm depends on the prospects of collective action.

94 Economic Systems Analysis and Policies

The co-ordination problem in the case of collective failures can be presented along the lines of a prisoner’s dilemma. This applies also to externality failures. Let the only two existing firms a and b assess the consequences of each one’s initiative to build a non-excludable railway on its own or collectively. In the example given below, total cost of building the railway is 8, while the benefit of using the railway for each firm is 12. The two strategies give four combinations of net benefits in Table 3.2. A co-operative decision to collectively build the railway gives a highest total benefit (8,8). This may not occur, however, as long as the individual returns from acting as a free rider are higher, and it is very likely that no railway will be built at all given the relative individual returns. Intervention of a third player who is entrusted with maximizing the collective benefit, i.e. government; can enforce (or facilitate) the construction of the road. Table 3.2

A game theoretic presentation of the problem of collectivities Firm b

Build railway

Do not build railway

Build railway

(8,8)

(4,12)

Do not build railway

(12,4)

(0,0)

Firm a

Of course, this government has to arbitrate, earn an arbitration income, monitor execution and settle the distributive problem of allocating costs and benefits to the individual firms in correspondence with their respective revealed preferences and displayed strategies. 3.5.2 Responses Where there are unresolved collective needs governments are anticipated and invited to act. Government intervention relating to public goods is necessarily coercive, however. As long as agents can free-ride on private or governmental provision of a public good, they will not reveal their true preferences for it. The remedy to the free-riding problem is to manoeuvre agents to behave in ways consistent with collective interest. Extending the above example, the financing of transport networks countrywide, building of schools, hospitals and parks and alike require levying taxes. All firms and households have to pay such taxes whether or not some of them value the public goods provided by the government. The coercive nature of tax incidence and of public provisions implies that some individuals who really do care about the public good will be taxed too little. This discrepancy occurs because taxes are not based on willingness to pay. Thus, forcing agents to pay a ‘fair share’ is difficult as government provision almost always unintentionally redistributes income. The lengthy public debates about how much should be spent on national defence, business infrastructures, skill development or how much should be spent on police, health or social security and so forth reflect difficulties in obtaining informed guesses of the real needs, as well as the concerns associated with the

Firm Intensive System: Economic Challenges 95

redistributive effects of the associated taxes. The actual allocation between these alternatives is often a reflection of the relative strengths of opponent beneficiaries, consisting mostly of business and community interests, together with political bias in the implementation of the political functions of state agents, as will be laid out in the next chapter. This is a suitable moment to emphasize the differences in the degrees of firmsstate response to the different economic failures so far. In the cases of economic failures due to indivisibilities and uncertainties, it was seen that the response of firms was more significant than state intervention. Such past state interventions in FIM as nationalization and regulation have been converted over time into privatization and deregulation, respectively, and thus enhancing the scope for more activities in firm settings. As to the problems of imperfect information in FIM, firm responses have taken the lead over state intervention in matters of signalling and reputation, and in the upgrading and monitoring of corporate governance. Regarding the problem of externalities in FEM, firm responses in the way of internalization and state actions to close the gap between private and social benefits and costs appear to combine in remedying the problem. In contrast, the solution of problems of collectivities in FEM relies more on state actions than firm responses. This happens for two reasons. First, the coordination problem, as depicted in Table 3.2, cannot be solved by the two firms without access to the providing services of a third party, the state. Second, the collective needs posed by opponent firms are relatively small when compared to the demand for public goods put forward by households and supported by the electorate.15 Public expenditures, and the task of collecting public revenue to finance the public spending, are managed by the state in all modern economic systems. In general, public expenditure is divided into two categories: exhaustive public expenditures and transfer expenditures. Exhaustive public expenditures consist of purchases of current goods and services (e.g., consumption goods, employee costs in health, education, administration and alike) and capital goods (e.g., investments in roads, buildings, construction and alike). Exhaustive expenditures are purchases of inputs by government that are then used to provide public goods. This has been the concern of this section. The second category (transfer expenditures) is more important in the context of income redistribution and will be treated in the next section.

3.6 Income distribution: Problems and firm-state responses 3.6.1 Problems Welfare economics postulates that for a given income distribution, the market mechanism will result in an economically efficient outcome whereby costs will be minimized while satisfaction will be maximized. This implies that there will be as many technically efficient outcomes as there are possible distributions of income and wealth. One technically efficient outcome above others requires that the existing distribution of income and wealth for that one is more ‘fair’ or more ‘equitable’ than those for the others. The market failure comes in the picture

96

Economic Systems Analysis and Policies

when more agents feel that the existing income distribution is unfair, to them or to others; and when this feeling is transformed in actions that would affect the economically efficient outcome of that moment negatively. To prevent a market failure the economic system responds with measures that assure ‘fair’ outcomes for all agents. For the economist a crucial question is thus what is ‘fair’? Since the topic is not value free it is difficult to determine consensus answers in objective ways; but economic research has achieved a lot in narrowing the scope for value judgements. Conceptually, there are two approaches economists use in treating the question of what is ‘fair’: a positive and a normative. We treat these approaches below. The positive approach. The focus here is on causal explanations of income distribution. First, the measurement of income distribution has to be treated. Second, as factor earnings play a prominent role in determining income, these factor earnings need to be decomposed for a causal explanation of differing patterns of income distribution. Third, there are also many supplementary causes than factor earnings that influence income distribution, and that need to be considered. Fourth, the positive analysis of income distribution has the ability of distinguishing between causes that are consistent with FIM motivations, and causes that can be termed market failures in the FIM context. Such market failures call for policy corrections. First, there is a wide range of concentration measures that describe the actual income distribution among the population in a region. Most commonly used concentration measure is the Gini index (or Gini coefficient) which can be derived from the Lorenz curve, obtained by plotting the percentage of total income (national income) earned by the various income groups within the population. The Gini index gives the area between the observed Lorenz curve and the diagonal line of absolute equality as a proportion of the total area under the diagonal line in Figure 3.8. Percent of income 100 75

50

3 2

25 45° 0 Figure. 3.8

25

Lorenz curve and Gini index

1 50

75

100

Percent of population

Firm Intensive System: Economic Challenges 97

With complete equality, the poorest quarter would have a quarter of the national income, and the poorest half would have half of the national income, etc. The equality would move along the diagonal. With a great deal of inequality, as depicted by curve 1, the poorest 25 per cent can have 2 or 3 per cent of national income. More generally, as curve 2 lies more northwest of curve 1 the distribution of income in curve 2 is more equal than in curve 1. Note that when one curve crosses another, like curves 1 and 3 in the figure, it cannot be optically determined which distribution is more equal. It can be shown that for a quite broad class of social welfare functions, including the utilitarian form as a special case, moving from an income distribution such as 1 to one such as 2 in Figure 3.8 will increase social welfare. Intuitively, with diminishing marginal utility of income and equal capacities to enjoy income, a reallocation from a higher income person to a lower income person yields a utility gain to the lower income person that exceeds the loss to the higher. Thus, social welfare must increase when we move from the more unequal income distribution to the more equal one. Second, since factor earnings play a prominent role in shaping distribution of income, a decomposition of factor earnings in exclusive elements and information about the relative significance of these elements will contribute to a positive analysis of income distribution. Factor earnings of an individual can be analaysed in terms of: (a) the types of factor endowments possessed by the individual, various skill types, land, capital; (b) the quantity of the factor that the individual chooses to transform into earnings; (c) the ability of the individual to get a higher remuneration per unit of factor use above the average remuneration as determined by market forces for that factor; and (d) Market forces beyond the individuals determining differing factor remuneration. Those who gamble and succeed become wealthy. Those who try and fail go broke. Hence, some income differences arise voluntarily. How much of the inequalities are due to each of the four elements above? Although the question can be treated quantitatively, the available data do not allow this as yet. The following can be speculated, however. Take first the distribution among the population of the ‘earnings potential based on ability’. There are many measurable abilities of people that probably influence their earnings. For example, physical attributes such as height, weight, strength, endurance, intelligence can all be measured objectively. All of these measurable attributes appear to have what is called a normal distribution in the population. For example, if the horizontal axis in Figure 3.9 measures intelligence levels and the vertical axis measures the number of persons at each intelligence level, the curve in the figure would trace the percentage of persons at each height. The distribution is symmetric. That is, for each person above the average score of ability there is another person who is below the average by the same amount so that the two are like a mirror image of each other. The range of individual ability is a major source of differences in income and wealth. But it is not the only source. If it were, the distributions of income and wealth would have a normal distribution curve that describes the distribution of

98 Economic Systems Analysis and Policies

Number of people

Score of ability Figure 3.9 The untouched normal distribution of abilities

Percentage of the population

25

Most frequent income

Medium income

20 Average income 15 10 5

0

Figure 3.10

10

20

30 40 50 60 70 Income in thousands euros per year

80

90

100

The real world distribution of income

ability and a large number of other human characteristics as in Figure 3.9. In the real world, the distribution of income looks like figure 3.10. There are many more people below the average than above it and a relatively small number of people receive extremely high incomes. The asymmetric shape of the distribution of income and wealth is partly explainable by ‘differing intensities of factor use’. For example, the distribution of weekly is symmetric around an average rate of x dollars an hour. But, since people who earn a higher hourly wage tend also to work longer hours, their weekly income becomes disproportionately larger than that of people with low hourly wages who work shorter hours. Choices make the distribution of income skewed, therefore. The wage rate of the highest paid is only 9/5  1.8 times that of the average wage; in contrast, the ratio of income of the highest to the average is 300/130  2.3 times. This example is, of course, artificial. But the point that it illustrates applies in the real world. Other things being equal, the higher the wage rate, the more labour will a person supply; therefore the distribution of income is more unequal than the underlying distribution of abilities. Even if the distribution of abilities is symmetric, the distribution of income will be skewed. More people will have incomes below the average than above the average.16

Firm Intensive System: Economic Challenges 99

Third, there are other causes for the skewed distribution of income than causes a, b, c and d discussed above. Wage differentials are maintained to compensate for jobs that are more arduous or dangerous than others. More experienced workers earn higher wages, too. Gender and race matter: those with higher incomes tend to be males, not females, and whites, not blacks. Income differences associated with these two characteristics imply involuntary choices as they are caused by unfair starting positions and distorted market operations. Not all income is derived from work since a tiny number of people inherit enormous fortunes. Furthermore, wealthy individuals seek wealthy partners, giving rise to assortative mating, which has the consequence that inherited wealth becomes more unequally distributed. These sources of income differences are involuntary. Fourth, can the positive analysis of income distribution identify among the causes of income inequality those that can be justified in terms of the FIM motivations and those that can be termed as market failures, also in terms of FIM motivations? So far it was maintained that while differences in individual abilities and work intensities tend to closely associate with differences in incomes, there is yet no full correspondence between favourable/unfavourable characteristics and high/low income. Thus, income inequalities can be due to (a) some individuals having innate abilities that differ (as, for example, with special talents), and because they choose to put more effort to increase their earnings; other individuals being less naturally endowed; or (b) some individuals, even though willing to pursue efforts to increase their earnings, are overpowered by circumstances and cannot move forword; while other individuals experiencing the contrary. The relationships between earnings and individual characteristics can be thus decomposed into two parts. Some favourable individual characteristics are innate and/or can be chosen, but some other parts are unfavourable and may have come into being involuntarily, mostly due to nature, or to informational imperfections, discrimination and other barriers. The public at large, and the policy-makers, are inclined to focus on the second case when they call for collective actions on distribution issues. The second case stands for an involuntary bias and is identical with ‘blame freeness’. As such it is a market failure. It is also the most reachable by appropriate policies. The normative approach. Turning to the normative question of what constitutes a ‘fair’ distribution, economists and non-economists alike opened inquiries about whether there is such a thing as an objectively fair or equitable distribution of income and wealth. Some believe that there are inconclusive answers on this.17 It has been suggested that a fundamental weakness of welfare economics is its apparent inability to choose between these possible outcomes come to agreement about what ‘fair’ distribution is. Others believe that the normative question should be formulated otherwise. In the context of the current chapter, the normative question can be asked as follows. Why should welfare economics, or in particular issues of fairness in income distribution, be of interest at all to the prospering agents in a firm

100 Economic Systems Analysis and Policies

intensive economic system? In this system all agents are maximizing their individual material benefits, so why bother on relative material benefits of the less fortunate? The answer then follows: yes, there is reason for the firms, and the maximizing society at large, to bother about the issue if they keep to their maximizing principle. The reasoning can be displayed in several steps, i to iv, that coincide at some points quite closely with the positive analysis stated earlier. (i) In a firm intensive economic system, some people with skills or abilities that are in great demand, but are very scarce, will end up rich, or enormously rich. Other individuals with skills or abilities that are in abundant supply or not demanded at all will, involuntarily, end up as poorest. (ii) There is thus bound to be inequalities because (a) individuals have innate abilities that differ (as, for example, with special talents) or individuals choose not to make changes to increase their earnings; or because (b) the maximization principle in the system may make particular individuals – the unfortunate few – economically redundant and unable to sustain an earning level sufficient to maintain basic needs. These displaced persons can be seen as a ‘corner solution’ in an optimization problem seeking the ‘firm-efficient’ allocation of resources. The displaced persons, unable to maintain themselves, may end up in crime activities that are nevertheless judged as involuntary and ‘blame-free’. (iii) The firms, and the society at large, face a dilemma. The choice is between more real resources going into combating crimes and protecting firms and their employees, or entitling and guaranteeing to all individuals a blame-free income.18 (iv) Of course, the institutional structure of the economy under consideration forms the basis for judgements on the blame-freeness of any agent’s acts and his/her entitlements. This is necessary because the entitlements that need to be installed do not exist in a vacuum. It is here that the relative distribution of income becomes relevant in making judgements on entitlements. The above exposition demonstrates a convergence between the positive and normative approaches in handling the distribution issue in welfare economics. The converging conclusion is that there are some roles for state interventions to correct for unnatural causes of income inequality and to combat unfairness related system damages. The rationale for these roles is thus fully consistent with the principle of the maximization of material benefits in the firm intensive exchange system. 3.6.2 Responses Private responses are less vital than state intervention in the area of income redistribution towards reaching more fairness. State intervention to redistribute

Firm Intensive System: Economic Challenges 101

income and wealth take two forms in FIM countries: influencing earnings and public transfers. Each form will be briefly introduced. The first form involves the manipulation of earnings so that some would earn a bit more than they would have done. Where parliaments impose minimum wage rates for employees or maximum rent charges on landlords, they are indulging in this type of behaviour. A side effect is that the working of the price mechanism is thus distorted. As regards public policy on earnings in OECD countries, it is generally recognized that there is less labour legislation on minimum wages in the US than the EU. The second form involves direct income transfers from one group of households to another. Here too, there is a side effect as these measures can alter the relative incentives that the market mechanism would provide. In countries where the welfare system provides an effective floor to incomes, i.e. most EU, there is a tendency that such a policy results in a greater number of unemployed, more government transfers, a higher budget deficit and a lower economic growth. The austere welfare system in US is a contrasting example, suggesting a trade-off between redistribution and growth.19 We mentioned that private forces respond less than government policies in addressing the problem of fair distribution. The earlier conclusions reached in the previous section on a greater role for state intervention than private responses in resolving the collectivities problem is also valid with regard to distribution. Public spending on public goods and income transfers are major instruments that the state manages in tackling the two problems. In the next chapter, we touch again on state interventions with regard to public spending on public goods and income transfers, but the focus there is on the political role of state agents in fixing the levels and designs of spending and revenue collection. The reasons for the light response of firms in case of the distribution problem are similar to those encountered in the case of the collectivity problem. First, firms are engaged in economic transformations and they pursue profit maximization to survive in the firm intensive system FIM; firms are not specially suited for coordinating transfer payments to eligible persons even though some firms in some countries are marginally engaged in such social transfers. Second, the distribution problem is much more relevant for agents in households than for agents in firms. Eligible persons for social transfer payments are those in households with little or no income. What if the time horizon is expanded to consider intergenerational mobility and private versus public endowment strategies that could enrich the productive levels of those child segments of future generations that are denoted as poor today? This opens the way for considering long-run privately steered mechanisms of growth with equity, with complimentary public support, which may escape the trade-off between growth and inequality with least mobilization of government policies in the future. Optimizing redistribution policies is delicate because policies that narrow the inequality in the distribution but make mobility more difficult may very well increase rather than decrease inequality at the

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Economic Systems Analysis and Policies

Box 3.7

Recent trends in income inequality and poverty incidence in FIM countries

In general, there is a positive correlation between these two indicators. US is shown to have the highest income inequality and poverty rate. Japan, with Sweden and Netherlands, show lowest income inequality and poverty rate. The other European countries occupy intermediate positions. In most of the countries both indicators increased over time. Most countries have become more competitive over time. This gives support to the hypothesis stated in this chapter that income differences tend to accelerate with greater firm competition in firm intensive economic systems. As a result, the phenomena of involuntarily displaced persons and corner solutions may occur more often. The organizational culture of the economic system, while acknowledging involuntary displacements, acts collectively to compensate the involuntary displacements via income transfers for the needy. Between the two reported periods, there is a noted tendency for the Gini index to rise in US and Canada, being more stable in other FIM countries. Relative poverty as defined here follows suit. Countries period

Gini index

Poverty rate

Final level

Change over period

Final level

Change over period

US

(1985–95) (1995–05)

34.4 40.8

0.4 6.4

17.1

1.2

France

(1979–90) (1995–05)

29.1 28.0

0.5 1.0

6.8 9.0

1.5 0.0

Germany

(1984–94) (1995–05)

28.2 28.0

1.8 1.0

9.1 9.0

2.9 3.0

Italy

(1984–93) (1995–05)

34.5 33.0

4.4 0.0

14.2 13.0

3.9 2.0

Netherlands (1977–94) (1995–05)

25.3 27.0

3.0 2.0

8.0 6.0

3.0 0.0

Sweden

(1983–95) (1995–05)

23.0 26.0

1.5 1.0

6.4 9.0

0.4 0.0

UK

(1983–95) (1995–05)

32.0 34.0

0.0 2.0

10.0 11.0

0.0 1.0

Japan

(1984–94) (1995–05)

26.5 24.9

1.3 1.4

8.1

0.8

Source, note: Figures for the first reported period are from OECD Economic Review NO.29, 1997/II. Figures for the second reported period are from http://devdata.worldbank.org/query/ for non-EU and from http://www.eurofound.europa.eu/areas/qualityoflife for EU countries. The Gini index is based on equivalent household disposable income per individual. Poverty rates are defined in relative and not absolute terms. These refer to the share of individuals in the population with equivalent household disposable income less than 50% of the median income of the distribution. For a disaggregated review of tendencies in factor earnings and their impact on income distribution patterns in OECD countries, see Atkinson (2003).

Firm Intensive System: Economic Challenges 103

Box 3.8 State spending on income transfers for the working age population in FIM countries The box shows income transfers expressed as percentage of GDP. The transfers are in lieu of unemployment, occupational injury invalidation, sickness, housing subsidies, poor family and other welfare allowances. There is a large diversity by country and period reflecting country differences in institutional arrangements and periodical fluctuations in the size of the receiving target groups. Note, however, that received benefits are often taxed more heavily in countries with higher income transfers. Notwithstanding, while in the US around 3.0 per cent of the GDP is transferred by the state, the figure for EU is 7.7 per cent, supporting the hypothesis that the EU is a more state-oriented firm intensive economic system. At the other end, state income transfers/GDP in Japan do not go beyond 1.3 per cent, which is possible as Japan makes greater use of traditionally developed sharing arrangements in the context of inter-household allocations that are also applied within firms for the needy workforce and their families associated with the firm.

Countries

Level 1980

Level 1992

Change

Average 1980–92

US

3.0

3.2

0.2

3.1

France

6.5

7.0

0.5

6.75

Germany

6.5

6.0

0.5

6.25

Italy

3.5

3.7

0.2

3.6

12.9

12.7

0.2

12.8

Sweden

8.7

11.7

3.0

10.2

UK

5.1

8.1

3.0

6.6

Japan (1984–94)

1.3

1.2

0.1

Netherlands

1.25

Source: OECD, Social Expenditure Database, various years. OECD: Economic Studies, 1996/II.

individual career level. Conversely, policies that enhance mobility may very well increase measured annual inequality while decreasing truly experienced inequality. However, empirical evidence on intergenerational mobility in US and EU does not show major breakthroughs. 20 Hence, the collective demand for government policies of redistribution in both the short and long run is in place. Three boxes show how state interventions respond to redistribution needs in the FIM countries. Box 3.7 gives recent trends in income inequality and poverty rates. Box 3.8 follows up with recent trends in total state spending on income transfers for the population of working age, expressed as percentage of GDP. In Box 3.9, current and future demographic changes are shown to have a significant influence on transfer expenditures.

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Box 3.9 Social security spending and projected composition of the population in FIM countries Demographic changes primarily influence transfer expenditures. Transfer expenditures consist of public expenditures on pensions, subsidies, unemployment benefits and so on. It is important to notice that these expenditures do not represent a claim on resources of society (in contrast with exhaustive expenditures!). Rather, transfer expenditures are flows of income from individuals in society to other individuals in society passing the government sector as an intermediary. These flows can be compared with reimbursements made by an insurance company for which premiums have already been paid in the past. When, over time, the demographic composition of the population changes, this influences the amount of transfer payments. Clear examples of this are an increase (decrease) in the percentage of elderly or unemployed persons in society, which lead to a higher (lower) public share. Obviously, the factors leading to an increase in the public share are outside the scope of the government sector, and therefore cannot be seen as a government failure. A demographic change like population growth is often seen as a factor that increases public expenditures. The larger population demands more goods and services from the public sector. To meet this demand more inputs are needed, i.e. the derived demand for inputs increases and thus public (exhaustive) expenditures.

Social security spending as percentage of GDP 1970 USA

1990

Percentage change in aged population ( 65) 1990–2010

2010–2030

Percentage change in aged dependency ratio 1990–2010

2010–2030

7.9

11.2

18

65

2

69

France

17.0

21.2

22

33

17

46

Germany

13.1

15.2

21

10

37

42

Italy

12.4

18.2

22

17

28

Netherlands

17.4

25.8

Sweden

35

3

39

11.1

19.5

UK

8.7

11.4

Japan

4.6

11.5

71

2

82

8

OECD

9.1

13.7

28

36

19

45

1

Source: OECD, Social Expenditure Database, 1995, Table 6.3; and OECD: Ageing Populations: The Social Policy Implications, 1998.

Firm Intensive System: Economic Challenges 105

3.7 Summary and conclusions We reviewed the economic principles of the pure firm intensive economic system. The firm intensive system can be seen to consist of firms (and individuals) who are motivated by commercial self-interest. Firms maximize profits subject to technological and budget constraints. Individuals follow suit and maximize their utility subject to budget constraints, which are the incomes the individuals earn from the firms for work done in these firms. The firm intensive system relies on the competitive price mechanism, which is characterized by indirect exchanges between many independent sellers and many independent buyers. The firms are sellers. The optimal performance of the perfect market economy centred on firms depends on the fulfilment of four presumptions; that is, absence of indivisibilities, uncertainties, externalities and collectivities. There are technical and behavioural dimensions to these presumptions. The optimal performance of the market economy would require fulfilment of the technical presumptions as well as absence of behavioural bias in the four directions. Non-fulfilment of underlying presumptions in the real world results in inefficiencies – market failures – that are remedied by firms and market solutions and/or state interventions. There is a fifth market failure. Welfare economics states that any Pareto optimal state is equilibrium for some initial distribution of endowments. The market failure comes in the picture when more agents feel that the existing income distribution is unfair, to them or to others; and when this feeling is transformed in actions that would affect the economically efficient outcome of that moment negatively. To prevent a market failure the economic system responds with measures that assure ‘fair’ outcomes for all agents. For economists and politicians dealing with economic systems a crucial question is thus what is ‘fair’? Conceptually, there are two approaches economists use in treating the question of what is ‘fair’: a positive and a normative. Both approaches are highlighted in the context of FIM countries. In subsequent sections, the five market failures are treated. We reviewed the ingredients of the problem and examined the response of firms in remedying the problems and state intervention. We made use of FIM related country data to illustrate the problems and show how firms and state have responded in US, Japan and major EU countries. In relative terms, the US stands closest to the modern firm economy where free markets are paramount in determining the character of the economic system. In comparison, the EU allows for a greater influence of collective features typical of state settings, while the Japanese economic systems manifest elements of sharing typical of kinship settings. The chapter made use of additional comparative boxes. We examined (1) changing country patterns of nationalization and privatization in infrastructural sectors in 1980, 1990 and 2005; (2) indicators of firm intensity and open competition for 1995, 2000 and 2005; (3) business and state resources in Research & Development in FIM countries, 1970–1980, 1990–2000; (4) corporate governance patterns in FIM countries, around 2000–2004; (5) the response to liberalization

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initiatives of the World Trade Organization in FIM countries; (6) pollution control in the framework of responses of FIM countries to the Kyoto Protocol; (7) recent trends in income inequality and poverty incidence in FIM countries, and (8) state spending on income transfers for the working age population, and social security spending and projected changing composition of the population.

4 The Firm Intensive System: Polity Functioning and National Accommodations in US, EU, Japan

4.1

Introduction

All nations face collective needs. State authorities have evolved as the effective institutions to resolve many of these collective needs. In doing so, state authorities secure and enjoy a political monopoly. This allows state authorities to acquire and practise political influence. The circumscription of the economic system by state institutions brings with it political dynamics and political influences that usually go beyond the initially posed problems and proposed solutions. Resolution of economic imperfections requires the functioning of and intervention by the state, this in turn can lead to political influences that may run counter to the intended resolution of collective needs, and furthermore, may bias the structure of the economic system and undermine its performance. In the previous chapter, it was emphasized that the business community in a firm intensive economic system, FIM, and the population at large, call on state authorities and national politics to provide collective solutions for problems they cannot solve privately. This chapter will examine the needs for polity and the behaviour of the polity in general terms as well as their practical accommodation in countries with a firm intensive economic system. The relationship between the state and firms in a capitalist economy has been a regular subject of modern political and economic thinking. Schumpeter contributed to the view that the capitalist system would be dominated by monopolist firms which will collaborate with a powerful state. The partnership strengthens both forces to the detriment of other players. Then there is an opposing view by Hayek that monopoly firms are transient and the capitalist economy will manifest a competitive and continuous entry and exit of firms, which by implication will exclude coalitions between firms and the state. There is a third position that lies somewhat in between. Stigler coined the word capture to denote the tendency of monopolistic firms to use the regulatory state to bolster the firms’ own market power. Stigler allows also for newcomer firms to lobby for their entry and use the state accordingly. In all three cases, the firms are dominant actors and the state 107

108 Economic Systems Analysis and Policies

rulers are sideline beneficiaries. However, the state seems to be more active under Schumpeter than in the cases of Hayek and Stigler. There were periods in recent history in which large firms collaborated with a powerful state.1 But contemporary countries, that have a FIM economic system, correspond more with the viewpoints of Hayek and Stigler, than Schumpeter. Regulatory captures and state lobbying by incumbents and newcomer firms occur in Europe, US, and Japan, but these captures are transient in a FIM economic system where regular entry and exit of firms wipe out such captures. While Stigler holds in the short run, Hayek holds more for the long run. In either case, firms are the dominant players and profit maximization is the dominant motive in the FIM economic system. In countries that lie close to a purely firm dominant system, the closest to this will be the US, the behavioural motive of profit maximization would have sufficiently spread across the spectrum to become the institutional norm that guides not only the actions of the firm but that of the state, too. In the extreme, all actors in a firm dominant system will behave as profit maximizers. Political behaviour can be interpreted in a FIM economic system in terms of economic motivations. Where acts of mutual capture involving firms and the state occur, these acts can be interpreted in terms of the motive of profit maximization as well. In more competitive economic and political settings, where the legal system incorporates more checks and balances on non-permissible handlings, less mutual captures can be expected. In a FIM economic system, it will be plausible to consider profit maximization as the underlying common behavioural pattern of all actors, thus both firms and state.2 The political process in such a system can be described as exchanges process subject to laid constraints, or in short, a constrained market. The functioning of state institutions and state agents, and these include voters, political parties, governing politicians, bureaucrats, interest groups public sector employees, can be described as a marketplace where actors maximize their gains, and subject to checks and balances that serve the FIM system. The elaboration of such an analytical framework and its application to the FIM system/countries requires addressing several questions and answering them. (a) Who are the main actors in this polity? How do they function and interact with each other in the FIM nation state? (b) There are many areas in which the state is neutrally active, in the sense that it is not taking side with one or the other beneficiary. But in the areas of public regulation and public spending state agents may not be always neutral. The question is how to interpret the functioning of the polity in the FIM nation state regarding the task of public regulation, and what are the consequences of this functioning for the economic and social welfare of the nation as a whole? (c) In similarity with the above, there is also the question of how to interpret the functioning of the polity in the FIM nation state regarding the task of public spending, and what are the consequences of this functioning for the size of

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the public sector versus the private sector, and for the economic and social welfare of the nation as a whole? (d) Even though a group of nation states share the FIM economic system, the independent functioning of differing polities in different nation states tend to increase country divergences within the FIM group. The question is then how to position and understand country divergences and system convergence among the FIM countries? Accordingly, this chapter falls further into four sections that treat these four sets of questions. Use will be made of comparative country examples to illustrate the extent and variety of the political influence of the executive branch on the economic system and its economic performance.

4.2

The political process as a political market

4.2.1 Overview Since we are dealing with a firm intensive economic system where economic motives are dominant, it is logical to explain and analyse the political functioning of the state in economic terms as well. If the functioning of state institutions, and state agents, can be described as a political market where actors maximize their gains, then who are the main actors in this political market, how do they interact, what are the results, and what is the end assessment of this political market in terms of consequences for the economic system and social welfare? The historical evolution of the firm intensive economic system went hand in hand with an associated evolution of a political regime that is characterized by a voting public that elects a parliamentary democracy, that assigns a government, that is supported by a bureaucracy; a separation of state powers in the spheres of the executive, legislature, and the judiciary; and a host of checks and balances on each sphere to assure accountability of the functioning of each political actor in each sphere to the electorate. The checks and balances can be seen as controlling devices on behalf of the electorate, which includes all agents in all firms and their dependents, for assuring that the authorized political actors act consistently and fairly to the benefit of the electorate, and for preventing the rent appropriation perils of monopolistic state settings. Who are the political actors in a political market? These are the voting public, political parties, government leaders, state bureaucracies, interest groups, and political media. Although public sector employees are not active political actors, they will be seen to play a prominent role in shaping the polity and the economy. All these political actors and their interactions play significant roles in shaping government policy, political influence, the polity, and the economy. And, ultimately influence economic and social welfare. It can be initially assumed that these political actors behave in ways that maximize their individual material utilities, material self-interest. As such, the functioning of the state can be analytically simplified in some respects to that of an application of standard microeconomics to the political market.3

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Economic Systems Analysis and Policies

In the microeconomic terminology that associates with the firm intensive economic system and that is typical of exchange markets, the political market can be described basically as consisting of buyers and sellers who undertake mutually beneficial exchanges of political compromises and material benefits within a world of varying uncertainties. The voters are the buyers: they demand security, regulations, services, and redistributions from the political parties and governing leaders. In exchange they supply taxation. The buyers are assumed to maximize their utility, which is derived from alternative government policies, taking into account differential benefits and taxation schemes that are related to these government policies. Political parties compete for a majority of electoral votes to form the governing party or a coalition of governing parties. The winning political party in an election usually institute the government leaders. The political party in charge of governing is comparable to an incumbent company that supplies goods; the opposition party is an aspiring company. Political leaders, who are appointed in government, as ministers or deputy ministers, direct the plans of the (winning) government party. While it is logical to assume that political parties strive to maximize votes gained, political leaders within a political party, once elected or appointed in government, may not necessarily pursue this consistently. In the real world, some or many of the political leaders may opt for short run personal gains, acquire rewards and satisfactions while in office rather than seeking the office to implement the party beliefs, or use the office to maximize future influence outside politics. The roles of the political party and its political leaders are comparable to those of the company shareholders and the company board of directors. State bureaucrats implement the plans of the ministers and deputy ministers. State bureaucrats can be compared to business managers. State bureaucracies are responsible for overseeing and implementing regulations and provision of public goods like defence, roads, health, education, and so on. The appointed ministers and state bureaucracies run the government and are the final suppliers of political solutions. The relationship between the minister and the bureaucrat has much to do with principal–agent relationships and asymmetric information. Bureaucracies are experts on their field of research whereas their political superiors, the ministers, only have the general view of what is going on in the departments. Because it is too costly for any individual minister to monitor bureaucracies, the latter have an opportunity to influence the quantity and efficiency of public sector output in biased ways. Several models describe bureaucratic behaviour that will be examined. Lower in the hierarchy of decision-makers is the large number of other public sector employees who execute and deliver the public services provided by the various ministries and allied publicly funded organizations. Although public sector employees are not active agents in the political process, they indirectly play a central role in shaping the polity and economy. The nature of the delivered public services of public sector employees differs from that of the private sector results in productivity differentials. Furthermore, the political commitment for

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equal pay to public sector employees and private sector employees has significant consequences for the operation and outcomes of the polity and economy. Another set of actors in the political marketplace consists of interest groups. A narrow notion of interest groups would refer to pressure groups like individual firms or associations of firms, employer organizations, trade unions, regional areas, and so on. These pressure groups share in common the motive of influencing policies to meet their objectives. In reaching their objectives they mobilize bureaucrats and politicians to circumvent regulations and raise public provisions to the advantage of the pressure group concerned. The notion of interest group can have a wider interpretation when it refers to large socio-economic groups or classes within society; for example, the higher income and lower income classes. These groups are not in a position to organize themselves and apply pressure; but their interests shape the polity and economy since they are eligible voters and governments strive to maximize votes. The next political actor is political media. We started with the voters who are buying. They are comparable to consumers. Voters, as consumers, are also subject to information constraints, their information base is limited, and the search for information costs money. The search for information applies not only to voters but also to all political actors. This provides an opportunity for political parties, politicians, bureaucracies, and interest groups, which do dispose of specialist information, to influence opinion, voting, and policy. Political media is an additional political actor that engages in information search and dissemination. Their role is close to that of advertising agencies that highlight the merits and demerits of political suppliers, their leaders, associates, and operations. As stated above, we shall assume that these political actors, in a FIM system, behave in ways that maximize their individual material utilities, i.e. material selfinterest. This is in correspondence with the behaviour of economic agents in the FIM system. In terms of outcome, it has been analytically shown in the previous chapter that the maximization of material self-interest is not a guarantee for the highest economic and social welfare. This has applied to the functioning of the economy in the previous chapter and it applies also to the functioning of the polity in the present chapter. Just as the economic market in the FIM has its failures, and the FIM responds by creating institutions that check and correct these economic failures, so the polity in the FIM may falter also and hence the institution of checks and balances in the FIM to control the functioning of the polity. The checks and balances are instituted at the legislative, executive, and judiciary levels. In a FIM system, the economic and political markets share various similarities. Just like a normal market for economic exchanges, the political market can be described to face similar limitations in the way of a perfect functioning. Perfect competition, in the context of political market, exists if parties would compete and thereby eliminate abnormal ‘profits’ that might arise due to discretionary behaviour on the supply side. So with a large number of voters and political parties and with no significant entry barriers a Pareto optimal solution would result, in which parties respond to demands of voters. However, in reality many of these

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Economic Systems Analysis and Policies

conditions are not satisfied, just like in normal markets. Various imperfections exist, which lead to Pareto sub-optimality. It is sufficient to mention a few examples of imperfections that relate to indivisibilities, uncertainty, and externalities. As regards indivisibilities, competition in the political market is of the all-or-nothing type; the winning party gets the whole market and gain monopoly power. Regarding uncertainty, all political actors are faced with imperfect information and there are no existing institutions that resolve this problem in effective ways. Externalities abound. Interest groups are able to influence in indirect ways the policy-makers and the implemented policies, without taking part in a direct process of political selection that is sanctioned by popular vote. Furthermore, the electoral system influences the preference revelation of voters: usually the voter votes for a package instead of specific issues. This means that indivisibilities are present, and voter preferences are not genuinely revealed. Besides, voters cannot commit politicians to do as they have promised so that there is room for discretionary behaviour on the side of politicians, more uncertainty and greater externalities. Now that the political market has been introduced in more general terms, attention will be directed in the following sections to examining the roles of the various political actors, the generated political influences, and outcomes for the economic system and social welfare. 4.2.2 Voters The polity rules in a parliamentary democracy are that voters elect representatives freely and periodically, and that the elected majority governs until a next period. Theoretically speaking, as voters are comparable to consumers who maximize utility, they can be assumed to be able to assess the merits and demerits of actions taken by alternative representatives in the past and in the expected future before making a choice for specific representatives who will give them the highest utility. Voters will consider then the past record of political representatives, related to what they had promised to do initially, as a basis for future performance and based on this they make their final decision on which party to elect. In practise, the ability of the voter to assess the utility he gets from each and every act of alternative representatives in government and opposition is not feasible due to rationalizing limits and uncertain information. So, the voter looks for additional short cuts that can help in making voting assessments and electoral choices. Short cuts are found in voting along political parties that stand for advocated ideologies, or in voting for political parties led by admired leader. Examination of voter behaviour cannot be done in isolation from political parties and political leadership. Therefore, political parties and political leaders emerge and end up occupying central roles in the polity in all parliamentary democracies. Political parties are eager to announce and disseminate their ideologies and allied policy implications in an attempt to win more voters, and in this same process they provide the highly needed information that voters search for. Similarly, a political party tries to select from among its members the most vote gaining leaders and does its utmost to expose the best of their leadership qualities

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in an attempt to gain more votes; and in doing so the voters are helped in their information search for assessing leadership. If rationality and information were fully certain, the assessment by voters of alternative ideologies would have tended towards uniform outcomes. A diversity of party political ideologies can exist only because uncertainty prevents a judgement of the superiority of one ideology over the others. More or less applies to party political leaderships. The responses to uncertainty by voters, parties, and leaders result in a clustering of voters into abstaining groups and a variety of voting groups that manifest high to very low degrees of confidence in their election decisions. The sub-optimality in voter behaviour translates in a sub-optimality of voting outcomes, and a distorted allocation of political authority. The above account on voter behaviour, which constitutes a first phase of the political process, is indicative of (an early phase) polity failure in the political system that has evolved with the FIM. 4.2.3 Political parties Voters want to elect a government responsive to their wants; they make use of political parties to run the government. Political parties want to take charge of governing the country; they make use of voters to get elected. The two processes, with different motivations are interlocked to form the political system of parliamentary democracy. The main goal of the parties is the winning of elections. Parties campaign to maximize votes. They compete with each other for the votes, which are necessary for control of the government apparatus. If a political party believes it can enhance its probability of gaining office by announcing unchecked policies, disseminating imperfect information, being vague on policy standpoints, allowing contradictions or pursuing ambiguous actions that discourage voters from being rational, it is rational for the party to do so, up to the point that voters do not lose trust in the whole political system for at that point the parties, as main stakeholders, would be main losers. The urge for political parties to win as many votes as they can, drive them to adopt policies favoured by the median voter. Thus, the majority-voting equilibrium is the policy preferred by the median voter. Where there are tendencies of political parties, and politicians, to move towards the median voter, consensus politics is likely to emerge. Both parties agree on any policy issue favoured by a majority of voting. Although parties in a two-party system tend to converge ideologically towards the median voter, the fear of losing outlying voters avoids them from being identical. The limits to convergence/differentiation are determined by the characteristic distributions of the voters; the more heterogeneous the voters the more likely that parties gain by distinguishing themselves more distinctively, and eventually resulting into a multiparty system. There can also be one-issue parties who attract segments of the population that are more concerned with a specific issue. The common denominator that unites a party can be also regional interest, ethnic background, or religious belief. Faced by ambiguities, contradictions and uncertainties, created by interacting parties, voters may step side the political debate and vote parties in along

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emotional, incidental, or predetermined a-political lines that can be described as irrational and sub-optimal in terms of decisions and impact. In this respect, a major conditioning determinant of political development and social welfare is the distribution of voters along political and non-political scales. The more heterogeneous and divided the voters the greater the chance that parties will exploit the divisions, which in turn reinforce a divided voter behaviour along a-political lines. The performance of the polity is likely to be more optimal in countries where voters, and parties, are more homogeneous. Another conditioning determinant is the historically installed voting rule; it happens that the majority rule associates with more homogeneity and two-party systems, while proportional representation has gone more with heterogeneity of voters and multiparty systems. Ambiguity and contradictions in party politics are not only characteristic of the voting phase but show up also in the governing phase. In general, these anomalies are more common in a government by a coalition of parties as each party’s reasonably integrated programme must be adjusted at parts to the programmes of the co-governing parties, resulting in overlapping policies and sub-optimal performances. 4.2.4 Governing politicians The governing party, or parties, commonly strive to apply those policies that are favoured by a majority of voters. For if they do not, opponent parties will propose those policies in a next election and defeat the incumbents. But the government may follow an inter-temporal strategy: take unpopular measures at one time that may please more of the electorate at a later time, if indeed more voters will conceive the final effect positively. Political leaders of the majority elected political party, or parties, take charge of running the government. Political leaders running a current government may not abide with the political programme that formed the basis for electoral votes and which brought their political party to run the government. This can be explained in terms of the inter-temporal strategy mentioned above: causing disappointment among some loyal voters now for the sake of gaining more voters later. This anomaly can be also understood in terms of acquired information that requires a change in positions previously defended and/or deviating interests between the political party and its self-interested appointed ministers. The anomaly is very common in a world of uncertain information and moral hazard. Countless accounts of such anomalies can be recalled in many FIM relating countries. The impact of the anomaly on the performance of the political system, and the economic system, is of more concern here than how and why it occurs. The anomaly can be indicative of a polity failure in the sense that other policies than the promised policies are realized. The deviation can be exploited politically, irrespective of whether it is justified or not, and this can lead to a loss of confidence by the voters in the governing political party and in its leaders, with loss of valuable votes in a next election. But this may also not happen due to a weak memory of the electorate, putting the blame on the deviating politician, discounting the

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deviation as an incident, or a timely reversal of government policy towards voter friendly issues as the next election round is approached. In either case, the functioning of the political process is sub-optimal. Uncertainty causes additional complications. Governing politicians, as well as the political parties to which they belong, are uncertain as to what the electorate wants. Governments and parties rely upon bureaucrats and other intermediaries to find out. The intermediaries include favour-buyers, interest groups, and paid as well as unpaid political advisors. As any of these intermediaries has its own biased agenda of political interest, its contributions to governing leaders in terms of opinion formation and policy formulation carry cost tags. In general, the more resources an intermediary possesses, the higher is its political influence. Furthermore, as information providers to government groups, all intermediaries taken together are able to master proportionately a greater political influence than their relative size in the electorate. Thus, government leaders, under uncertainty and gaps in their information, reward their informants in unequal ways, and depart from the principle of equality of political influence of individual voters. In the above paragraph it was maintained that government leaders facing uncertainty are forced to engage intermediates, resulting in unequal political influences. The polity is bound to drift in more sub-optimal performances when a governing politician goes beyond the mobilization of intermediaries strictly for the purpose of forming an opinion, and assumes an active role in fixing deals with intermediaries against benefits for the government politician in question, and/or his associates, now and/or later. Political influence is thus gained in the process of governing and instituting political solutions to problems that individuals cannot solve. The governing politician unequally distributes political influence, and he may not be able to do otherwise under uncertainty. Political influence can be intentionally used also to realize unintended gains for the politician involved at the cost of negative side effects for the voters who elected him/her. Both are instances of polity failure, whereby the latter is a greater one. Numerous cases can be quoted of both instances in the context of FIM relating countries. 4.2.5 State bureaucrats Bureaucracies are governmental departments. They advise governments (local, regional, national) on present microeconomic policies and on opportunities for new initiatives. In practice this ranges from the provision of public goods, like defence, to purchasing goods and services from the private sector. They also take care of collection of taxes, regulation of firms and industries, and of redistribution policies. As can be expected, the profiles of state bureaucracies are much more stable than those of governing parties. Less obvious, but more important, are the inclinations of bureaucracies to cause upward budgetary bias and hazardous regulation bias. This section will elaborate on both aspects. Upward budgetary bias. In the context of the political marketplace, bureaucracies are the suppliers of goods, services, and information to the governing party and

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the community. Because of their protected position (entry is restricted, and all property rights are allocated towards the existing bureaucracies) they are the sole suppliers in their specialist area. Because each bureaucracy specializes in a certain area, there is usually no competition within the public sector. The special position of bureaucracies is similar to that of the interest groups: they are also extremely well informed in their specialist area, and in the absence of alternative information resources the government is not sufficiently well informed to question a bureau’s behaviour. To increase their departments, bureaucracies often want parts of the public sectors to be centralized. In this way a bilateral monopoly will come into being: the bureau is the sole supplier, whereas the government is the monopsonist who purchases goods, services, and information in return for an agreed budget. The lack of competition leads to opportunities for discretionary behaviour. Discretionary behaviour is typical for large organizations operating in noncompetitive markets with ill-defined objectives. The larger an organization is, the bigger the control loss which gives rise to opportunities for discretionary behaviour. In such an environment politicians and top executives will find it difficult and costly to ensure that their orders are carried out. With more levels in a hierarchy, the chance that the original order will be changed (accidentally or not) increases. In such an environment bureaucrats have an incentive to deliberately distort or hoard information for the furthering of their own objectives. This is reinforced by the fact that the employment contract of a bureaucrat is often incomplete and lacking in efficiency incentives. Private markets encounter moral hazard as well; in these contexts consumer choice, competing producers, and market institutions serve as ‘policing’ mechanisms. They provide incentives to improve efficiency. Unfortunately, such controls are absent in the political marketplace so that another solution has to be found. Measures to reduce distortions are the appointment of external advisors or independent audits. Also, awarding the release of new and valuable information might create incentives. Various models of bureaucracy behaviour will be discussed below based on presentations by Hartley and Tisdell (1981) and Cullis and Jones (1998). These are known as those of maximizing bureaucracies, information misrepresentation, and paperwork models. Maximization of ministerial budgets. Niskanen (1971) assumes that bureaucrats maximize their budgets. By increasing their budgets they can satisfy personal needs like perquisites of office, job opportunities, higher salaries, and so on. The government, the sole purchaser of goods and services from bureaucracies, has to pay for these large budgets. The political marketplace thus is characterized by a bilateral monopoly with bureaucracies acting as monopolists and the government acting as monopsonist. Niskanen assumes that bureaucracies are perfect price discriminating monopolists as they take away all consumer surpluses from the purchasing government. Figure 4.1 reflects on the budgetary bias.4 The government will demand a certain amount of goods and services from the bureaucrats. The median voter determines this demand, as a vote-maximizing,

Firm Intensive System: Polity Functioning

Benefit B cost

117

MC

D MR X

A

AC

C

E

Q Figure 4.1

Qm

Qc

Qb

Output

Upward budgetary bias I

government will adopt that policy that is favoured by the median voter. So D represents the demand function of the median voter. MR is the marginal revenue and MC and AC are the marginal cost and average cost, respectively. A bureaucracy maximizes its budget, but of course under the constraint that total cost is covered by total revenue. The maximum output level at which the budget is maximized, subject to the cost coverage constraint is Qb. The total cost is equal to OACQb. OBEQb represents the budget, which is revenue for the bureaucracy. Because OACQb equals OBEQb, all costs are covered. As expected the solution is not socially optimal: Qc, the socially optimal output level (found by equalizing the demand curve and the MC) is less than Qb. The consumer surplus at Qc (ABX) is fully captured by the bureaucracy. The bureaucracy uses ABX to increase total output to Qb. Going from Qc to Qb extra cost equal to QcQbCX arises, which is not fully covered by the increase in the budget of QcQbEX. ABX is then used to cover this ‘extra’ cost (XCE). The figure can also be used for analysing the difference between a public and private monopoly. The solution under a private monopoly would be Qm, which is less than Qb, the solution in case of a public monopoly. Qm is socially preferable to Qb because at Qm the consumer surplus is still positive, while at Qb it is zero. Underestimation of specific costs. Figure 4.1 has shown that bureaucracies by maximizing their budgets tend to ‘overproduce’ compared with the socially optimal output level. Additional misallocations are caused by the distortion of information from agent (bureaucracy) to principal (the government or the minister in charge): bureaucracies have an incentive to misrepresent information on costs and benefits, because by doing so bureaucrats can increase their budgets to an even greater extent, as will be shown in Figure 4.2. First, departments have an incentive to exaggerate or overestimate the demand for policies or projects that they have to carry out. They are likely to stress (exaggerate) benefits of projects in the form of creation of employment, technology push, and an improvement of the balance of payments.

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Benefits cost MC0 AC0 MC1 AC1

D0 0 Figure 4.2

Q0

D1 Q1

Output

Upward budgetary bias II

Bureaucracies often make use of expert knowledge of interest groups, particularly producer groups, who are willing to help because they benefit from the project (or policy). Also, departments can hire independent consultants to provide further expertise supporting their case. Governments are likely to listen to the advice of producer groups because they are vote maximizers: the median voter is usually uncertain about cost and benefits: voters with median voter preferences are usually wary of the costs but positive about the potential benefits. In such circumstances the government is likely to listen to those people who are best informed. At the same time, the costs of projects and policies are usually underestimated to make them look more attractive in terms of costs and benefits (including external effects). Projects that seem to be relatively cheap are more likely to be accepted by the government. In this way ‘too low’ cost estimates can lead to the purchase or spending of ‘too much’. This also implies that in the implementation the project will cost more than the biased low figure of the (average) cost in the budget. But any recognition of this will in general be too late because, once the implementation has started, the process is usually not reversible. Again, a lot of producer groups like architects, engineers, scientists, surveyors, unions are involved and have an interest in the continuation of the project. Using the support of these interest groups bureaucrats can easily show vote-conscious politicians that the project is in the ‘national interest’ and will produce substantial social benefits (in the form of jobs, and so on). One might say that cost escalation also occurs in the private market, and therefore is not necessarily a typical public failure. But private firms are less likely to underestimate costs in the first place, or to continue a project with unnecessary high costs in the second place, simply because their profitability and thus competitiveness in the market will suffer from both. Figure 4.2 shows what happens when bureaucracies misrepresent information on costs and benefits. Bureaucracies will create an impression of allocation efficiency

Firm Intensive System: Polity Functioning

Total costs and budgets, B

119

TC2 TC1 TC0

B2 B1 B0

0

Figure 4.3

Qb Output, Q

Upward budgetary bias III

by overestimating demand, so that the original (true) demand curve D0 shifts to the right to D1. At the same time costs are underestimated which shifts downwards the original marginal cost curve MC0 to MC1 and respectively AC0 to AC1. Compared to the original situation output increases substantially from Q0 to Q1. In general one may conclude that the system creates incentives to spend and to overproduce. Obviously, the tax payer is the one that ultimately bears the full cost. Overestimation of general costs. This model incorporates the presence of X-inefficiency (slack) in the public sector. The model distinguishes general public costs (administration costs), as different from specific public good costs. Specific public good costs were mentioned in the foregoing discussion. It was argued there that costs of a specific public good will be underestimated, whereas now it is argued that bureaucracies will overestimate general administration costs, the so-called paperwork. Therefore, the distinction between general and specific costs is an important one. Cost of administration, a typical characteristic of bureaucracies in dealing with the private sector, has been introduced to model X-inefficiency: it can be used as an output indicator to inflate costs. The government cannot easily check this, so that a higher budget to cover these ‘costs’ is easily obtained. Once a bureaucracy has obtained such a budget it can try to shift some of the costs of paperwork onto private firms. The bureaucrats can use the ‘cost savings’ for their own purposes (e.g. office perquisites). Figure 4.3 shows how this works. The government requires an output of Qb from the bureaucracy, and in return the government will pay the total cost for it. The true cost of the bureaucracy of producing Qb is represented by TC1. The budget at these true costs is equal to 0B1. The bureaucracy will try to get a higher budget by misrepresenting information on

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costs: the department will claim that its true cost is represented by the TC2 curve. In that way it will obtain a budget of 0B2. Now, by hiving off some of the cost of paperwork to the private sector, the bureaucracy can increase its discretionary expenditures even more. As a result the bureau’s new total cost curve is equal to TC0, so that the total amount of discretionary expenditure amounts to B2B0. There are limits to the opportunity of this kind of discretionary behaviour: firms will respond by lobbying politicians, arguing for less bureaucracy, and for the work to be ‘hived off’ to the more efficient private sector. The above paperwork model, combined with the misrepresentation of information, leads to the following conclusions. Bureaucracies, in maximizing their budgets, have an incentive to misrepresent information on costs and benefits. In particular, when a specific project or public good is under consideration, bureaucracies will underestimate costs (overestimate benefits), while costs of general public administration will be overestimated. Bureaucratic bias in the running of state regulation and state ownership of enterprises. Finally, attention can be directed to bureaucratic bias and economic distortions related to state regulation and state ownership. These are (a) economic distortions due to catch and/or corruptive behaviour of bureaucracies and/or enterprises in the actual implementation of regulation rules, which was discussed in the previous chapter; and (b) economic distortions due to incentive problems commonly encountered in publicly owned and run enterprises, and known as the ratchet constraint, and the soft budget constraint. Berliner (1952), Kornai (1979), and others treated the ratchet and the soft budget constraints in the context of a centrally planned economy. It is noted that they apply only marginally to the public sector in FIM, given the very limited extent of a simultaneous state ownership and state management of public enterprises in FIM. The ratchet constraint arises in a situation where the ministerial authority (or central planners) fix a future output target for the public enterprise Q t1 at a higher level than the achieved current output Qt. Calculative managers of the public enterprises will deliberately produce low Qt and pass to the central planners underestimates of their real production to avoid compelling targets. The ratcheting of targets by the central planners creates an X-inefficiency. The problem can be solved by persuading public enterprises to disclose their true estimate of maximum enterprise output, given input authorizations; but developing such mechanism designs is difficult. The soft budget constraint problem applies in situations when the state guarantees that the operations of loss-making public enterprises will be continued nevertheless. As a result, there is no incentive for the public enterprise to economize in the use of capital and to minimize on other costs. The ratchet and the soft budget constraints are incentive problems that are best analysed in the framework of principal–agency theory. Both constraints are also linked to each other in the context of cross-subsidization, as when the ratcheting of output targets for the better performing enterprises is used to finance the soft budget constraints of the loss-making enterprises. Responding rationally to this

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cross-subsidization, both firms will not maximize their effort and will end up in lower efficiencies. 4.2.6 Public sector employees A large number of public sector employees execute and deliver the public services provided by the various ministries and allied publicly funded organizations. public sector employees are lower than the bureaucracy in the hierarchy of decisionmakers. Although public sector employees are not active agents in the political process, they indirectly play a central role in shaping the polity and economy. The nature of the delivered public services of public sector employees differs from that of the private sector results in productivity differentials. Furthermore, the political commitment for equal pay to public sector employees and private sector employees has significant consequences for the operation and outcomes of the polity and economy. Most of the public sector consists of public services. This implies that the product (service) which is produced (delivered) is labour-intensive, and, more importantly, that the employed labour itself is the end product. Public sector employees can be seen as the input that goes in public services, but it is also in a sense the end product of public services. Substituting capital for labour is then simply impossible without changing the nature of the product. This is like trying to replace something (labour) that is part of the product itself. Growth in labour productivity in the public sector is quite limited.5 In contrast, in the private sector labour can easily be substituted by capital without changing the nature of the product, because labour is just an input (an instrument) to the production process from which the end product results. So while substitution of capital for labour in the public sector would change the product completely, such a substitution in the private sector does not change the nature of the product at all, and it has been always occurring, resulting in the increasing productivities of the private sector. These technological differences give rise to the productivity differential between employees in the public sector and the private sector. In the public sector, the growth in productivity stays behind that of the private sector, in relative terms. To what extent are these labour productivity differentials translated in differences in labour remuneration rates? In the private sector, increases in labour productivity are followed by equal increases in wage rates. As a result, unit costs remain constant over time. If this economic principle were followed for the public sector then the relatively lower productivities would go with relatively lower remuneration rates for public sector employees. But, this does not happen. There is a widely held political commitment, a convention, to equalize the remuneration rates of equivalent labour efforts. To prevent labour moving from the public sector to the private sector, wages in the low productivity public sector are set to match those in the high productivity private sector. Given that the productivity growth is less in the public sector compared to the private sector, this implies that unit costs in the public sector will rise. With an income elasticity of demand that exceeds the price elasticity of demand, the output of the public sector will not fall. Rising input costs will then lead to higher total costs of the public sector and

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thus to higher exhaustive public expenditures, presumably destined towards the provision of public goods. As the high productivity private sector would increasingly carry the obligation of financing the low productivity public sector at equal remuneration rates, and the public being a sector with a high demand elasticity, economic growth would tend to slow in the long run. Baumol (1967) analysed formally this problem of productivity differentials that for some non-economic considerations are not transformed in equivalent wage differentials. In his analysis he distinguishes two types of sectors: the (private) progressive sector and the (public) non-progressive sector. A progressive sector is characterized by economies of scale and technological change, which lead to increases in productivity per unit of labour. In the non-progressive sector labour productivity grows at a much lower rate. He righteously recognizes that this difference in productivity is caused by differences in the nature of the product that is produced. The following model summarizes the problem formally. Take X1 as the output of the non-progressive sector, and X2 as the output of the progressive sector. The production functions of each sector are then as follows: X1t  a1L1t X2t  (a2ert)L2t

(1) (2)

with L1 and L2 being the labour force in the non-progressive and the progressive sector respectively, t is the time index and a1 and a2 are constants. The production in the progressive sector is assumed to grow at an exponential rate of r. Equations (1) and (2) are used to derive the ratio of government output to total output, as shown in equation 3 below:

X1t ( X1t  X2t )

a1 L1t ( a1 L1t  ( a2 e rt )L2t )

(3)

An implication is that if the ratio of public sector output to private sector output is to remain constant, then it must be that labour is transferred from the private to the public sector. This is indeed observed in reality. It is assumed that wage rates are equal between both sectors and that they follow increases in productivity in the private sector. w0 is a constant, and wt is the wage in period t. wt  w0ert

(4)

From the equations above, unit costs can be derived for the public sector in equation (5) and for the private sector in equation (6).

C1t

( w0 e rt ) L1t a1 L1t

w0 e rt a1

C2t

( w0 e rt ) L2t w0 = ( a2 e rt )L2t a2

(5)

(6)

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From equations (5) and (6) it follows that unit costs in the public sector will rise steadily, while private sector costs remain constant. Together with equation (3) another conclusion of the model is that public exhaustive expenditures will rise faster than private sector expenditure on inputs. The growth potential of the economy is only partially realized. 4.2.7 Interest groups Pressure groups are groups that try to influence policy in their own favour. For example, when several firms strive for a monopoly position each of them might try to ‘buy’ these rights by lobbying for protection against competition. The firm who bids the most is likely to get the monopoly position. Each firm’s maximum bid will be equal to the expected profit that will be made in the monopoly position. This example shows that lobbying for favourable policies can be regarded as an auction: the governments supply favourable legislation to groups that outbid their rivals. A group is willing to pay a price equal to the expected profit of protective legislation. Payments in general may take the form of bribes, votes, cash contributions to the governing party, supply of persuasive information, provision of campaign speakers, and so on. These payments are not necessarily socially wasteful: e.g. in the above example, the payments are not more than transfers from the (potential) monopolist to the government. The government, however, spends the received payments. First, it supplies favourable regulations to the one that outbids his/her rivals, which mostly lead to social distortions (deadweight loss). Furthermore, the rest of the money is likely to be used in a non-optimal way by politicians and bureaucracies. For a recent overview of the modelling of government as a rent seeker, see Nitzan (1994). The most influential type of interest group is the one that arises from the income-earning side of the voters. In the market substantial information and transaction costs are present. In such an environment people are likely to be best informed in the area of their speciality, which is their income-earning (production) activity. So producer groups, like firms and unions are important sources of information that have to be taken into account by the government. An additional advantage that adds to their strength is that they dispose of substantial amounts of money that can be used to influence government policy. To influence politics, producer groups have to show that they are more knowledgeable than the best-informed voters. This is very easy because voters usually are generalists, whereas producer groups are specialists. To become a specialist in a certain area a lot of information has to be acquired, although producer groups already dispose of much information. If new information is required it is easy for producer groups to acquire it, not the least because of scale economies in the collection and distribution of data. Producer groups not only acquire information just because they have to, but also because they find it worthwhile to: the potential returns from purchasing information to influence policy are high enough to make the initial investments worthwhile. Of course, income earners will gain directly from any policy that is in their favour. And because this money is spent in a lot of areas, the area of earning is much more vital to them than their spending or consuming activities.

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Policies of democratic governments tend to favour producers more than consumers. Voters whose income is directly influenced by a policy are likely to be well informed (producers), whereas voters whose income is not directly influenced (consumers) will be less informed. Therefore, policies of democratic governments tend to favour producers more than consumers. Examples are tariffs and import control that favour domestic firms and create domestic jobs, while consumers pay in the form of higher prices; or policies that support higher prices in agriculture to protect farmers, and the price incidence is shifted to consumers. This all sounds reasonable, except for one thing: it seems unlikely that votesensitive governments ignore large numbers of consumers and focus only on a small group of producers. Vote-maximizing governments will only be concerned about the income of voters if this affects votes. If this is not the case, or if the voter does not realize that his income is affected, the government does not need to look after the effects on income of voters and can behave discretionary. The argument above still does not explain why consumers do not organize themselves in an interest group, to protect themselves against producers, and so influence policy in their favour instead of the favour of producers. The reason is given by the fact that it is costly to form such groups: consumers have to be located, and negotiations have to take place about how much each individual has to contribute to the group and about how the benefits are divided up. For an individual consumer it is too costly to acquire all relevant information and the benefits to this consumer are likely to be (relatively) small because others can free ride. So overall, the government will tend to oversupply policies favouring producer groups. There are organizational limits to the number and size of interest groups as formulated by Olson (1971). Large groups have higher costs of communication, identifying potential group members, bargaining, higher cost of staffing, and so on. If the group is small, these costs are much lower. As a result more groups will be formed. On the benefit side there is a problem of free riding: the benefits of government policies, partly brought about by lobbying of interest groups, are available to all so that no individual has an incentive to join a specific group. This is the problem of free riding. In that case no group would exist, reality shows otherwise. Olson concluded that groups only exist if they are small (low costs of forming and maintaining the group), or if there is coercion or some incentive to make individuals act in their common interest. Olson explains the existence of large groups in terms of their linkage with private organizations. These groups come into being either through coercion (people working in a certain branch are obligated to become a member of a certain group) or by offering private (non-collective) benefits to individual members. Examples of groups that result from coercion are professional bodies consisting of accountants, doctors, or lawyers, who govern themselves by specifying rules of conduct and minimum standards and qualifications for practitioners. These bodies have the power to discipline members who fail to maintain the required standards. Examples of benefits that can be acquired by membership of a professional body

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are favourable access to insurance, access to recognition, exchanges in conferences and journals, and professional support. So both negative (coercion) and positive (incentives) stimuli are used to maintain large organizations, which can then act as powerful interest groups. Mueller and Murrell (1986) were the first to develop and test the hypothesis that pressure groups increase the size of government. They showed that the formation of bargains between political parties and interest groups leads to an increase in government size, as usually the government budget, together with the passing of specific legislation and political appointments are basic ingredients in the formation of bargains. Empirical results support the hypothesis in that the number of interest groups was found to be positively related to the relative size of government. Interest groups can be also interpreted in a wider sense meaning socioeconomic strata of the population: among others, income classes with distinct interests and expectations. Although these groups do not organize as a pressure group for reasons displayed above, they indirectly influence the political process and political decisions via their voting power, and allegiances to opposing political parties. As policies tend to focus on the median voter, then the median voter, and thus all voters that favour the same policies as the median voter, automatically become a powerful interest group. In such a situation, patterns of income distribution that favour the median voters, and which associate with specific income classes, are more popular and are most likely to be enacted by politicians and be realized. Such a powerful interest group will reject a policy that negatively influences the median voter income. This means that either the policy has to be revised or redistributionary measures towards the median voter has to take place via the tax system or via public spending to their benefit. These measures are meant to prevent loss of votes. If the median voter belongs to the middle-income class redistribution will be towards this middle class, whereas if the median voter belongs to the poor class, redistribution will be directed towards the poor. Downs (1957) calls this the coercion-via-the-ballot-box argument: ‘many poor outvote the fewer rich to impose redistributive tax and benefit regimes’. Apart from their electoral power (when forming a majority), the middle class and the poor could influence policy by acting as ‘real’ interest groups, e.g. poverty lobbies. The size of the public sector in terms of public revenue and spending, and their composition, are thus affected by redistribution of income towards the median voter, who can belong to the poorer or richer income classes. This can be shown by Figures 4.4 and 4.5. The preferred level of public expenditures is given by the maximum utility of a certain level of public expenditures (public goods). At this point the marginal cost in utility terms, or the foregone utility of consumption of private goods due to taxation, is equal to the marginal benefit (utility) of increased public expenditure. In other words, the net marginal benefit (utility) from additional government expenditures is equal to zero. Poor individuals are less willing to give up consumption of private goods for an increase in public goods compared to rich people. They also gain from additional public goods, but

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Utility rich

Utility Utility middle income Utility poor

Gm

Gp

Figure 4.4

Gr

Quantity of public goods

Uniform taxation

Utility rich

Utility

Utility poor

Gr Figure 4.5

Gp

Quantity of public goods

Progressive taxation

this gain normally is less than the foregone utility of consuming private goods due to higher tax payments. Therefore, rich individuals prefer higher levels of expenditures on public goods. This is shown in Figure 4.4 where a uniform taxation regime holds. Moving to a progressive taxation regime (where rich people are taxed relatively more than poor people), as shown in Figure 4.5, poor individuals have to pay now relatively less taxes as expenditures on public goods increase. As a result, poor individuals would prefer a higher level of public expenditures, since the preferred quantity of public goods by poor individuals actually exceeds that of rich individuals. Finally, whether the high preference of poor people for more public goods, and thus a bigger government, will also mean that the poor people will realize the highest benefits from the public goods is not certain. In some countries there is evidence that tertiary redistribution benefits the rich more than the poor as far as health and education facilities are concerned. Housing, public parks, etc. are more utilized by the poor, so that it is more likely that poor people mostly benefit from it.

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The relationships between the interest and influence of income classes via electoral power and voting lobbies on the size of the public sector and the composition of its revenue and spending has been extended in some studies to consider effects on growth and equality. Perotti (1996) emphasizes two mechanisms through which distribution and growth interact, with implications for the size and composition of the public sector. They have been named the fiscal policy mechanism and the socio-political instability mechanism. These mechanisms have in common that equality positively influences growth, reduces the need for redistribution of income from rich to poor income classes, and thus leads to a lower size of the public sector, and a less complex composition of its revenues and spending. By implication, inequality requires redistribution, a greater size of the public sector, more taxation, and less growth. The fiscal policy mechanism states that the preferred level of public expenditures and thus the preferred level of taxation are negatively related to the income of an individual. Since this is also true for the median voter, the median voter’s income and the level of expenditures and taxation are negatively related. At the same time, the level of expenditures and thus taxation negatively influence growth through their disincentive effects. In sum, this means that more equality, implying less need of redistributive expenditure and less distorting taxes, leads to higher growth. The socio-political instability mechanism emphasizes the phenomenon that in a country where urban slums and backward regions endure, and distribution of income and endowments are highly unequal, dissatisfied groups will ask for redistribution policies. If not listened to, the leaders of the dissatisfied groups will ultimately organize themselves in an interest group in the sense of a pressure group and put pressure on the government. This can be done by using political channels or by using ways outside the political marketplace, such as engaging in protests, riots, assassinations, and so on. In such a context, an unequal distribution of resources and opportunities will lead to socio-political instability that will further discourage investment and growth and cause uncertainty and market disruptions. By the same reasoning, equality ensures socio-political stability and growth. In FIM countries agents employ the state to redistribute income beforehand, so that a situation of socio-political instability is less likely to occur. The government therefore has to increase the public share by an amount that is reserved for redistribution purposes. By doing so, FIM countries and their governments manage to sustain a moderate level of stability and equality, combined with a relatively high share of the public sector in the economy, and a lowered prospective for economic growth. These relationships will be examined further in the chapter. 4.2.8 Checks and balances: Country tendencies In a FIM environment private agents, households and firms alike, would allow state agents freedom of action up to the point where the returns to costs of involving state institutions is equivalent to returns from average private activities. As there is no way of calculating such margins, private agents take comfort with the

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presence of checks and balances on the actions of state agents. In a FIM environment, state agents would also appreciate the presence of checks and balances on their actions since these would function as a guarantee of their political credibility. The observance of the checks and balances by state agents enhances the acceptance of the polity, together with what one can call permissible political influence, in a socio-economic system that is otherwise dominated by firm intensive behavioural features. To obtain an idea of the forms and extent of checks and balances imposed on state agents in the FIM context, and the systemic changes that these institutions may undergo over time, we show in Table 4.1 values for four proxy indicators in FIM related countries in 1975 and 1995. The indicators relate to the composition of the executive authority: proportion of fractionalization in government (indicator 1), special interest party in government (indicator 2), legislative control on government (indicator 3), and autonomy of the judiciary in relation to government influence (indicator 4). The table shows a stable system of controls on government in US and Canada in the sense that the height of the indicators remains the same over two decades. The table shows also a convergence among the EU

Table 4.1 Political power and political institutions in firm intensive systems: Country tendencies Country

(1) Fractionalization in government

(2) Special interest party in government

(3) Legislative control on government

(4) Align courts to government

1975

1995

1975

1995

1975

1995

1975

US Canada

0.00 0.00

0.00 0.00

0 0

0 0

4 3

4 3

1 1

1 1

France Germany Italy Netherlands Sweden UK

0.45 0.00 0.00 0.70 0.19 0.00

0.50 0.45 0.00 0.66 0.00 0.00

0 0 1 1 0 0

0 1 0 0 0 0

6 3 4 7 3 3

4 4 2 5 2 3

0 0 1 0 0 0

1 0 1 1 0 1

Japan Korea

0.00 0.00

0.47 0.00

0 0

0 0

2 3

5 2

1 0

0 0

1994

Source, notes: Indicators 1.2.3 are from T. Beck’s database of political institutions at http://econ. worldbank.org/wbsite/external/extdec/extresearch/0. Indicator 4 is from W. Heinsz’s dataset on political constraints, at http://www-management.wharton.upenn.edu/henisz. (1) Proportion of government fractionalization, indicator reflects the strength of minority fractions in executive affairs. (2) Is executive party special interest? Is first government party special interest? Are any coalition parties in government special interest? (3) Composite score of checks and balances by legislative on government actions. (4) Are judiciary courts aligned to government (majority appointed by sitting executive or 2/3 appointed by sitting executive’s party)?

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countries, Japan, and Korea towards the degree of control on the polity held in US and Canada, with the exception of fractionalization in government. This indicator is significant in most EU countries and Japan, which can be interpreted as an additional check on the discretionary behaviour of political agents. This can be expected in national contexts where voters are more fractioned along differentiated political interests.

4.3

Public regulation and national welfare

In the previous chapter it was shown that economic failures in the FIM, urge firms to innovate divisible technologies, engage in signalling and transparent governance, and act to internalize externalities, and where the limits for firm responses are reached, firms call for government actions to correct the economic failures. Firms urge for state actions in the sphere of public regulations to combat monopoly, reduce uncertainty, and internalize externalities. Households too urge for public regulation of matters relating to civil rights and community matters. Firms, and households alike, call also for state interventions in the sphere of the public spending. Public spending is the basic instrument for provision of industrial infrastructure and other public goods, securing income maintenance, and applying law and order. This section assesses state intervention relating to public regulation, while the next section assesses the task of public spending and its financing. If the objective of an analysis is to determine the degree of state power in a given economic system, then one has to go beyond considering only the extent of public regulation and the share of public spending, and extend the analysis to consider a host of other aspects falling under control of the state such as foreign exchange financial reserves, property ownership, appointment rights, mass media, etc.6 Public regulation of private business may carry disadvantages and repercussions that can be described as polity failures. We have already introduced in the previous section the background to these polity failures. In this section we shall review two potential polity failures: (1) uncompensated gainers-bias and losersbias, (2) acquiring and use of political influence by state agents for rent appropriation, carrier promotion, etc. First, state interventions cause gainers-bias and loser-bias and these can potentially reduce social welfare to the extent that the gainers do not compensate losers. State interventions in the sphere of regulations are almost always bound to favour one party at the cost of another party. For a state intervention to be socially efficient the sum of benefits and costs for all parties need to be sufficiently positive to compensate the interventionist service of the state and satisfy all parties concerned, which is not always the case. A similar reasoning would apply to the state budget. The costs and benefits of the state budget are never evenly distributed on all taxpayers. There is thus in the FIM economic system an economic failure with lost opportunities. Combating the economic failure with state interventions realizes gains in opportunities for some agents A and losses for other agents B. To the extent

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that the imposed losses on B are not compensated somehow by the windfall gains of A, one can argue a case for polity failure as well. Considering the sum of benefits and costs, it is evident that gainers can significantly outweigh the losers in the case of public spending on public goods with significant positive externalities; but the issue is whether the compensation from the over-gainers to the losers is actually realized. Second, we have already treated various aspects of the acquiring and (distortion) use of political influence by state agents. We examined selected aspects of the functioning of the executive branch, the sources of political influence, and the impacts of the political influence on the economic system. It was maintained above that while the basic function of the executive branch in the FIM system is to apply state interventions to remedy market failures, the state interventions have consequences that go beyond the remedies of market failures. Being political in motivation, the executive branch can acquire and use political influence for the benefit of the beholders, and that can negatively affect economic performance and social welfare, and thus constituting a polity failure. In the sphere of public regulations state agents can act with discretion to benefit themselves and other state agents. Where this happens discretionary behaviour becomes a major source of polity failure. We have emphasized that the FIM system includes checks and balances at various levels and a juridical structure that aim at minimizing and eliminating such discretionary behaviour. Even though the state settings may be able to appropriate some rent, the checks and balances in FIM see to it that rent appropriation if it happens is not institutionalized and is prevented from getting a permanent place in the economic system.

4.4

Public spending and national welfare

Tendency towards a larger size of government. It was observed in this chapter that the political market in FIM is likely to lead to the overexpansion of public spending, and to result in a larger public sector at the cost of the private sector. This is borne out by historical facts. On the whole and for many decades, public spending has been increasing at a higher rate than private spending in the FIM nation states. This section will evaluate the comparative empirical material on these trends and will seek interpretations of these trends in terms of the interests and interactions of private and state agents in the FIM environment. We have maintained that there are different forces that push up the public share: those driven by private agents, and those driven by state agents. For example, (a) firms and households alike have an increasing demand for public goods and this requires more public spending and an extended state sector; besides, there are inevitable exogenous forces such as periods of wars and emergencies that raise the need for collective action and a greater share of public spending, and the community as a whole recognizes and endorses these needs and their implications. Likewise, (b) various state agents are politically motivated to enlarge their spheres of influence and expand public spending.

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We maintain that for the FIM nation states of US, EU, Japan and alike, taken as a whole, the role of (a) is far greater than (b). This does not exclude differences between the countries apart. For instance, it can be reasoned that a lower public share outcome in US than in EU would reflect a relatively greater dominance of (a) on (b) in US than in the EU. This section will examine further comparative empirical evidence that suggests that the overexpansion of the public sector at the cost of the private sector may slow economic growth and lower welfare in the long term, next to causing resource misallocation. Adolf Wagner (1835–1917) was among the first to specify the relationship between the public sector and GNP. Wagner’s law, as it became to be known, states that an increasing share of public expenditure in GNP accompanies the development of an industrial economy. Wagner observed and predicted that public spending grows at a higher rate than GDP. Table 4.2 demonstrates the applicability of Wagner’s thoughts. All OECD countries experienced an annual growth rate in public expenditure greater than that in GDP. The OECD mean of the public share amounted to 39 per cent in 2000, with US and Japan consistently below the average over the mentioned periods and EU countries above the average. Although the share of tax revenue in the GDP has been lower in US and Japan than in European countries, the latter have consistently higher budget deficits than the former due to the relatively higher public spending. The share of the budget deficit in the GDP was around 2 per cent in US and Japan as compared to an average of about 5 per cent in the six EU countries in the reported years. Since the year 2000, the gap tended to close. Under the common Euro currency, the EU maximum target for the budget deficit that participating member countries should observe has been fixed at 3 per cent, and most participating member countries are operating within this limit.

Table 4.2 FIM related countries: Fiscal shares in the GDP, 1960–2000 Share of total government expenditure in GDP ⴝ GE/GDP

US Japan France Germany Italy Netherlands Sweden UK OECD mean

1960

1970

1980

1990

2000

Growth 2000/1960

27.6 18.3 34.6 32.5 30.1 33.7 31.1 32.6 28.3

31.3 19.3 40.3 39.2 34.7 43.9 42.8 39.6 32.3

32.9 32.0 45.5 47.7 45.2 58.0 61.1 43.4 38.7

32.1 31.3 49.8 46.3 50.5 56.7 58.1 38.0 37.7

31.6 35.6 53.9 47.4 49.5 47.5 59.6 39.2 39.0

1.14 1.94 1.56 1.46 1.64 1.41 1.92 1.20 1.38

GE/ GDP Average ‘60–2000

TR/GDP average ‘60–2000

Share of budget deficit

31.1 27.3 44.8 42.6 42.0 48.0 50.5 38.6 35.2

29.1 25.0 40.4 36.4 31.2 42.7 47.5 36.4 33.6

2.0 2.3 4.4 6.2 10.8 5.3 3.0 2.2 1.6

Source: OECD Expenditure and Revenue Statistics of OECD Member Countries (1963–94), Tables 1 and 6.5, and supplemented from the OECD sources for year 2000. Share of government expenditure in GDP  GE/GDP. Share of tax revenue in GDP  TR/GDP. Share of budget deficit in GDP  GE/GDP  TR/GDP.

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Furthermore, the table shows a tendency for a downward correction in the public share after remarkable rises as in the case of not only UK and the Netherlands but also Ireland and New Zealand, which are not shown in the table. The table shows also upward corrections after long periods of a low public share, such as in the case of Japan. The downward corrections are often associated with calls by political parties in opposition and on the verge of parliamentary election to downsize the public sector, reduce the budget deficit, and follow a smaller public share as in US, Japan. Economists attribute the tendency of a rising public share to a rising demand for collective goods as the economy grows. The primary driving forces behind this demand for collective goods are the private agents who demand these collective goods, even though state agents may contribute to pushing the demand further. These forces and other specific causes have been covered in abundant empirical investigations of the rising public share over time for specific countries and across countries at different levels of development.7 Changes in the pattern of governments over time tell much about the changing tasks and changing areas of focus of the state and the forces lying behind the changing pattern of collective needs in the longer run. The works of Musgrave (1969) and Rostow (1971) have looked at the time pattern of public expenditure in the development process of countries fitting most in the FIM. Following them, three phases in the development process are commonly distinguished: the start up phase, the growth phase, and the maturity phase. In the start up of economic development, some basic physical and human infrastructures are essential to start up the economy for economic growth. As this infrastructure has necessarily a public goods character the state leads, and is assigned, the task of providing the capital infrastructure. Government investments in the early stages consist primarily of investments in physical and social infrastructure: roads, education, health, law, etc. In this phase public sector investment as a share of total investment is relatively high. In the growth phase, the government continues to invest in the same types of sectors, but now these investments are complementary to private sector investments. Market failures can arise which frustrate the push towards maturity. Governments are called upon to deal with these market failures. Whenever this happens, government expenditures and revenues rise. The rise is moderate in case of state interventions in the sphere of regulation and monitoring (typical for market failures relating to indivisibilities, uncertainties, and externalities problems), but the rise is greater when public goods and income transfers are expanded (typical for market failures relating to collectivities and distribution problems). At one time, the maturity phase is reached. Here, total investment as a proportion of GNP increases, while the relative share of public sector investment falls. In the maturity phase the mix of public expenditures shifts from expenditures on infrastructure to expenditures on education, health, and welfare services, like income maintenance programmes. Also redistribution policies become more important. And, the public expenditure elasticities with respect to these social services tend to be higher than for infrastructure. This is also the phase

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that is observed in all FIM countries today, where the state is allotted the task of caring for public goods arising from collective needs of households rather than firms and organizing income transfers and security payments to least privileged households. The changing composition of the population towards the more aged accentuates these tasks.8 Among the inevitable tendencies that drive the public share upwards in FIM countries is the changing demographic composition. A greater share of the aged in the total population increases the demand for public goods and public transfers for income maintenance.9 While the changing pattern of collective needs of private agents is the primary force behind the changing pattern of public spending, private agents influence public spending in other ways. Mention was already made of the mutual interaction between the motives of politicians to gain the votes of interest groups, and the desire of competing interest groups to be served first and foremost in terms of public spending. The political motives of state agents and the private desires of interest groups reinforce each other and push the state in the direction of higher public spending on both public goods and income transfers. We dealt also with a built-in bias towards a bigger public share that is due to a productivity differential between public sector employees and the private sector labour that is not transformed in wage differentials. The requirement of equal pay for public and private sector workers can be described as a political objective, but it can be rationalized also on techno-economic grounds as a merit proposition that conforms to consumer preferences. It is important to emphasize that if the principle of equal pay is merited and endorsed by the concerned community, then it will not be correct to consider the principle a polity failure even though the application of the principle would lead to a higher public share, a slower economic growth, and a lower level of economic welfare. The implication is that the community prefers to get and give a higher weight to public goods relative to private goods, while accepting that the aggregate level of economic welfare will be lower. There are changes in the external environment, such as in times of war and insecurity, which tend to extend the functions of the state, and elevate public spending. For example, during wars or fears for wars, public sector expenditures rise at a higher rate to finance military necessities. Peacock and Wiseman (1961) have made a profound study of the time pattern of public expenditures that accounts for the influence of periods of unrest and insecurity on public expenditures. Their argument runs as follows. As an economy grows, tax revenue (tax rates are constant) increases proportionally, thereby enabling public sector expenditures to grow at the same rate, in line with GNP. In normal times therefore public sector expenditures show a gradual increase. During periods of unrest and insecurity this gradual pattern will be disturbed. Public expenditures will suddenly rise disproportionately, whatever cause of the unrest or insecurity. To finance the increase in expenditures, it is necessary to raise taxes. This is largely accepted in times of unrest and insecurity, because people realize the necessity of raising taxes. Peacock and Wiseman call this a displacement effect: during crises, public expenditures, financed by an increase in tax levels, displace private

134 Economic Systems Analysis and Policies

expenditures. After the period of the crisis, public expenditures tend to fall back but they do not fall to their original level before the crises. Mention was already made of politically motivated state bureaucracies in a FIM environment that pushes for an over-expanded budget of the public sector. Where state bureaucracies use imperfect information to exaggerate the demand for public goods and income transfers, overestimate general and project public expenditures, and underestimate public revenues, they succeed in raising the share of the GDP that goes to the public sector, i.e. the public share, at the cost of the private share. However, this influence of state bureaucracies is regularly constrained by governing politicians and opposition parties in a FIM environment, on behalf of voters who are inclined to demand downsizing of government when excesses occur. Size of government and economic growth. With due consideration of cyclical tendencies, the real growth rate of the GDP in FIM focused economies manifests a declining trend since the 1960s. There are various explanations of the declining growth. These vary from the less verifiable argument that higher levels of living in a matured economy are likely to associate with a lesser need to economize on material goods, to more verifiable arguments such as the ageing population that is more consumptive than productive, higher labour costs, diminished returns to capital, outflow of capital and investment to countries with lower labour wages and higher capital returns. Another argument for the diminishing growth, which is of special concern here, is the increasing size of government. We shall examine here the empirical tendencies and ways of interpreting these tendencies. The two variables of public share and GDP growth show opposite trends since the 1960s, as is demonstrated in Table 4.3. The table polarizes the relationship by focusing on the five countries with highest and lowest public shares in 1960 and 1990 and examining the GDP growth record in the consecutive five years, respectively, i.e. 1960–65 and 1990–95. Countries with lowest public share show a reduced GDP growth of 1.6 per cent with an increasing public share of 19.2 per cent , giving a falling GDP growth/public share propensity of .08. The propensity for the countries with highest public shares can be calculates at 5.5/33.5, or 0.16; which is further evidence of the acceleration of the negative tendency for countries with relatively more public spending. The negative relationship between the two variables is also directly observable from plotted observations in Figure 4.6. In principle, a minimum public share to cover such state activities as civil security and provision of basic public goods is required to allow a sustainable economic growth. These are the beneficial effects. However, as government continues to grow and relatively more resources get channelled via the public sector at the cost of the private sector the beneficial effects tend to reverse into detrimental effects for economic growth. There are various mechanisms behind the negative tendency. First, as government grows it may adopt activities that are more suited to the private than public management, causing diminishing returns for the adopted activities. Second, next to the negative effect of extended public spending on the

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Table 4.3 FIM related countries: Public share and economic growth, various periods Public share = GE/GDP Countries

1960

1990

Change

Growth rate of real GDP 1960–65

1990–95

Change

Five countries with smallest increase in public share US

27.6

32.1

4.5

4.4

2.2

2.2

Iceland

28.2

37.3

9.1

4.5

1.5

3.0

Ireland

28.0

37.7

9.7

4.1

5.9

1.8

UK

32.6

38.0

5.4

3.5

1.2

2.3

New Zealand

27.7

42.3

14.6

5.0

2.5

2.5

Average

28.9

39.1

19.2

4.3

2.7

1.6

Five countries with largest increase in public share Spain

13.7

45.4

31.7

8.5

1.8

6.7

Greece

17.4

49.4

32.0

7.2

1.2

6.8

Finland

26.6

59.4

32.6

5.6

0.0

5.6

Sweden

31.1

58.1

27.0

4.9

0.6

4.3

Denmark

24.8

60.8

36.0

5.9

2.0

3.9

Average

22.7

56.2

33.5

6.4

1.1

5.5

Source: OECD Historical Statistics and OECD Economic Outlook, various years.

9

GDP growth 1960–5, 1990–5

8 7 6 5 4 3 2 1 0 0

10

20

30

40

50

60

70

Public share 1960, 1990

Figure 4.6

Negative relationship between public share and GDP growth in FIM countries

Source: Table 4.3 columns 1, 2 on the X-axis, and columns 4, 5 on the Y-axis.

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long-run economic growth, the over expansion of public spending, as when it is due to bureaucratic influence and is not endorsed by the community as a whole, results in the misallocation of resources and a reduced national welfare. Third, once adopted, counterproductive activities tend to stick to the public sector as compared to the more dynamic private sector where adjustment to change is more rapid and elastic. Of course, expanding the public share to satisfy more collective needs can be a matter of legitimate choice. The adoption of more public goods that are particularly more demanding in terms of national resources and are consumptive in nature cannot be avoided, especially when the voters unanimously endorse them. There is a trade-off between these consumptive public goods and economic growth. There is the noncommittal view that the value of this trade-off is not an absolute figure but a value judgement that varies with the respondent, implying that the issue of an optimal size of government may not be identifiable without weighing preferences. The problem arises when voters are not unanimous in endorsing the collective need. There is the opposite view that if one abides with the common practise of giving equal weights for all agents then working with indicators of life satisfaction across the nation would indirectly include both objectives of collective needs and economic growth, and the issue of the trade-off can be ignored. Along this line of thinking, cross-country empirical studies show that life satisfaction indicators are negatively affected by an increasing government size.10 Finally, any public spending requires public revenue collection. In evaluating the impact of public revenue collection on national welfare the following can be stated. Taxes that are collected for spending on strengthening market institutions, stabilization in the face of uncertainties, and correcting externalities are designed to make allocation of resources more efficient in the sense of Pareto optimality. Tax collection and its use for meeting collective needs and income redistribution may also bolster the efficient allocation of resources. But taxes can also lead to misallocations of resources if the ensuing effects run contrary to consumer preferences. Apart from the spending avenues of a tax, there is the incidence effect of levying the tax and this depends on the type of tax levied. To demonstrate the argument take the simplest case, which is that of an excise tax on good j, ti. The tax will result in a consumer price pj, which differs from the producer price pj  tj. For goods i and j the consumers are faced with MRSij  pj/pi. Producers are faced with MRTij  (pj  tj)/pi. With MRSij unequal to MRTij the conditions for Pareto optimality are violated and both consumers and producers will have to adjust their utilities downwards as a result of the relative price distortions. A sales tax gives a distorting effect similar to the excise tax but is biased against consumption and in favour of savings. An income tax has a substitution effect (makes work less remunerative and encourages leisure) and a negative income effect (implying less leisure to maintain same income level). The distorted outcome is a mixture of both effects. A lump-sum tax is not related to the individual’s economic activity and does not have a substitution effect. This neutral character of the tax makes it highly recommendable for economic policy.

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137

National accommodations to differing polities

In this and the previous chapter we demonstrated the application of the FIM in various industrialized economies. Even though these countries share common features within narrow ranges, the diversity is significant and meaningful. In principle, differences can be sporadic or systemic. If these differences are randomly distributed, then there are as many forms of capitalism as there are nation states, and there is thus no ground for analysing country groups as belonging to major types of economic systems. Fortunately, this is not the case. The differences are systemic: groups of countries tend to cluster around common heritages and paths reinforced by differing polities. So, where do FIM countries differ, and why? Where do FIM countries differ? On the basis of various indicators on degrees of nationalization and regulation, corporate ownership and governance, outward openness, and public share (including both public goods and income transfers), and other considerations to be displayed below, we have positioned US in the centre of the firm intensive economic system, and placed Japan to the left of US on the firms-household axis, and EU to the right of US on the firms-state axis, as in Figure 4.7. This configuration is consistent with classification results in past and more recent comparative studies. These studies generally agree on a distinction between three configurations for industrialized economies11: the liberal-oriented, the reconciliation-oriented, and the control-oriented capitalist systems. The liberal-oriented capitalism is the configuration where coordination is run along commercial logic and profit maximization by firms, and where there is moderated competition monitoring, and limited public goods provisions and income transfers. Countries in this category have a freer operation of the product and factor markets, and relatively greater competition, higher factor mobility, wider income differences, and smaller public share in the GDP. The initiatives and responses of firms weigh more than the response of the state in matters of market failure. Firm settings dominate state settings. The English-speaking industrialized countries are found in this group, led by the United States.12

Japan

US

HIM

FIM

EU

SIM

Figure 4.7

Positioning of FIM countries

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The reconciliation-oriented capitalism is one based on frequent negotiations between firms, workers, community leaders, and public authorities at various levels of decision-making with the object of reaching consensus agreements among these groups on restrictive and promotional measures that correct for market failures and bolster group welfare. The reconciliation approach often contains elements of fair sharing of benefits and costs among the involved parties, which is a common principle in household settings, and HIM in general. The reconciliation can be coordinated at higher or lower levels of decision-making and under initiative and guidance of one or more of the involved parties. In Japan and Korea reconciliation occurs at a higher level of decision-making such as under corporate guidance. Big firms, allied workers, and community interests combine together to form conglomerated groups not only big enough to internalize externalities among its components, but also big enough to stand for recognized interests and to deal directly with ministerial authorities and formulate common strategies and actions.13 The control-oriented capitalism assumes regulated competition, moderate factor mobility, moderated income differences, and a larger state budget. Countries with a control-oriented capitalism are characterized by an array of state interventions at national, regional, and local levels meant to correct for market failures. Firms tend to shift part of their response in the correction of market failures towards the state. Although the resulting state interventions can be interpreted as serving the social interest, state interventions may at times serve the benefit of special interests, and if they are too many these interventions can restrict the free operation of commercial exchanges. This profile is typical of most continental European countries, with France being foremost. We elaborate further on the positioning of US, WE, and Japan. Among the FIM countries the US is likely to show a greater domination of the economic motive on the political motive in most behavioural settings. The positioning of US at par with FIM needs to be seen in a relative sense to the other countries, and specially when US is contrasted with the ex-Soviet Union as representative of a state dominated economic system. The order of subordination is reversed. While the economy directs the polity in US, it is the polity that stands above and controls the economy in the ex-Soviet Union, as will be shown in Chapters 5 and 6. All indicators considered in the previous and the present chapter show that market mechanisms and firm dominance are more advanced in US than the other FIM countries. The public share is also remarkably lowest in US, followed by Japan, and after some distance by the WE countries. Japan, a FIM country with sharing and reconciliation features, carries influences of a HIM environment. This fact is reflected in the positioning of Japan closest to FIM with a stretched link to HIM as in Figure 4.7. The reconciliatory orientation associates with agent interactions over long times within agricultural households, tribal environments, and the isolated island environment. At the same time, there are the drives to exploit outside relations and these associate with limited domestic resources, a large population, and the desire to maximize welfare.

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Households have long-term relationships with the employing firm, resulting in a relatively low labour mobility. Direct wage payment tends to be below labour productivity, and the difference used to ensure more income. Households have high savings ratio and prefer safe investment. Firms, mostly conglomerates, remunerate labour inputs following features of a share economy. Next to a base wage, there is often a share in profits, amounting to about a quarter of all earnings. Employees have long-term career development with employing firms, and lay-offs are relatively limited. Internal management of firms follows horizontal coordination and hierarchical incentives. External management is characterized by the firm being coupled to a main bank that is the primary stockholder. External management would delegate decision-making fully to corporate management and would intervene only in case of anticipated firm failure. Banks avoid bankruptcy and choose for restructuring and takeovers. Firms are mostly conglomerates. Government has a close understanding and coordination with firm conglomerates and main banks, and a qualitative role in industrial policy (government offices are invited to supervise individual industries, and larger sectors, negotiate low tax rates, investment incentives). In spite of the state support, the share of the public sector in the GDP remained low, around 25 per cent, which is closer to US than to EU. This is possible because the business sector takes care of such imputed transfers as social welfare and unemployment benefits. The orientation of Japan towards exports and the position of US as main importer, next to the position of US as an introducer of modern occupier policies shortly after the Second World War contributed to an extension of firm settings and associated behaviour. There is more recent evidence that Japan may be shifting more and more towards a fully fledged FEM, at the cost of some sharing features.14 The case of EU is more complex. We have positioned the EU closest to FIM with a stretched link to SIM, Figure 4.7. This is at best an aggregate picture of the European Union, as the EU members are quite diversified. In the EU there is a country like UK which shares the liberal-oriented capitalism of the US, and there are the Scandinavian countries, and to a lesser extent the Netherlands and Germany, which have reconciliation-oriented capitalism, with incidental elements that resemble some of those in Japan. Though, the rest of the EU countries led by France, Italy, Spain, and undoubtedly the newly accessing member countries of Central and Eastern Europe, are more inclined to the control-oriented capitalism. Taken across the board, although agent settings in the EU are intensively centred on firms, there are on the average more important influences of the state in matters of market regulation and public spending in most EU countries, as compared to US or Japan. The individual countries of EU are undergoing structural changes towards a unified structure in the framework of further unification and integration. It is more likely than not that the outcome of the unification process would reflect the tendencies in the majority of the EU countries, which is a control-oriented capitalism. However, the process of unification is complex and long, and the outcome can be subject to many influences that are unknown yet. A significant fact is that the

140

Economic Systems Analysis and Policies

national jurisdiction in the EU countries is overlapping. Approaching a unified jurisdiction would require significant institutional balancing among the members. How much jurisdiction and decision-making should be integrated at a central level in the EU, and how much of these matters should be left as they are in the hands of national parliaments and governments is by far the greatest problem waiting for solutions in the EU unification process. The EU Parliament and the EU Commission, which is the executive branch, have been so far advocating a greater shift of legislation and decision-making authority from the national parliaments and governments towards the EU Parliament and EU Commission.15 Governments in individual countries are not enthusiastic for centralization as this implies loss of political influence at the national levels. The country differences and the difficulties faced in reducing these differences are accentuated by country politics and vote catching that tend to accentuate national identities. To simplify and strengthen collective decision-making at the highest levels a proposed EU Constitution was drafted and put to vote for EU member countries. However, an increasing number of governments of EU countries have capitalized on the failure of the proposed EU Constitution to gain majority support in popular referenda in France and the Netherlands, and likely other members too if referenda were held there; and have subsequently called for adjusting the proposed EU Constitution to accommodate for greater autonomies of the member states. If greater autonomy will be the outcome of the unification process the implication would be a continuation of the control-oriented capitalism at the national level. In general, a transfer of polity power from nation states to the central authority in EU will tend to reduce state intensive interactions in state settings of the member countries and is likely to promote more firm intensive interactions, and further rapprochement of a FIM in the US sense. At the same time, a shift of more decision-making powers to the central authority of the EU need not mean a more powerful state at the cost of firms. A greater centralization of EU authority, and less political influence of national governments, often gives more freedom to firms to extend their influence. Besides, a central authority is not only able to speak for the whole, engage in negotiations at a world level, extend its influence but also be subjected to interaction with and the influence of other major powers. One indication of a gradual policy shift towards the liberal-oriented capitalism of the US is that after significant negotiation pressures in the context of the World Trade Organization (WTO), the highest authorities of EU agreed to liberalize its agriculture and remove agricultural subsidies by 2013. Another indication of a shift in similar directions is the debates on relaxation of regulations on market power and legislations on labour mobility. Why the differences and whereto? The above three varieties of countries share basic features of the firm intensive economic system, and yet they manifest significant differences between them. How to explain these differences within the framework of the FIM, and what are the expectations on convergence?

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The US was portrayed as the corner stone of the firm intensive economic system, FIM. The EU countries were portrayed as generally FIM but with a closer link to state settings. Japan was portrayed as generally FIM but with a closer link to household settings. There are two viewpoints for explaining the mutual presence of the three contrasting varieties within the same general system. The first viewpoint appeals to path dependence and supporting beliefs leading to multiple equilibria. The second viewpoint appeals to the universality of one development trajectory, though with phases, in which the US is in a phase ahead of Japan and EU. The two explanations can be displayed making use of themes from a few recent comparative studies. The first explanation sees the differences as the result of common sense responses to specific environmental settings, which develop later on in embedded traditions and path dependencies. Once a set of institutions develops and reasonably functions within the polity setting, and is being reasonably accepted by the actors concerned and endorsed by the polity, most of these actors tend to accept that large investments have gone into maintaining these institutions and that it is too costly and not worthwhile to replace a coherent set of institutions for an alternative, even though the alternative can be shown to render other benefits elsewhere. Applied to the welfare state, it was observed earlier that the public sector plays a greater role in transferring social security payments, unemployment, health and poverty benefits to the needy in the EU than in the US; and hence tax incidence is higher in EU than US. There is also empirical evidence showing that the greater these benefits are the greater their possible misuse, and thus having surprisingly as consequences the prolongation of unemployment, low mobility, and retarded economic growth. Higher taxes retard growth as well. These phenomena are more common in the EU than the US, cf. Gabisch (2000), Lindbeck (2003). The tendency to carry on with what one has gets further support via the belief in the goodness and fairness of what exists as more persons experience it. In reference to the European setting, some emphasized that as the share of welfare beneficiaries increases the belief in the goodness of the extended welfare state and associated public policies get strengthened.16 In contrast, a striking aspect of the American free enterprise system is the extent to which people, rich or poor, feel that individuals are entitled to the incomes they earn, no matter how large; and that poverty is the fault of the bearer.17 Alesina and Angeletos (2003) modelled the interaction between the real world, government policy, and people belief in two different settings representing the US and EU. Their conclusion is that when the interactions settle they are bound to produce multiple equilibria.18 Benabou and Tirole (2005) show similar results.19 Empirical surveys by Alesina, Ditella, and Macculloch (2001) support the differences between the two settings. The survey questions applied to European and American respondents showed that Europeans prefer more equal societies than Americans, and that this attitude associates with a lower social mobility in the EU than in the US.

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The second explanation singles the advanced phase of the US as a FIM country, and the tendency of countries in lagged phases to adopt US examples. More intensive interactions within and between firms in the US result in a greater practicing and acceptance of maximization of financial benefits, greater competition, lower public share, and less state regulation. Japan and EU are seen to be in an early phase of this interaction process. As these countries experience more FIM interactions and features, and due to more interaction with US, these countries tend to adopt more US examples.20 The duration of the convergence process is long, and hence different varieties of FIM can be observed. The two explanations are reconcilable to the extent that a turnaround from three equilibria to one equilibrium is predictable. When the median voter in US is financially better off for the same unit of effort than the median voter in the EU or Japan, and under conditions of complete communication between agents in the US, EU, and Japan, then the median voters in the EU and Japan would be induced to move to US or push for a transformation of the EU and Japan setting and institutions towards the US setting and institutions. Such moves will require long times to materialize. As of the present moment, the median voter’s ratio of financial gain/effort is thus likely to be equivalent in the US, EU, and Japan, which explains the mutual presence of differing variants within basically the same economic system. The interest in the issue of convergence or divergence of the EU towards US is not only of academic interest but is also highly political, and it is currently very relevant as the European Union elaborates further on its future integration trajectory. There is an intensification of the political discussion in the EU on the desired ultimate steady state and on the prospective union policies that go with that. The heated discussion reflects the contrasting institutional orientations of the member countries.

4.6 Summary and conclusions In countries that lie close to a purely firm dominant system, the closest to this will be the US, the behavioural motive of profit maximization would have sufficiently spread across the spectrum to become the institutional norm that guides not only the actions of the firm but that of the state too. In the extreme, all actors in a firm dominant system will behave as profit maximizers. Political behaviour can be interpreted in a FIM economic system in terms of economic motivations and economic exchanges. The political process in such a system can be described as exchange processes involving state agents acting within constraints laid by political institutions, similar to the functioning of an institutionalized market. The elaboration of an analytical framework that interprets the polity transactions as economic ones, and application of such an analytical framework to the FIM related countries requires addressing several questions that are treated in the chapter. Who are the main actors in this polity? These include voters, political parties, governing politicians, bureaucrats, interest groups, and public sector employees.

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For each of these we explained how they function and interact in the FIM nation state in relation to two main activities: public regulation and public spending. As regards political institutions we touched upon their role as checks and balances that constrain arbitrary behaviour of state agents. The political institutions are viewed as instruments serving the FIM system. Cross-country and cross-period comparative data are used to detect systemic changes in political institutions. There are many areas in which the state is neutrally active, in the sense that it is not taking side with one or the other beneficiary. But in the two areas of public spending and public regulation state agents may not be always neutral. Separate sections examined the functioning of the polity in the two areas and consequences of this functioning for the economic and social welfare of the nation as a whole. In the case of public spending, this has been increasing in the recent past at a higher rate than private spending in the FIM nation states. We evaluated the comparative empirical material on these trends and sought interpretation of these trends in terms of the interests and interactions of private and state agents in the FIM environment. We examined also the plausibility of retarding effects of higher public shares on economic growth and found that the empirical evidence supports the statement. In the case of public regulations we focused on uncompensated gainers-bias and losers-bias, and the acquiring and use of political influence by state agents for rent appropriation, carrier promotion, and alike. Finally, even though a group of nation states share in common the FIM economic system, the independent functioning of differing polities in different nation states tended to increase country divergences within the FIM group. We elaborated in this context on several features of the divergence between US and EU, among others, and sought system oriented explanations for these divergences.

5 The State Intensive System: Past Polity of the Soviet Union and Allied Countries

5.1

Introduction

Why do we call the economic system a state intensive economic system, SIM, and not socialist, communist, centrally planned as some others call them? The first chapter reflected on this question. The point is that state settings dominate other settings in this system. State settings in this system are all-political in their behaviour and via their dominance over and interaction with other settings, these latter get reshaped and are ultimately geared towards adopting rent appropriating behaviour typical of intrinsic state settings, organization structures, and coordination mechanisms. The main features common to the communist regime of the Soviet Union, but generally speaking to an all-political state intensive economic system, SIM, can be summarized in four categories. (a) The state has a (communist) ideology that offers the best promising prospects for the people. (b) The (communist) ideology and realization of its promises are contracted to the state’s party. (c) State is the sole owner of property. (d) State is the sole coordinator and driver of the economy via a system of central planning and monitoring. The operation of the four features stated above in the real world deviates from what the control sphere desires it to be. There are substantial differences between the prescribed rules and practice. It is important to recall here the distinction by Kornai (1967) between the control sphere and the real sphere. In the Sections 5.2, 5.3, 5.4, and 5.5, we describe the real world practices for each of the four features (a) to (d), listed above. Understandably, we shall go in more depth when we deal with feature (d) on central planning and monitoring. We shall treat in (d) the procedures, methods, forms, and the practical operation of central planning, look 144

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into the obstacles it encounters, examine how principals and agents inside and outside the state settings respond to each other, consider the problems which these responsive interactions create. In these contexts, governments in these regimes have initiated several rounds of planning reforms to save the situation, but in most of the concerned countries they were mostly failing reforms. The reforms will be reviewed and the failing results evaluated. To increase focus, we shall deal mostly with the Soviet Union, supplemented by some examples from Soviet satellites in Eastern Europe. In Section 5.6, attention is directed to the economic policies pursued by the governments of these countries regarding the major issue of where to allocate the factors of production. There is the difference between ‘how’ and ‘where’ to allocate. The ‘how’ relates to the economic system, while the ‘where’ relates to economic policies. There is an association between both but not a complete one. Although the communist regimes we examine follow more or less the same ‘how’, the ‘where’ differed: the economic policies pursued by the different governments were different. We shall look in Section 5.7 at the past performance of the Soviet Union and its allies. We shall introduce a few quantitative indicators such as economic growth, its decomposition in factor inputs and factor productivity, and indicators of wellbeing and apply them to these SIM countries. These will be compared with those of FIM countries to obtain a grasp into the missed opportunities of communist countries to achieve more. Not only did most of the reforms, policies, and performance fail, but the whole regime fell short of achieving the announced objectives which it promised for its people. The collapse of these communist regimes in the early 1990s became imminent. Since then the economies concerned entered into a transition phase towards a more normal mix between the state and markets and between the public and private sectors. Section 5.8 reviews alternative explanations for the failure of the communist regimes. The explanations rely, to different extents, on economic, social, and political theory. We present four explanatory complementary views of the communist failure as seen by Pesovic, Eggersston, Stiglitz, and Ellman. Immediately with the collapse of the communist regimes, recessions set in, with durations of four years or more. The recessions reduced production and wellbeing in the concerned countries by levels varying between 30 and 40 per cent. The next chapter reviews the recession and its background and examines the transition issues that these countries face, and how they respond to them.

5.2 The state’s ideology The ideology is communism. The origins of communism go back to the early days of the industrial revolution in Britain and France. Labour working in the new industries earned very little. And thus, the vast majority of people lived under poor conditions. A few individuals had considerable wealth and authority; they possessed the factories, hired workers at survival wages, and obliged them to work for long hours in risky and unhealthy conditions. Concerned with both the

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efficiency and equity of this capitalist system, Karl Marx observed people working hard and long, but the fruits of their work reaped by the owners of the firms, these being the capitalist class. Marx postulated that workers will not be able to increase their wages, since capitalists want to accumulate and save. Capital will be substituted for labour that becomes increasingly redundant. Marx was convinced that the workers will and should unite; that power will shift, and that the system will inevitably change towards socialism, and eventually communism, and become thereby more efficient and equitable. Marx thought of a communist system where effort and goods are organized along the lines of from each according to his ability, and to each according to his needs. Such a system, he argued, would require abolition of private property and establishment of a guardian state that would make all mobilization and allocation decisions. The two basic works of Marx, Das Kapital and The Communist Manifesto, caught the imagination of many engaged thinkers and leaders. The first to have had the opportunity to bring Marxist’s ideas in practice was Vladimir Lenin, after a revolutionary takeover of government in Russia towards the end of the First World War in 1917. Russia itself has hardly touched capitalism at the time of the communist seizure; it had a poor, large and sparsely dispersed population, and an undeveloped economy. From 1917 onwards the declared ideology of the country became communism, and it was the task of V. Lenin, and his followers starting with J. Stalin, then N. Khrushchev, L. Breznev, etc., and ending with M. Gorbatshev to defend the declared communist ideology and soviet promises, safeguard state capitalism and develop procedures and programmes for running the economy in ways which will hopefully approach these promises. As things have developed, it is now obvious that fulfilling the soviet promises was a mission impossible. We shall come back to this theme later on.

5.3

The state’s party

The communist ideology required that there be a dictatorship of the proletariat. The underlying thought is that the regime must be a dictatorship of the proletariat, by the proletariat, and for the proletariat. Since obviously the proletariat in its totality cannot exercise a dictatorship, some representative body must be called upon to exercise it. Traditionally, this is the Communist Party. The working class is supposed to exercise its leadership over the state through its vanguard, the Communist Party. It is the only party the state tolerates. The party controlled many aspects of political, social, and economic life in the communist regimes. At school and workplace people were taught how to respect and love what the Communist Party and its chairman have done for the country. The party took good care of its members. The best jobs, housing, privileges were reserved for them. Accession to the membership of the Communist Party is highly esteemed and is very valuable for the member. The party would pick and choose the suitable members, those who have mobilization qualities, follow orders faithfully, and have trustful personal connections. In the Soviet Union, the phenomenon of the party cadres as caretakers is known as nomenklatura. The top

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of the nomenklatura is the Politburo, whose decisions become the law of the land. Members of the Politburo do not have tenure. To be removed from the Politburo is a very great loss, hence the eagerness of persons in the top to form protective alliances among themselves. In practical terms, the economic system, no matter how it will turn out to be, it is embedded in a political dictatorship. The subjection of the economic order to the political order is manifested in many ways. By simultaneously politicizing all information and decisions, the party eliminated possible corrective feedback mechanisms. Party leadership in this context has an interest in exaggerating statistics on production and export, and in hiding the extent of economic failures, famines, productivity declines, inflation, deterioration in health standards and the like, so as not to undermine the image of the promised glittering future to which the party is leading the country. Politics superseded economics. Indeed, some party leaders recognized that a major reason why economic reforms in the past were not carried to their ultimate ends was that in practice the reforms would weaken the role of the state and the Communist Party in the management of the economy. The power of the Politburo has limits, however. The limit is Politburo’s perception of the maximum price people are willing to pay so that the ruling party can pursue its political objectives and personal benefits. Communist rulers have been always anxious to know the attitude of the people. Opinion polls to that purpose were conducted under cover, and on a regular basis. In the Soviet Union and Eastern Europe the maximum price was exceeded around 1990, paving the way for the fall of the communist regime.

5.4 State ownership of property Marxist thinking blames the contradictions in society on the division of the population between owners of the means of production and the proletarians who are non-owners and have to sell their labour cheaply to the owners. To overcome the contradiction, the solution is that the state should become the sole owner, this being the highest form of social ownership. The other argument put forward for state ownership in communist regimes is that it is necessary for realizing strategic decisions on large investments and delayed consumption that would bring the country to the promised glittering future, and that a consistent national economic plan cannot be formulated and executed otherwise. The law of state ownership allowed the state to own all natural resources including land and all enterprises, whereby the authority to run state property is assigned to the Politburo. Collective farms and gardening plots for the collective farmers are tolerated but are not transferable. The only fully accepted private property is that of consumption goods which people pay for from the earnings or transfers they receive from state enterprises or state authorities, respectively. In the real world, the law of state ownership is reducible to merely a façade hiding the true owner. The Politburo of the Communist Party, being the legitimate caretaker, has absolute property rights on decisions regarding the use and

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disposal of the total outcome from the state wealth. The institution of state ownership opened the way for the marriage between political power and material benefits for those in charge of decision-making. Individuals can thus acquire material benefits only by joining the ruling party. State ownership provided the ruling party two rights: the right to appropriate a large share of the outcome for its own consumption as deserts and benefits, and the right to allocate the remainder on the population at large. The institution of state ownership and a legitimized caretaker with a monopoly on the economy are basic instruments in this respect.

5.5

The central planning system

With nationalization of the means of production in the Soviet Union by the ruling Politburo, a system of central planning and administrative command was put in place in 1928. We shall explore this system in terms of procedure, methods, practical operation, and planning reforms. (1) Procedure. The economic plan is formulated in the following way. General directives on economic development are provided by the Politburo, and converted into control figures by the central planning department, Gosplan. Tentative production targets for major commodities are then sent to the ministries for further specification, and from there down to the level of individual enterprises falling under the supervision of each ministry. The enterprises are supposed to send back comments and information on limitations and prospective. Ministries adjust and send ministerial plans to Gosplan. It is here that the final matching between inputs and outputs for a large number of commodities, varying at times between a few hundred to a few thousand, is done via the use of material balancing methods, resulting in final production targets. These are disaggregated further and disseminated to the ministries and through them to the concerned individual enterprises. Consequently, there are ministerial plans focusing on aggregates and enterprise plans that take up details. The plan for each enterprise contained detailed directives on input provisions, operations, outputs, and deliveries – from whom and to whom – for the forthcoming year. While the enterprise plans are legally binding, they are simultaneously supported by incentive designs to comfort and motivate enterprise managers in fulfilling the enterprise plans. (2) Methods. Gosplan applied some kind of planning-in-stages methods. Two main types of methods are used. In the upper stage, the material balancing method is used to formulate commodity plans, for which the respective ministries carry the responsibility to implement. At the lower stage, the investment effectiveness method is used in the selection of expansion projects at the enterprise level. The material balance method is an iterative process of concurrent adjustment of the supply and demand for each commodity considered, resulting from an exchange of information between Gosplan, ministries, and enterprises, and ending when the closing balance shows the sum total of all demands for a commodity equal the sum total of the supply for that commodity.

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Table 5.1 SIM planning: Demonstrative scheme of material balance for a major commodity, i.e. coal in 000s tonnes Supply (or availability) Domestic production

Demand (or requirements) 1100

Using stocks

50

Imports

50

— Total

Intermediate inputs for productive sectors

800

Collective consumption

300

Private consumption

100

Exports 1200

Total

0 1200

Moreover, in principle, this balance should hold simultaneously for all commodities considered. The iteration process can be done at different levels of sophistication It made use sometimes of input-output tables, consistency and optimality criteria, but it has mostly settled at partial tabulations as in Table 5.1, which satisfy consistency criteria only. The aim is to remove imbalances that appear in such tables via adjusting technology in the use of intermediate inputs, and adapting collective and private consumption, or through changing domestic production, calling on accumulated stocks from the past, and exporting or seeking foreign supplies through imports. The definite adjustments are then detailed in operational directives. Traditionally, ministries and planning agencies in communist regimes formulate targets in physical terms, so many tonnes, cubic meters, thousand pieces, and so on. Although money exists, and there are financial flows corresponding to the physical flows, the former are subordinated to the latter. Prices, which converted the physical into monetary, are cost-plus based. The primary function of prices in the system is only to serve as means for aggregating physical data and for financial control. The dominance of the physical on the monetized form has important consequences for achieving equilibrium at the macro level and the micro level, which will be reviewed. The investment effectiveness method operates at the lower level of the enterprise. It is placed as a stage below that of material balances where the production targets are determined. Soviet authorities used the investment effectiveness method for choosing among proposed investment projects that expand production capacity of a specific product. The equation can be written as Ci  rK i  A i

(1)

where Ci  annual operational costs of investment project i K i  capital costs of investment project i A i  annual total costs of investment project i r  normative rate for discounting capital use, exogenously fixed The objective is to select projects with the lowest Ai. In periods and sectors in which capital was especially scarce, the value of r was raised. From 1969 a

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standard value of r  0.12 was used, although it was sometimes allowed to vary per sector. C, K, and A can be eventually specified per unit of production to allow for economies of scale. (3) Practical operation. On paper, the picture depicted above of the central planning system in the Soviet Union is a strictly centralized one. Truly also, here is the most centralized of modern economies. Nevertheless, the rigidity gave way to quasi-market mechanisms that existed economy-wide. We review here the practical operation of the planning system from the points of view of different agents involved in the process, consider the problems they face, how they are affected, and the effects of their responses. We shall take up in consecutive order the (i) Gosplan, (ii) the ministries, (iii) enterprise managers, (iv) individual consumers, and (v) hidden dealers. (i) The Gosplan level. Theoretically speaking, the role which the auctioneer of Leon Walras-or the invisible hand of Adam Smith, plays in bringing equilibrium prices and an efficient allocation of the quantities of goods and resources in the perfect market economy, this same role can be played by the state. If the state can model the economic behaviour of the agents in numerous equations, solve for the equilibrium prices, and fix them accordingly, then an efficient allocation in quantities would follow. As Pareto and Baron have shown around 1908, the allocation problem is the same in both systems. This idea has functioned as the working proposition of all attempts at central planning, including the Gosplan. The practice is otherwise. In the first place, indivisibilities, uncertainties, externalities, and collectivities persist in all economies and make it impossible to reach an efficient allocation, see Chapter 2. Second, there is no way for the Gosplan of getting all the correct information and processing it. The subordinates may transmit distorted information, unknowingly or on purpose. In the transmission of information important parts are lost. The information can be out of date. If really all the relevant information is to be used the data processing problem and the discovery of the right allocations will be computationally an impossible task. The material balances, which are very crude approximations, are never iterated to their ultimate round, but are stopped prematurely. Third, the Politburo feeds the Gosplan with information on its own preferences which can be in variance with that of the population at large; as a result, the targeted allocations will be different than the spontaneously desirable allocations of the population and this will cause imbalances in supply and demand. This problem does not occur in competitive markets. Fourth, for specific goods, direct contact between demander and supplier is necessary to settle design questions, and this is impossible to settle at the central level. Also in competitive markets these specific goods have to be negotiated personally between buyer and seller. Of course, the Gosplan did not ignore market forces in all respects. Market forces of demand and supply did play a role in some segments of the economy. Wage differentials were used to influence the distribution of labour by profession, sector, region, and season. Furthermore, a hidden market was tacitly accepted to deal with exchanges that cannot be planned, these took place in the hidden economy.

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(ii) The ministry level. In a previous chapter we made reference to bureaucratic behaviour within ministries, and its distortion effects for the economic process. These apply here too. Bureaucratic considerations such as risk aversion, subservience to superiors, adherence to periodical plan fulfilments, carrying instructions to the letter, take precedence over economic considerations such as cost saving, wastage avoidance, quick delivery, customer satisfaction, technical progress, and so on. The latter aspects have been adversely affected by bureaucratic behaviour. (iii) Enterprise managers. The formal plan was only the initial blueprint for economic activity at the ministry and enterprise levels. In the course of plan fulfilment many mechanisms are activated by ministerial authorities and enterprise managers, which affected economic performance as well as the feedback of information for the next round of plan formulation. At the end of the day, the enterprise gets a production plan in physical terms that it has to execute. The plans are imperative orders and not desirable forecasts. The availability of physical inputs is necessary for achieving the production targets. For the enterprise it is far more important to obtain an allocation certificate for scarce physical inputs than money. The risk of not securing the physical inputs in time for production of its own output brings tension in the enterprise. The response of the enterprise manager in such a context is varied, and it betrays many deficiencies in the planning system. We list here some of the responses. First, frequently the plans sent by the ministries arrived late at the enterprises, so the enterprises continued to operate on the basis of the old plan. That by itself was not problematic for the enterprise, since many plans for year t were, in effect, little more than revisions and update of the plans for t-1. The results are delays in introducing change and a tendency to increase the dependence of the state on the discretion of the enterprise managers. Second, the monitoring of the execution of enterprise plans is weak and the sanctions for counteractions by the state in case of management failures are limited, for ministerial authorities responsible for the failure would be uncovered as well. So there are tendencies for cover-ups. Third, in a situation of a general scarcity of excellent managers the state paid managers average bonuses of 25 per cent of their base salary, and reaching 50 per cent for top managers. The result has been dysfunctional managerial behaviour; this caught communist thinkers by surprise for they assumed that managers would obey the orders of superior authorities. Fourth, fulfilling the gross output targets is a crucial condition for safeguarding his position as enterprise manager. To do that he bargains intensely and lobbies for obtaining allocation certificates of inputs, and he uses the resources of his office for exchanging favours with local party and state officials, he may manufacture attractive but hidden products that he can fruitfully exchange with the associates, thus there emerge cross-departmental cliques whose members dispose of their respective official prerogatives to mutual advantage. It is through these local power elite that plans are modified and implemented.

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Fifth, alternatively the enterprise manager may expand his informal delivery network and engage unofficial supply agents in arranging deals in the hidden economy, but he may also neglect assortment targets and adjust quality downwards to meet the quantity targets. Sixth, enterprise managers supply information to the responsible ministry higher up that underestimates production capabilities for next year, in this way biasing the ministry to opt for easy gross output targets which the manager can achieve with least effort. A slack enterprise plan has the additional benefit to the enterprise manager of creative excessive reserves of material, equipment, and labour to which he has access in periods of shortages, or which he can exchange for other favours. Slack enterprise plans are associated with the ratchet effect. This arises in a situation where the central planners fix a future output target for the public enterprise Vt1 at a higher level than the achieved current output Vt. Calculative managers of the public enterprises will deliberately produce low Vt or pass to the central planners underestimates of their real production to avoid compelling targets. The ratcheting of targets by the central planners creates an X-inefficiency. The problem can be solved by introducing mechanisms that persuade public enterprises to disclose their true estimate of maximum enterprise output, given input authorizations; but reforms have failed to design such mechanisms. Seventh, the state guarantees that the operations of loss-making public enterprises will be continued nevertheless, a condition known as soft budget constraint. As a result there is no incentive for the enterprise manager to economize in the use of capital and to minimize on other costs. Eight, most of the above responses are best analysed in the framework of principal–agency theory. Some responses are also linked to each other in the context of cross-subsidization, as when the ratcheting of output targets for the better performing enterprises is used to finance the soft budget constraints of the lossmaking enterprises. Responding rationally to this cross-subsidization, both enterprises will not maximize their effort and will end up in lower efficiencies. (iv) Individual consumers. The overruling of the preferences of the Politburo over the preferences of the consumers manifests itself in the chronic dissatisfaction of the latter. This manifests itself in widespread shortages of consumer goods and queues, a limited assortment of goods and services, poor qualities, very slow introduction of new goods. Consumers respond in different ways to the shortages. Consumers can try to obtain their desired goods at a higher cost if they can afford to, from informal dealers in the so-called second economy. Consumers, who are also state workers facing mutual shortages, may practice moonlighting. Consumers may also delay consumption and hoard savings for spending in a future period; the effect can be a strengthening of repressed inflation. A passive attitude can also develop among consumers that ultimately reduces the drive to consume better and more and the working effort towards that end. (v) Informal dealers. In communist regimes the planned economy is often identified as the first economy, in contrast to the second economy that has developed, to the dismay of planners, to resolve imbalances between demand and supply which are created by plan directives. Terms that describe this second economy

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more fully are underground economy or hidden economy. Informal dealers are the primary coordinators in the hidden economy. As was clear from the above accounts, the imbalances arise in the contexts of (a) inter-deliveries among enterprise managers, and (b) sale of scarce goods to individual consumers. Transactions of type (a) arise because it is not easy to fulfil the enterprise plans with the issued allocation certificates of inputs. Enterprise managers often use the services of a tolkach. This is an unofficial supply agent or organization whose job is to see that the necessary materials and equipment will arrive from one enterprise to another. These agents do this via arranging a deal, or using unorthodox means like bribery and agitation. They are remunerated in kind. These activities are normally tolerated by the local party authorities since otherwise the official economy could scarcely function, but at the same time leading to erosion of work ethics and dealing norms. Later, during the transition, these organizations would come in the open and merge with the remnants of the official allocating agencies to build strong bartering corporations that eye on non-competitive privatizations and takeovers. Transactions of type (b) have created a small class of market-oriented business people who sell scarce goods and services to affording consumers, such as owners of vehicles providing private transport services; producers of farm products from gardening plots and collective farms; craftsmen fixing repairs privately in exchange in kind; and medical doctors charging more for better treatment. The prospering of a hidden economy encouraged the emergence of activities that are legally forbidden, some of which criminal, but are difficult to sanction. Such activities may relate to the misuse of official positions for personal advantages such as moonlighting and use of state buildings, enterprise resources, and managers inning personally the sales of speciality goods to high payers. The activities may involve criminal actions such as officials granting unofficial foreign exchange transfers, facilitating illegal trades along borders and in seaports, and dealing in contraband merchandise. The activities may extend further to participation of officials in the formation of powerful mafia groups who are able to influence police, civil servants and infiltrate in and collaborate with the nomenklatura cadres. (4) Planning reforms. It was observed above that the limitations of the central planning techniques manifest themselves in processing distorted information, delayed and frequent revisions in enterprise plans, disturbances in the production process, wrong deliveries, and so on; causing significant losses in labour time that some estimate to amount to 10 per cent. The planners do not see these problems as consequences of an infeasible central planning system; they see them instead as obstructions in procedures, methods and practice, which can be removed by planning reforms. The reforms applied in the 1970s in the Soviet Union and Eastern Europe focused on improving the information structure, planning techniques, and incentives. Furthermore, in later years and especially in Eastern Europe, economic reforms were tried with the purposes of introducing commercial considerations in running public enterprises and integrating the hidden economy with the official economy.

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The multi-information channels were reduced to only two, those of the ministry and the enterprise. An attempt under Khruschev to decentralize and involve the regional governments was abandoned when he left. Regarding planning techniques, Kosygin introduced greater use of mathematical programming, management information systems, and computers. The efforts were effective in shortening the planning process but the pressure for more advanced technologies kept outpacing the introduced efforts. Kosygin reforms have also tackled the incentive problem at the enterprise level. This was done via taut plans. The equation for rewarding the enterprise with a bonus B can be written as B  aVp  b (Va  Vp)

(2)

where Vp is the planned value of the bonus forming index that can simply consist of output but can include other indicators as well, Va is the actual value for the bonus forming index, and a and b are rewards whereby a  b  0. The first term provides an incentive to adopt a big plan. The bigger the planned value, the higher is the bonus. Besides aiming at taut plans the second term in the bonus equation encourages the over-fulfilment of plan targets. There is higher weight for the first term than for the second term. The intended result of avoiding the ratchet effect did not work as was anticipated. Instead of mobilizing the hidden reserves of enterprise resources, it strengthened the inclination of enterprise managers to strive for slack plans, that is a smaller Vp, and in a bonus on the second term, while ignoring the bonus on the first term. The reform had also the adverse effect of motivating ministries, which are eager to report that not only have they fulfilled their plans, but that most of their subordinate enterprises have also, to alter the original plans of the enterprises in an ex-post manner to present a better performance for the lagging enterprises. Just as they did in the 1960s, Soviet leaders under Gorbatchev debated the perestroika reform in the mid-1980s with the objective of changing incentives of enterprise managers by relating their rewards to enterprise profitability. This has been defined as the ratio of profits to the stock of capital. The reformer’s hope was that managers would then go for less use of capital, seek efficient production techniques, more innovation, and upgrade quality. To let work the reform implied changing the management’s property rights in capital goods. However, to implement the principle of profitability, the Politburo must accept a reduction in its own property rights as regards its authority on the stock of capital held by business firms, and the future pattern of capital formation. This is a conflict in principles, and conflict of interests of rulers versus ruled, which brought the inadequacy of the institutional rules in the communist regime in the open. Finally, some brave attempts of economic reform were tried in Czechoslovakia, Hungary, Poland, and the GDR in the late 1950s and 1960s to increase decentralized decision-making at the enterprise level and make it more commercially conscious. But these reforms were doomed to fail at that time due to the absence of four prerequisite conditions. These are microeconomic consistency

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(this requires that cost calculation, profit maximization, price fixing, and competitive bidding should fit to each other and form a harmonious whole), macroeconomic consistency (the input and output outlets, should be readily available and undisturbed by instability and uncertainty), institutional governance that guarantee fairness in case of mischief, and a peaceful and benevolent political environment. Later on, in Hungary from 1982 onwards, decentralization reforms were introduced, next to moving somewhat away from soft budgets, permitting the setting up of private enterprises up to one hundred workers, and stimulation of branch associations to sell in export markets. These reforms were relatively successful and can be interpreted as the starting steps in the transitional process. The relative success of these reforms was possible as the economy inched in a slow tempo towards the above-mentioned prerequisite conditions. In this context it is important to realize that Hungary, of all communist countries, is probably the closest to Western Europe by reason of history, culture, and heritage.

5.6

Pursued allocation policies

Economic policy makers in the Soviet Union and Eastern Europe faced very difficult choices in the allocation of the limited resources. On the one hand, they were committed to the socialist aim of maintaining incomes for all citizens at levels sufficient to buy basic goods at cheap prices; this in addition to freely provided collective goods. On the other hand, they were committed to the communist ideology that sees a deepening of capital formation as the development strategy, which will bring success in the longer run. Policy makers wanted to do and did both, with the result that they encountered shortages of all types of goods. They saw the shortage to be associated with the underdeveloped industry, so they diverted even more of the scarce resources to huge investment programmes, resulting in a vicious circle of chronic shortages. The policy makers faced a policy conflict between cheap consumption now or investment now in capital extensive industrial projects with long gestation periods permitting more consumption much later. Whenever they chose for the latter solution the results were less goods to consume, and greater shortages, now and in the future. It is estimated that the planned share of gross investment in the net material product varied between 25 and 40 per cent in the SIM countries. The actual share was even higher as investment agencies underestimated their budgets to get approval. The problem was aggravated by a desire for political equality with the capitalist countries, leading to a significant leakage of unproductive capital allocations to defence, space, and military technological research. There was little feedback between the results of this research, and innovative research in general, and applied production, due to lack of incentives and networks in the planning machinery to effectuate the link. Besides, collectivization of farmlands and transfer of peasants to cities pushed the needs for more capital. Furthermore, the higher priority was given to industrial over agricultural production; resulted in wheat shortages that had to be bought with scarce foreign exchange. Export of

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mineral resources was the main source of foreign exchange in an otherwise semiclosed economy. Insight into the policy conflict, how it was dealt with, and the consequences can be gathered from the following two equations. To reach equilibrium aggregate demand D should equal aggregate supply S. In the communist context aggregate demand D can be simply written as the wage income, i.e. the average wage W multiplied by number of earners L, less hoarded savings H. The aggregate supply S is the physical quantity of consumer goods Q plus the change in inventories from last year I, these multiplied by the price level of consumer goods P. Note that prices for most consumption goods are based on cost, they are fixed and are hardly affected by imbalances. D  WL  H S  (Q  I)P

(3) (4)

To satisfy the population, the soviet authorities were under pressure to increase wages, and with more earners, the aggregate demand increased appreciably; but as is well known, the physical production of consumer goods Q lagged behind due to reasons of lagging priority and general shortages caused by increasing inefficiencies. At the same time, prices P were not allowed to increase fast enough to absorb the increase in demand. In such circumstances equilibrium between a demand that is driven by money and a supply that is physically fixed can only be reached by increased hoarding by consumers and a depletion of inventories, implying delayed consumption and repressed inflation. The accumulated tension will turn to be significant in empowering the inflationary pressure, once at some time later, when the economy in transition would allow price liberalization. Although the Politburo was committed to pursuing a policy which gave priority to capital formation in heavy industry on consumer goods, the Politburo was responsive to political pressures from the consuming population to change course underway, halt the heavy construction plans, and go for more consumption goods; this continued only for a while after which policy reversed back again. The Politburo’s power to invest in capital deepening is limited by its perception of the maximum price the community is willing to pay in exchange for the granted delegation of authority to the ruling class to pursue the political objectives and economic strategies of a communist state. Conceptually, the ruling class will invest in capital deepening up to a point where its own gains from the last unit invested is equal to its own costs from violating the preferences of the consuming public. So, Soviet leaders responded to consumer grievances between now and then. In the late 1960s, under Khruschev, consumption growth caught up with investment growth, but lagged again from the early 1970s. In the late 1980s, under pressure of public opinion, investment plans were again interrupted to allow for an enhancement of consumer goods. The limited interruptions in investment, which were necessary to satisfy the public, tended to increase gestation lags, postpone production operations of installed capacity, and accentuate the shortages of goods.

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Another set of pursued economic policies related to the selection of the optimal unit of production. The policy has been to minimize costs by exploiting economies of scale. The result was to choose for very large capital extensive enterprise units and a highly concentrated industrial structure. Such a skewed structure happened also to be preferable in a central planning context on grounds of easier control and administration. As a result, industrial concentration in the Soviet Union is much higher than in EU and US, noting that the background to the concentration is different in the two systems. The communist trusts are not the results of mergers as in Western economies, but are the outcome of political-administrative and costeffective decisions, and are not related to a competitive outcome. Outside the large enterprises there are no medium or small enterprises. Small workshops, where they exist, are internalized within the large enterprise. This inherited, highly concentrated industrial structure will make it very difficult to execute a competitive privatization programme in a transitional phase later on, for these giant enterprises capture a monopoly share of the market, and they will require a de-monopolization as much as a privatization strategy. Furthermore, the pursued policies in the past saw to it that these giant enterprises are not only just production and management units; they have also political, administrative, and social functions in support of the workers and as control leverage on their political allegiance. When we shall deal later on with the transitional phase, it will be important to realize that, because of the previously pursued policies, the conversion of the communist industrial organization into a modern one would have to involve much more than a conventional privatization programme.

5.7 The failing past performance In which ways can one really measure system performance? Why is comparing performance relevant? In which sense is the past performance of the communist system a failing one? The three questions are highly related. Following our propositions that we laid down in Chapter 1, agents are inclined to compare the outcomes they receive from the setting in which they are actively working and living, with the outcomes of competing settings. If their system is seen as an underperformer beyond doubt then they will either transform the foundations of their setting towards the superior one, or if feasible, they will physically move from their system/country to the superior system/country. Obviously, under the communist regime there are no possibilities for any large-scale movement of people from their country to other countries with brighter prospects. Hence, the drive to abandon the communist foundations becomes the only alternative left, and to replace them with more successful foundations. The best evidence of a failing system is the failure of its performance versus other systems. Failing performance is by definition a relative concept based on comparing and evaluating outcomes accruing to the agent in competing settings. In the context of the Soviet Union and Eastern Europe – the SIM related countries – the agents there looked at Western Europe and US – the FIM related countries – for a comparative evaluation.

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The outcomes that people are interested in range from intangibles such as happiness and freedom to tangibles such as material well-being, present and future income, purchasing power, employment security, civilian security, etc. We shall use some of these indicators to review the past performance of Russia and Eastern Europe. The average annual growth of the GDP, and the GDP per capita, for SIM and FIM related countries are displayed in Table 5.2. Both groups experienced high growth from 1950 to 1970. The growth of SIM countries started declining in the mid-1970s and reached a standstill in late 1980s. Why did growth decline? What is the source of the decline? To get more insight in the problem distinguish between extensive growth that is identical with growth of factors of production such as labour and capital inputs, and intensive growth that is identical with growth in total factor productivity, i.e. more output per unit of input. It is generally acknowledged that during the early stages of economic development economic growth tends to be of the extensive growth type, as output expansion is achieved largely from mobilizing and using more factor inputs. At higher stages of economic development intensive growth dominates as factor productivity increases significantly through better use of the factors of production, higher technology, more efficiency, etc. The usefulness of these distinctions is readily seen from eq. (5). Take v, for growth rate of output, to consist of the two components: growth in factor use and growth in factor productivity. The first component is the weighted sum of the growth rates of inputs of labour l and capital k, the respective weights should reflect their respective marginal returns as represented, under market equilibrium conditions, by each input’s share in the national income, thus rl and rk . The second component is the growth in factor productivity, denoted by y. v  (rll + rkk)  y

(5)

By inserting the value of the growth of output v and the growth of weighted input (rll  rkk) and deducting, the growth in factor productivity y is obtained as Table 5.2 groups

Average annual growth of GDP and GDP per capita in the SIM and FIM country

1950–60 1960–65

1965–70 1970–75 1975–80 1980–85 1985–90

SIM countries GDP GDP per capita

5.4 4.5

4.5 3.7

4.1 3.5

4.5 3.9

2.1 1.7

1.1 1.1

0.9 0.8

FIM countries GDP GDP per capita

5.0 3.7

5.1 4.3

4.5 3.7

2.8 2.4

2.7 2.4

2.3 2.3

2.4 2.4

Source: Various sources reported in and adapted from Gregory and Stuart (1999), p. 220. East includes the Soviet Union and six East European countries. West includes US, Canada, Japan, and eleven West European countries.

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Table 5.3 Annual growth rates of output, inputs, and factor productivity for the SIM and FIM country groups Countries

SIM

FIM

Years

0utput v

Labour l

Capital k

(rll  rkk)

Factor productivity y

1950–60

5.2

0.8

4.2

1.7

3.5

1960–85

3.0

0.8

5.1

2.1

0.9

1950–60

4.8

0.9

4.7

1.8

3.0

1960–85

3.7

0.9

4.7

1.9

1.8

Source, note: Various sources reported in and adapted from Gregory and Stuart (1999), p. 225. The shares of rl and rk we assumed in these calculations are 0.75 and 0.25 for 1950–60, and 0.7 and 0.3 for 1960–85.

residual. These productivity calculations are shown for the two groups of countries, in Table 5.3. Of course, the rough nature of these productivity calculations should be emphasized. Note that the income shares will reflect the returns under restrictive conditions of market equilibrium. However, the general magnitudes of the results remain intact under varied plausible weights. The 1950–60 period saw factor productivity to grow at similar rates, in the SIM block by 3.5 per cent and in the FIM block by 3.0 per cent. After 1960, a great drop is noted for SIM, with growth in factor productivity declining to 0.9 per cent, as compared to a growth in factor productivity in FIM of 1.8 per cent. This means that in the SIM countries economic growth in the past four decades depended increasingly on the mobilization of more and more factor inputs and decreasingly on growth in factor productivity. Rather than becoming more intensive, the growth of the communist regimes continued to be more extensive. For a modern economy, the opposite pattern of intensive growth should have happened. The very low past performance with regard to factor productivity has manifested itself in what was previously mentioned as failing outcomes of the communist system, such as persistent shortages, waste due to misallocations, backward technology, low quality of goods and services, and retarded advancement of well-being. Another measure of the performance of economic systems concerns fairness in the distribution of income and wealth. There are many possible measurements of inequality. But given our approach to the field of economic systems the important issue is not which indicator is analytically more meaningful, rather which is the relevant indicator of fairness that people in one country commonly experience, observe, and employ in a comparative evaluation with the fairness outcome in another country and, thus, in forming an opinion on the relative fairness of one setting versus another setting. The search for such indicators is a major study apart. It is very likely that such subjective indicators may correlate with analytical indicators that we use in economic investigations. For lack of alternatives we give in Table 5.4 for SIM and FIM countries readily available statistics of the ratio of per capita income for persons in the 75th percentile to the per capita income

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Economic Systems Analysis and Policies

Table 5.4

Equity indictors for selected SIM and FIM countries Per capita income of individuals in the 95th percentile/same for the 5th percentile

Bulgaria 1964 Czechoslovakia 1965 Hungary 1964 USSR 1966 Average SIM Canada 1971 Italy 1969 UK 1969 US 1968 Average FIM

Per capita income of individuals in the 75th percentile/ same for the 25th percentile

3.8 4.3 4.0 5.7 4.45

1.7 1.8 1.8 2.0 1.83

12.0 11.2 5.0 12.7 10.23

2.4 2.5 1.9 2.6 2.35

Source, note: Various sources reported in and adapted from Gregory and Stuart (1999), p. 231. The income statistics for East exclude top income earners like state officials, and remunerations earned in the second economy.

for persons in the 25th percentile. A second indicator is calculated using the 95th and 5th percentiles. Discounting for the shortcomings and the incompleteness of these statistics it can be generally established that the income was more equally distributed in the SIM than the FIM countries. The average ratio for the first indicator for the SIM is 1.83, for the FIM it is 2.35. The second indicator emphasizes the differences even more: the ratio in SIM is 4.45, and in FIM it is 10.23. The smaller differences between rich and poor in SIM than FIM, as shown in the table, are consistent with the prevalent contrasting priorities that the two systems hold on the equality issue. Clearly, state property and centrally fixed remuneration levels are two conditions in East that secure more effective policy instruments to effectuate a more equitable income. If the two conditions are removed, which is by definition what happens in the transition to a more optimal mix between state and markets, it will be seen that the equity ranking of SIM and FIM would immediately reverse, and to a much more significant degree. Alternative equity promoting policy instruments such as safety nets, fiscal transfers, and social security do not exist in SIM but are well developed and form a coherent part of the economic system in FIM. Next to growth and equity, the past performance can be evaluated in terms of commonly experienced and observed indicators like unemployment and inflation. Unemployment did not exist in an open form in SIM, although hidden underemployment in ministries and enterprises was common. In general, a high degree of material security was present, even though the basic level available to each and everyone was, by FIM country standards, on the lower side. Inflation as a process of continuously rising prices did not exist in the communist countries. Prices were fixed for long periods. After the mid-1970s, sporadic

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161

rounds of price increases took place. More significant is the price hike which producers charged to willing consumers for delivery of scarce goods or better quality in the second economy. Important, too, is the built-in repressed inflation that took the form of hoarded savings for lack of consumption outlets, and which was the result of pursued allocation policies.

5.8

Causes of system rise and failure

We shall briefly reflect on the rise of the communist regime, and the economic success of the Soviet Union up to around 1965, before examining the slow downturn in the economic system that finally ended with its collapse some thirty years later. We shall give our interpretation based on the propositions on the functioning of economic systems that we displayed in the first and second chapters. There are various other economic interpretations and theories that reflect on the collapse of the communist regimes. We shall subsequently review these other interpretations of the failure. Russia’s rise. To start with, the initial environment in Russia in 1910s and 1920s was featured with a heterogeneous and highly skewed population groups in terms of intellectual and material endowments. This environment was functional for the start sign of a communist regime. The more endowed leaders, headed by the Politburo and party cadres, and supported by central planners, state bureaucrats, and enterprise managers, took charge of running the regime on behalf of, and for the good of, the population at large; supported with an ambitious communist ideology. The institution of closed borders and imposed isolation from the rest of the world over many years allowed tendencies to develop that would adapt the internal structures in the system to each other to form an apparently coherent whole. In Chapters 1 and 2, we identified four internal structures. These are the personal attributes of the endowed leading groups and the population at large, Q, the physical–technological transformation, T, the institutional rules, I, and the information structure, N. The systemic adaptation that took place was geared to the tunes of politically behaving state settings. The following is a demonstration. For example, the economic system operated along the lines of state plans for state enterprises, but because important aspects of the real world could not be incorporated in instructive plans, the control system deviated from the real system. In practically all areas of economic activity more examples of deviations between the control and real systems can be quoted. In resolving these deviations and frictions agents transact with each other, but under the circumstances they are inclined to do that in hidden ways that exclude competition, and pursue non-transparent behaviours that allows for monopoly rents. Such a political behaviour pattern – typical for pure state settings – permits the better-equipped agent to extract and secure a quasi-permanent rent from the less-equipped agent, over and above a normal one-time remuneration.

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Economic Systems Analysis and Policies

This political behaviour was reinforced repeatedly by state settings that behaved politically. State settings, in their intrinsic form as was used to be the case in the Soviet Union, were driven by political agents seeking political gains.1 Political behaviour, and the rent extraction traits that associate with political behaviour, were observable features for all agents in an all-political state intensive social system. When the coverage of a political behaviour extends beyond some threshold, it tends to become the norm that is expected in mutual behaviour and gains more momentum. The internal structures referred to above tended to unify along the same lines. In such a politically based system the economy is subordinate. This does not mean that a dominant polity will show up in a slow economic growth. As long as there is a sufficient yearly flow of inputs of land, labour, and capital to produce the economic growth, this growth remains positive and can accelerate. This happened in the period of the economic rise, from the 1920s up to the 1960s–1970s. In this period, the material achievements of the Soviet Union were a source of inspiration for many countries of the developing world. Russia’s fall. In a systemic analysis of Russia’s fall we would like to distinguish between internal pressures and external pressures that caused the end of the communist regime. The internal pressures date from around the 1960s and 1970s, when by that time, the population increased significantly and its profile Q changed appreciably. Demand for more goods, and of a more specific nature, contrasted with a draining up of factors of production. To meet the demands a shift upward in production possibilities was badly needed. One and the other required renewing and modernizing the technological transformation processes T, changing the institutional rules I from privileged control on state property towards a coupling of individual property rights to individual work efforts to enhance incentives, and a decentralization of the information structure N towards micro agents, to avoid problems of incomplete and asymmetric information. If such changes would take place the management functions of the economy as well as the created surplus would flow to non-state agents, which would have made the party cadres and most bureaucrats redundant. The prospective losers opposed such changes; the changes were also unthinkable for the Politburo who acquired its political legitimacy as custodian of collective property rights. The apparent harmony between the four internal structures that characterized the first few decades of the communist regimes cracked from the 1970s onwards. The four structures could not adapt to each other primarily due to conflict of interests under changing circumstances. With inconsistencies increasing and the same old policies continuing, inefficiencies, waste and shortages multiplied, leading to reductions in overall growth. Rent extraction practices added more distrust and a further deterioration in the daily running of the economy. With the well-being of the endowed leading groups hardly affected, the incidence of the reductions shifted to the population at large. And the differences in well-being were observable and noted by people. The external pressures came later. The external environment circumscribing the communist regimes, has appreciably changed in the 1970s and 1980s. Media and travel made information over the performance of the industrial world, living

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levels, and liberties readily accessible. As the closed regimes gradually opened up, their public was in a position to compare and evaluate their performance versus that of neighbouring market economies, and come to the conclusion that their regime performed less. Our introductory principles tell us that one of three choices is decided in such evaluations. The first choice is to remain loyal to the regime and the rulers in the hope that promises made will one day materialize. Some did that, but in relative terms that was only a very small minority. The second and third alternative actions are either to exit or to voice. Possibilities of exit are extremely limited, even though some outflow took place from East to West Germany. Voice was the popular and anticipated action by the new wave of political leaders and their massive supporters. This started in Eastern Europe and spread to the Soviet Union. The targets were to wipe out the communist rule and to replace it with a reorganization of society along new structures similar to neighbouring market economies.2 Other interpretations. Economists have put forward other interpretations of the system failure that focus on or another feature of the communist regimes. We shall review them below with the understanding that our interpretation based on our introductory principles as well as each other interpretation are not exclusive of each other. Each can be said to look at the failure from a different angle. Pejovic (1982), and extended in Pejovic (2001), focuses on the first and second features introduced at the beginning of this chapter. His thesis is that the original terms of contract between the Politburo and the Soviet people lost validity due to the realization that the Marxist thesis that socialism is a historically superior system to capitalism is refuted in view of the proven lower performance of socialism as compared to capitalism; besides, new generations are less willing to trade the quality of life today for a hazy vision of future improvements. The ideological justification of the communist regime became void as its leaders increasingly abandoned the ideology, or paid only lip service to it, so that the regime came to be uncovered as simply equivalent to that of any other ordinary and arbitrary dictatorship that lacks popular legitimacy. Eggersston (1990), close to Winiecki (1986), put emphasis on the second and third features of the communist regime. They place their interpretation within the analytical frameworks of agency problems, transaction costs, and property rights. They argue that (a) the managers of state enterprises respond to incentives which discourage cost minimization, and (b) the organizational structure of state enterprises have not adapted to technological developments, resulting in rising transaction costs. The solution of these problems would require replacing the command by prices, i.e. writing off the communist regime and instituting a profit-maximizing market economy. A competitive market for managers would represent a huge transfer of wealth away from party functionaries who hold property rights at the managerial levels. This explains the opposition of party cadres to meaningful reforms. Eggersston adds If a state is to prosper and stay close to the economy’s technical production frontier, it must have the political strength to adjust the structure of property

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Economic Systems Analysis and Policies

rights to changes in the economic environment. However, adjustments are often blocked by agents of the state, who believe that reforms threaten their self-interest. When structural changes are expected to raise society’s aggregate wealth, both ruler and subjects may find it in their self-interest to offer state agents compensation for expected losses and to attempt to buy their compliance. Yet high transaction costs are likely to prevent such side payments. (Eggersston (1990), p. 333; the italics are my emphasis) An interesting question arises in the above context as to whether the state agents could be treated as a homogeneous group. As will be seen later some skilful party members and ministerial authorities were able to capture significant property rights in the privatized enterprises in the transition period immediately after the collapse of the regime. What they captured is much more than the possible sidepayments. But most of the remaining party cadre and bureaucrats have ended as losers, and their side-payments would have been insignificant. The problem is that it is hardly possible to identify beforehand who will be the winners and the losers. Stiglitz (1993) focuses on problems of incentives and information in his interpretation of the communist failure. The interpretation of Stiglitz fits neatly within the principal–agency analytical framework. The principal is the planning bureaucrat while the agent is the enterprise manager. Firms could not keep any profits they made. There was no competition, and the soft budget further attenuated managerial incentives. Equally important, here was no incentive for innovation and growth ... Socialists wanted to replace the market mechanism for allocating resources with central planning. But they encountered two problems. First, the bureaucrats did not have the requisite information to know how to allocate resources efficiently. Managers of firms had no incentive to tell the central planners what the minimum inputs required to meet their production goals were. Rather, they had every incentive to claim they needed more than they really did. This made their job easier. And they had no incentive to exceed their goals for if they did, the planners would raise their targets for the next year. Second, planners could not perfectly monitor the various firms in the economy ... And firms had only limited incentives to comply with the planners’ directives. There were no rewards, and they knew they were only imperfectly monitored. (Stiglitz (1993), pp. 196–97) Ellman (1989) focuses on difficulties concerning the fourth feature of communist regimes, i.e. central planning, as the cause of failure. The theory of rational social decision making implicit in the traditional Marxist-Leninist theory of planning is inadequate because it ignores the fundamental factors of partial ignorance, inadequate techniques for data processing and complexity. (Ellman (1989), p. 34)

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Finally, some economists have blamed the economic policies pursued, rather than the economic system, as an explanation of the communist failure. Given the scarcity of capital, this opinion argues that the Soviet strategy of heavy industrialization was wrong. The performance would have been better if more attention would have been given to industries that require less capital, and to foreign markets as additional outlets.

5.9 Summary and conclusions In the state intensive economic system, polity matters overrule economy matters. In this chapter attention is directed to how such a system has been working under the communist regime in the former Soviet Union and its East European allies, and how it has come to an abrupt standstill. As will be appreciated in the next chapter, which deals with the transition, the political paths pursued in the past under state dominance, have been very influential in determining the course of economic transition that SIM-related countries went, and are going. To contain the analysis, we focused more on the past system in the Soviet Union, but elaborated on situations in the East European allies when they differed significantly from the Soviet Union. Among the features passing the review were the communist ideology, the assignment of the Communist Party as sole interpreter and formulator of the communist ideology, and the motor for its implementation via state institutions; the elevation of the state as the sole owner and manager of property; the introduction of a state system for the planning, implementing, and monitoring of the economy’s production and distribution. The chapter examined the procedures, methods, forms, and the practical operation of central planning, looked into the obstacles it encountered, examined how principals and agents inside and outside the state settings responded to each other, considered the problems which these responsive interactions create. In dealing with the above we adhere to the important distinction made by Kornai (1967) between the control sphere and the real sphere. The operation of the system of planning, implementing, and monitoring in the real world deviates from what the control sphere desires it to be. There are substantial differences between practice and the prescribed rules and practice. These differences betray why the control system was not able to work in the face of upcoming contradictions. In this context of upcoming contradictions, governments in the ex-communist countries initiated various rounds of planning reforms to save the situation, but in most of the concerned countries the reforms failed. The reforms were reviewed and the failing results evaluated. The chapter then directs attention to the economic policies pursued by the governments of these countries. There are greater differences between the countries in this respect and that explains differences in economic performance between them. But, taken as a whole, the past performance of the Soviet Union and its East European allies in terms of economic growth did not match those of FIM related countries over the longer run. Growth accounting showed a remarkable decline in factor productivity in the SIM-related countries in contrast to a rising

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Economic Systems Analysis and Policies

contribution of factor productivity in FIM related countries. In contrast, indicators of income inequality showed a more equal income distribution in the SIM as compared to FIM related countries. Not only did most of the reforms, policies, and performance fail, but the whole regime fall short of achieving the announced objectives which it promised for its people. The collapse of these communist regimes in the early 1990s became imminent. There are alternative explanations for the failure of the communist regimes. The explanations rely, to different extents, on economic, social, and political theory. We presented our own interpretation based on the analytical framework developed in Chapters 1 and 2. We state also four different, though complementary, views by other economists that explain the communist failure.

6 The State Intensive System: Economic Transitions

6.1

Alternative paths

The regime crises in the SIM relating countries ended in the collapse of the state intensive dictated regime in the Soviet Union and European allies, and the break up of the Soviet Union in Russia and a large number of independent countries. Understandably, the new leaders in these renewed countries looked Westwards to EU and US for a helping hand to restructure their polity and economy. US and EU responded enthusiastically, displayed their systems of national institutions for adoption, and mobilized technical assistance towards that end. International agencies such as the IMF, WB, and other UN agencies, mobilized their resources and gave advice and aid in transmitting these countries from state economies to market economies. In practical terms, there was only one alternative economic-political system available for adoption. This is the commercial market based system prevalent in US and EU. In that sense, the ex-Soviet Union and allied countries are rightly described as transition economies: a transition from a state intensive economic system to a firm intensive economic system. These count 25 countries in total. China is not counted among the 25 transition countries. The situation that China faced in restructuring its polity and economy was different. China introduced and institutionalized systemic reforms way ahead of the Russian bloc and did not experience a regime crisis or regime collapse as the Russian bloc did. In some sense, China was able to be master of its own destiny. The scope of the required change in agent behaviour accompanying transition from a state dominated system to a firm dominated system can be grasped from Table 6.1, which displays the macro frameworks (items 1 and 2) and the micro behaviour in opposite systems (items 3 to 8). In the short term it is plausible to consider that behaviour of agents at the micro level is conditioned by the macro features. For the longer term it is logical to expect that changes in the behaviour of agents at the micro level will have their bearing on the macro features of the system. The new political authorities in the transition economies introduced market elements in different ways and at different speeds. This led some analysts and 167

168 Economic Systems Analysis and Policies

Table 6.1 to FIM

Required changes in agent behaviour accompanying transition from SIM

FROM Typical situation in SIM

TO Typical situation in FIM

Macro framework

Macro framework

(1) Revenue and expenditure in state budget overlap, not instrumental, due to state prefixing of prices and of values of revenue, payroll, subsidies, current, capital spending.

(1) Conditions of macro stability observed (low price inflation, tax burden, etc.) in managing the balance of revenue and expenditure in the state budget.

(2) Balance of foreign payments determined by state fixing of exports, imports, capital flows, and exchange rate.

(2) Balance of foreign payments determined by market forces. Fully or quasi liberalized movements of prices and quantities.

Micro behaviour

Micro behaviour

(3) Monopoly of communist party in governing the state.

(3) Political parties compete for government power in an elected parliament.

(4) All agents accept state ownership of property.

(4) All agents accept private ownership of property.

(5) Preponderance of bureaucratic coordination in the management and distribution of state ownership.

(5) Preponderance of market coordination in the management and distribution of private ownership.

(6) State enterprises are driven by quantitative targets, plan bargaining, soft budget, etc. not responsive to prices. Commercial law and related judiciary system irrelevant and absent in the context of state enterprises.

(6) Commercial firms are driven by profit maximization, face hard budgets, and are responsive to prices. They operate within the boundaries of commercial law and related judiciary system.

(7) Consumer response: Seller market, demand certain, enterprise not motivated to sell more than instructed by production plan, no effort to attract buyer or improve quality, chronic shortages.

(7) Consumer response: Buyer market, demand uncertain, firm likes to sell more to increase revenue, effort to please buyer and improve quality, cleared markets.

Quantity coordination: Minor role for prices, weak price responsiveness.

Price coordination: Firm is highly responsive to prices. Quantities determined by prices.

(8) Financiers response: Financial violations, wage and inter-enterprise credit arrears, nonperforming loans, negotiated tax relief, no outsider accountability of financial accounts, no valuations of assets, and no exchanges of ownership.

(8) Financiers response: Financial discipline, factor payments in accordance with contract, loans paid back, tax obligations met, yearly accounts filed and verified by accountants, value of firm determinable and ownership exchangeable in stock exchanges.

Enterprise mobility: No free entry, no exit in case of failure due to soft budget.

Firm mobility: Free entry, exit in case of failure due to hard budget.

State Intensive System: Economic Transitions 169

advisors to distinguish between ‘gradual change’ and ‘shock therapy’ as two alternative approaches in transforming the economy. The two terms were never given rigorous and exclusive definitions. In general terms, the gradual change approach is understood to mean a slower but more balanced approach that transforms the economic system in a stepwise fashion. At each step reforms of macro features and micro behaviour are adopted and adjusted to each other. In contrast, the shock therapy, or big bang as called by others, is more abrupt in its strategy, tends to introduce once and for all sudden and significant changes in the external environment. By nature it focuses more on reforms of the macro features while shifting the burden of micro adjustment and the learning of new behaviour to producers and consumers at the micro level.1 While the gradual change approach requires policy interventions over more years, the shock therapy approach concentrates policy interventions in a shorter period, but the successful completion of micro adjustment takes more years and may ponder. Hungary is considered to have followed a gradual change approach. All republics of the ex-Soviet Union and most allied countries have undergone sudden shocks in their economic environment, these shocks being characterized by the precedence of exogenous macro measures over an otherwise endogenous selfcorrecting micro adjustment at the micro level.2 The collapse of the state dominated system and its abrupt replacement by elements of the market dominated system could not possibly happen without a general downturn in economic activity along all branches of the national economy in each and every transition economy. The recessions, which endured from four to ten years depending on the transition economy, were serious; wiping on average about 40 per cent of the GDP of the pre-transition period. This chapter will be organized along the following lines. In Section 6.2 the magnitudes and causes of the transitional recession in the ex-Soviet Union and European associates will be examined. In Section 6.3 we give a review of transitional reforms and their phasing into what is called short transition and long transition. Section 6.4 treats the short transition, Section 6.5 treats the long transition, and Section 6.6 summarizes and concludes. A SIM country undergoing the long transition is confronted with economic failures that appear also in the FIM countries. These are economic imperfections due to the presence of indivisibilities, uncertainties, externalities, collectivities, and inequalities. It will become clear that the responses of firms and state settings to these economic challenges are different in the two systems. In contrast to FIM countries where firms orchestrated the remedies, the responses in most of the transition countries reflect a dominance of state interests that is consistent with the assumptions of the state intensive economic system.

6.2 Magnitudes, causes, and effects of the recession in transition countries All 25 transition countries experienced significant falls in their GDP, but with wide variations. Table 6.2 shows that output has fallen in the group Baltic, Central

170 Economic Systems Analysis and Policies

Table 6.2

GDP performance in transition countries

Country

LY = lowest year of GDP

GDP decline 1988–LY, % of 1988

Annual growth GDP LY–2000, %

Annual GDP GDP GDP Ratio of growth change change change cumulaGDP 1988– 1988– 1988– tive GDP 2000–05, 2000, % 2005, % 2005, 1988– % of 1988 of 1988 billion 2005/ US$ 1988

Czech Rep.

1992

–15.4

1.7

3.7

0

19

10.9

16.6

Estonia

1994

–36.5

3.2

7.6

–12

27

1.7

15.0

Hungary

1993

–18.1

3.1

4.2

6

30

13.2

17.0

Latvia

1993

–52.8

2.6

8.1

–27

8

0.9

13.0

Lithuania

1994

–40.8

3.0

7.6

–31

0

0.0

12.9

Poland

1991

–13.7

5.1

3.0

35

56

71.3

19.9

Slovakia

1993

–24.7

4.9

4.9

2

29

5.8

16.7

Slovenia

1992

–20.4

3.8

3.4

11

31

5.4

17.3

Albania

1992

–39.9

6.6

5.4

14

48

1.6

17.5

Bosnia

–

–

–

5.0

–

–

–

–

1997

–36.9

3.0

4.9

–26

–6

–1.0

13.4

Bulgaria Croatia

1993

–37.6

2.2

4.7

–17

5

1.0

14.2

Macedonia

1995

–45.6

2.0

1.4

–37

–33

–1.9

10.5

Romania

1992

–26.6

0.0

5.7

–25

–1

–0.6

13.8

–

–

–

5.2

–

–

BCEE group (a) (b)

Serbia

1993

–31.5

3.2

5.0

–8 4

16 27

8.3 108.2

15.2 16.8

Armenia

1993

–65.1

5.4

12.3

–6

68

1.4

17.5

Azerbaijan

1995

–63.1

5.9

13.6

–48

–2

–0.2

10.6

Belarus

1995

–36.9

6.0

7.5

–14

23

3.4

14.9

Georgia

1994

–76.6

5.8

7.3

–67

–53

–4.9

7.3

Kazakhstan

1998

–40.2

1.7

10.4

–33

10

2.8

13.4

Kyrgyzstan

1995

–50.5

4.1

3.8

–28

–13

–0.3

13.2

Moldova

1999

–69.2

–

7.0

–64

–49

–1.7

9.1

Tajikistan

1996

–74.0

3.7

9.5

–65

–44

–1.2

Turkmenistan

1997

–49.6

10.5

–

–

–

Ukraine

1999

–64.5

–

–58

–39

7.7

–

8.6

0

–

–28.8

10.1

Uzbekistan

1995

–14.4

3.1

5.4

3

34

4.5

17.3

EXSR group (a) (b)

1996

–54.9

5.1

8.4

–38 –43

–7 –16

–2.4 –25.0

12.2 11.7

Russia

1998

–46.5

3.2

6.1

–36

–14

–55.1

12.3

Source, note: Columns 1, 2, 3 are from International Monetary Fund, International Financial Statistics, World Economic Outlook, IMF staff estimates; as published in Fischer and Sahay (2000). GDP decline is from 1989 to the year in which output was the lowest. Columns 4, 5, 6, 7, 8 are from http://devdata. worldbank.org/query/. GDP is measured in US$, in constant prices of 2000; Output is measured in real GDP on an annual average basis. a = group average, b = group total.

State Intensive System: Economic Transitions 171

and Eastern European countries, to be named BCEE by about 32 per cent on average by the time it bottomed out. By 2000, six countries have recovered back their loss in the GDP, and by 2005, eleven of thirteen reported BCEE countries have recovered the GDP loss. Countries of the ex-Soviet Republics, to be named EXSR, lost on average about 55 per cent in their worst year. In 2000, the loss was about 38 per cent of their GDP level of 1988, on average. In 2005, the loss was reduced further to about 7 per cent of the GDP level of 1988, on average. When the EXSR is summed as a whole instead of taking a simple average, the loss in GDP of EXSR is shown to be more severe. The losses in the GDP in 2000 and 2005 are 43 per cent and 16 per cent, respectively. The average is biased downwards because of the high performance of Armenia whose GDP has a small weight in the total of the EXSR group. It is noted that the opposite results are found for the BCEE group, where the performance in terms of the total GDP is higher than in terms of the simple average. The main cause is the very low performance of Macedonia with a relatively small GDP, which biases the simple average downwards. The magnitude of the recession in Russia was similar to that of the EXSR group, with a highest loss in the real GDP of about 47 per cent in the lowest year of GDP as compared to 1988. Recovery followed bringing down the loss by 2000 to 36 per cent, and a further reduction of the loss by 2005 to 14 per cent. For highlighting the GDP decline and recovery Table 6.2 includes next to growth rates and percentage changes in the GDP, two other indicators that tell the same story in a different form. Column 7 gives the absolute loss (or gain) in the GDP of 2005 as compared to 1988 in US$ in constant prices. The BCEE has a gain, EXSR and Russia show losses of about 25,000 and 55,000 billion US$, respectively. Column 8 highlights another aspect of the recession and recovery. It gives the ratio of cumulative GDP in constant prices from1989 to 2005 to the GDP of 1988. Since the period covered counts 17 years, recession and recovery are even for ratio scores of around 17. Poland has the highest score of 20 and Georgia has the lowest score of about 7. Figure 6.1 highlights the differences in GDP fall and recovery between the three groups of transition economies. The figure highlights the shorter duration of the recession in BCEE, from 1989 to about 1992, and a quicker recovery afterwards that pushes the GDP gain in 2005 to 27 per cent. The recession in EXSR and Russia is extended to 1995 and 1998, respectively. In EXSR, the GDP decline is in 2005 at about 16 per cent. For Russia, it is slightly lower at 14 per cent. Figure 6.1 displays along the x-axis the corresponding annual growth rates of the GDP for the three groups. The different orientations among the 25 transition countries indicate that a division of countries into the above-mentioned three groups is a sensible step for understanding why and how these economies experienced different paces in their fall and recovery.3 When countries change from one system to another they go through heavy adjustments that reduce activity now but can promise more growth in the future. The decline was severe and varied appreciably per country group. What are the causes of the downfall in production? Four groups of causes are behind the

172

Economic Systems Analysis and Policies

20 10 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 –10 –20 –30 –40 –50 –60

BCEE GDP index

EXSR

RUSSIA GDP index

BCEE GDP growth

EXSR

RUSSIA GDP growth

Figure 6.1 Transition countries: Time profile of GDP decline and recovery by country group Source, notes: World Bank at http://devdata.worldbank.org/query/ GDP index = (GDP(t) – GDP(1988))/GDP(1988). GDP growth = annual growth rate. GDP in constant prices.

downfall: statistical distortions, system disorientation, transition policies, and external effects. Statistical distortion is one cause. To meet plan targets, there has been built-in over-reporting of output figures in the old system. But also in the transitional phase, there were statistical distortions caused by an under-reporting of production by public enterprises to evade taxes. The transitional phase saw also a strengthening of activity in the informal sector, which is not traceable in national accounts statistics. The Polish downfall estimated by 1990 at 20 per cent was revised favourably to 10 per cent after applying statistical corrections along the above lines. Observers tend to agree, however, that the magnitudes of the GDP recession in most transition countries will not be significantly affected by statistical revisions. System disorientation came abruptly. Planning institutions and supportive mechanisms vanished instantly with the collapse of the regime, before new market institutions were created. This led to coordination failures in incentives, production, and trade. System disorientation took different forms. ●

●

Labour inputs diminished as people encountered shortages, faced political uncertainties, and lost work appetite. Faced with shortages of basic goods, enterprises diverted their reserves to buying consumption necessities for their workers, at the cost of provisions for investment and production.

State Intensive System: Economic Transitions 173 ●

●

●

●

●

●

Uncertainty on privatization, and the political climate in general, encouraged expropriation of public enterprises by managers and ministries, and the flight of the appropriated capital, reducing investment and production further. Plan instructions, supported by informal networks on deliveries of intermediate inputs, ceased to be obligatory as the old system collapsed. These led to a melting down of obligations to mutual delivery between enterprises and to a widespread inter-industrial supply defaults and production decline in view of established but unfulfilled input–output relationships. Republics and regions, anticipating shortages, took measures to restrict mobility of goods to other regions, and causing production bottlenecks in the latter. In Russia the Law on State Enterprises, 1988, which required self-financing, caused a credit crunch that held production back. Financial arrears between enterprises, based on real production deliveries that could not take place, accumulated and there was no mechanism to settle them. The phenomenon obstructed the further obtainment of inputs for regular production plans. Bank managers, in control of supplying credit, favoured enterprises from which they profited most at a personal level, this leading to a misallocation of financial resources, and a prospective deadweight loss in production.

Transition policies were expected to reduce production temporarily. This is natural, as resources would have to be moved from less to more desirable activities that reflect consumer sovereignty. But there were also specific initial conditions and policies that intensified the transitional recession. They are reviewed briefly below. ●

●

●

●

●

●

Consumer hoarding that was built up before and during transition, and which constituted a potential purchasing power, was wiped out by inflationary measures and consecutive devaluations. Transition policies redistributed income from wages to profits, and increased the proportion of the non-earning population. These policies led to a further deterioration in aggregate demand. Price liberalization pushed prices up, leading to a reduction in aggregate demand. Price coordination failures led to cuts in production. For example, as the equivalent price of fodder exceeded that of animal products, livestock production activities were cut down. As was stated above, the transition aimed at a restructuring of industrial production. This started with a rapid decline in the production of military equipment and capital goods that had knockout effects on other industries as well. The parallel restructuring that was intended to enhance the light industry did not materialize either due to input shortages, or weak demand from consumers in view of not only lower aggregate demand but also non-saleable goods, low quality, inferior technology, and hardly competitive goods in an opening economy.

174

Economic Systems Analysis and Policies

The greatest drop in output occurred in the first year of transition, and continued for some time concurrently with the liberalization and stabilization programmes. Output began to grow two years after execution of these programmes, on average. This is also about the time that inflation started subsiding from its highest growth levels. Finally, external factors influenced production differently in the different countries. Weak oil prices did not help Russia, and the war in Chechnya diverted resources to non-productive uses. Foreign trade between the communist countries declined substantially with the dismantling of the Soviet Union, leading to reduction in related production. Border countries of Russia that imported energy and raw materials at cheap prices experienced deterioration in their terms of trade. Some countries ended with severe debt crises. Other countries situated close to the European Union have gone through reforms that were directed towards their eventual integration in the EU and had the benefit of a larger inflow of foreign assistance per head than countries of the former Soviet Union. Cumulative net capital flows during 1992–97 amounted to between 600 and 800 US$ per capita for BCEE, and between 0 and 200 US$ per capita for EXSR and Russia.4 Table 6.2 and Figure 6.1 have shown that the recession was shorter and milder and recovery was stronger in the Baltic, Central and East European country group (BCEE). The incidence of the above four causes favoured the BCEE country group more than the ex-Soviet Republics (EXSR) or Russia. Next to these causes, differences in the level of economic development in the individual countries before the transition period are also behind differences in performance in the transition period. The BCEE group contained countries that are economically more advanced than EXCR and Russia. Various empirical studies that attempt to explain the variance in GDP performance among the transition countries conclude that the different initial conditions and the different implemented policies during transition were significant. Both contributed to the differences in the magnitudes of the recession and recovery among transition countries.5 Turning to distribution issues, SIM countries exhibited relatively low levels of income inequality compared to other countries. But once they entered transition, transition countries tended to take over profiles of income distribution typical of other countries at a comparable level of economic development. Table 6.3 gives the Gini index in the pre-transition period and about five years later, in 1995. We show 1995 as this was the average year with lowest level of GDP for transition countries as a whole. The Gini index increased by about six points in the BCEE group to reach 31, and twelve points in the EXSR group to reach 39, and showed a remarkable jump in Russia from 25 to 44, a rise of 19 points. These changes tended to stabilize in later years at the reached levels. Latest comparable figures available for 2005 show the Gini index to settle in BCEE group at 32, in the EXSR group at 39, and in Russia at 42. Income distribution has thus worsened less and is more equally distributed in BCEE than in EXSR and Russia, which suggests that rent seeking behaviour associated with the SIM is less spread in BCEE than in EXSR and is most in Russia. The remarkably increased and higher disparity in Russia are

State Intensive System: Economic Transitions 175

Table 6.3

Socio-economic performance in transition countries

Country

GDP per capita

US$ 2005 Czech Rep.

ppp$ 2005

Gini index, %

1989

Change in Gini index

1995

2005

1995/ 1989, %

2005/ 1995, %

Income based Gini index/Earnings based Gini index

2005– 1989, points

Progressive Regressive 1995–2005 1995– 2005

11,220

19,560

20

22

26

10%

18%

6

9,060

14,660

28

40

36

43%

–10%

8

10,070

16,780

22

24

28

9%

17%

6

Latvia

6,770

13,490

26

b32

b30

23%

–6%

4

0.92

Lithuania

7,210

14,140

26

b34

b36

31%

6%

10

0.90

Poland

7,160

13,370

28

32

37

14%

16%

9

Slovakia

7,950

15,200

20

a26

26

30%

0%

6

Slovenia

17,440

22,140

24

26

b22

8%

–15%

–2

Albania

2,570

5,410

Bosnia

2,700

Bulgaria

3,450

9,140

Croatia

8,290

12,620

Macedonia

2,830

7,130

Romania

3,910

8,980

Serbia

3,220

–

Average BCEE group

6,923

13,278

25

Estonia Hungary

–

–

–

–

–

23

38

36

a36

– 24 –

30 31 – 31

– 34 –

36

32

1.00 0.71

1.11 –

–

–

–

–

–

–

–

65% 0%

–11%

11

–

–

16% –

23%

3%

–

12 –

– 7

0.96

1,470

4,990

25

b34

43

36%

26%

18

0.89

1,240

4,380

31

b46

a51

48%

11%

20

–

Belarus

2,760

7,920

23

25

24

9%

–4%

1

0.72

Georgia

1,320

3,410

28

a50

a46

79%

–8%

18

0.95

7,120

28

c35

c34

25%

–3%

6

Kyrgyzstan

450

1,860

27

b34

39

26%

15%

12

Moldova

930

2,360

25

b43

43

72%

0%

18

Tajikistan

330

1,300

28

38

36%

–

–

–

–

Turkmenistan Ukraine Uzbekistan

– 1,520 520

–

–

28

28

–

6,770

23

47

b33

0% 104%

–30%

–

0.89

Azerbaijan

2,940

–

1.22

Armenia

Kazakhstan

–

1.19

30% 29%

–

0.81

–

39

–

0.89

10

–

–

0.85 1.09 –

–

–

–

0.80

2,060

28

c45

c37

61%

–18%

9

Average EXSR group

1,348

4,217

27

39

39

44%

–1%

11

0.88

–

Russia

4,460

4,460

25

44

b42

76%

–5%

17

0.93

–

Source, notes: Columns 1, 2 are from World Bank at http://devdata.worldbank.org/query. Gini index data in Columns 3 to 9 are derived from Transmonee 2007 database at http://www.unicef-icde.org/research. Observations marked with (a) relate to one or two years around the reported year. For observations marked by (b) earnings based are converted into an income based Gini index using concerned country weights for 1996 to 2005. Observations marked by (c) are from http://devdata.worldbank.org/query.

176

Economic Systems Analysis and Policies

manifested in the reduced incomes in real terms of manual workers, the pensioned and the unemployed and the alleviated incomes for the more educated and the self-employed small entrepreneurs and related workforce. Of course, the aggregation level of the Gini index does not reflect the income disparities arising from the formation of new riches at the highest top of the income ladder, but this too is much more pronounced in Russia than the other transition countries. In general, there are relatively more persons and groups benefiting from monopoly rent in a SIM than otherwise, and this shows up as well in a worsening income distribution when the SIM experiences transition. Within the country groups there is a tendency for countries that showed more than average increases in income concentration during 1989–95 to have less than average increases during 1995–2005, which suggests convergence tendencies. This is shown in Table 6.3 in the columns that calculate the percentage change in Gini index in the two periods. For example, Gini index for Russia experienced one of the highest rises in the early transition, 76 per cent, and was somewhat compensated by a fall in later years by 5 per cent. For all countries as a whole, the secondary income redistribution mechanisms organized by the state result in a more progressive income distribution. The ratio of Gini indices based on income to that based on earnings, last columns in Table 6.3, is averaged at .96 for BCEE, .88 for EXSR, and in-between at .93 for Russia. Even though the aggregate picture suggests progressiveness, there are individual countries where state actions clearly result in regressive redistributions. In the BCEE group, as the last two columns of Table 6.3 show, the ratio of Gini indices in Bulgaria, Poland, and Macedonia amounts to 1.19, 1.11, and 1.22, respectively; which is indicative of a regressive role of the state in the secondary income redistribution mechanisms. These three countries happen also to have within the BCEE group the highest concentrations of income, with Gini index at 34, 37, and 39, respectively. Redistribution mechanisms are most progressive in Slovenia, Hungary, and Czech Republic with the ratio of Gini indices at .81, .71 and .89; these are also the countries with lowest Gini index at 22, 28, and 26, respectively. In EXSR, Moldova is most regressive and Belarus is most progressive in income distribution policy and results. The sharp rise in income inequality during the first years of transition shows up in more transparent indicators such as poverty headcounts, unemployment rates, and unpaid pensioners. The magnitudes of these indicators, the needs they imply for income redistributive measure, and what has actually happened in terms of income transfers to these groups is dealt with in a later section, see Section 6.6. The relationship between economic growth and changing income inequalities is multi-sided. Empirical evidence for the transition economies as shown in Table 6.3 and Figure 6.2 shows Slovenia positioned in the upper left-hand quarter, this is where positive economic growth associates with a progressive reduction in income inequality, i.e. Gini index declining. Most of BCEE are in the upper right-hand quarter showing higher growth with increased income inequality, i.e. Gini index increasing. Russia and some EXSR are in the lower right-hand quarter showing retarded economic growth with increased income inequality.

State Intensive System: Economic Transitions 177

change in GDP percent

80

60

y = –2.2673x + 30.43 R2 = 0.1822

40

20

–5

5

10

15

20

25

–20

–40

–60

change in Gini points

Figure 6.2 Transition countries: Relationship between percentage change in GDP 1989–2005 (y-axis), and change in the Gini index 1989–2005 (x-axis)

A multi-sided causal relationship can be also sought from Figure 6.2. One is that in a country that is more inclined towards the state intensive economic system, like Russia, an economic transition would inevitably bring about a sharp increase in the Gini index, and this hinders factor mobility and economic growth. Simultaneously, lower economic growth due to distributional bias or other limiting factors would drain out trickle down effects and can result in greater income inequality. For most of the transition economies the heightened economic growth in later years must have had sufficient progressive trickle down effects to maintain the Gini index in 2005 at about the same level as that in 1995.

6.3 Overview of reforms and their phasing in transition countries The economic elements of system transformation, and the sequencing of the transitional reforms, were developed and recommended by the World Bank, WB, and the International Monetary Fund, IMF, respectively.6 WB and IMF proposed Table 6.4, which distinguishes between four areas of policy reforms: macroeconomic stabilization and control, the more microeconomic oriented price liberalization and market reforms, then private sector development and privatization of public enterprises, and finally and throughout the process, redefining the role of the state. These policy areas are then distributed over time in what is called the sequencing of transitional reforms. As can be seen from Table 6.5 that gives the sequencing, the transitional reforms phasing is not linear. Although groups of policy reforms are introduced after each other, there is overlapping that allows for complementarities. The particular consequence that takes place in any country

178 Economic Systems Analysis and Policies

Table 6.4 Economic elements of system transformation 1 Macroeconomic stabilization and control Governments and enterprises: Fiscal tightening, Tight credit policies, Addressing existing problems (money overhang, bank losses), Expenditure-switching measures for external balance 2 Price and market reform 2.1 Goods and services: Domestic price reform, International trade liberalization, Distribution systems (transport and marketing services), and Housing services 2.2 Labour: Liberalizing wages and labour market 2.3 Finance: Banking system reform, Other financial markets, Interest rate reform 3 Private sector development, privatization, and enterprise restructuring 3.1 Facilitating entry and exit of firms 3.2 Enterprise governance 3.3 Establishing private property rights 3.4 Clarifying and allocating property rights: i.e. agricultural land, industrial capital, housing stock, and commercial real estate 3.5 Sectoral and enterprise restructuring, including break-up of monopolies 4 Redefining the role of the state 4.1 Legal forms: Constitutional, property, contract, banking, competition, and so on, Reform of legal institutions, Regulatory framework for natural monopolies 4.2 Information systems (accounting & auditing) 4.3 Tools and Institutions for indirect economic management: Tax system and administration, Budgeting and expenditure control, Institutions of indirect monetary control 4.4 Social areas: Unemployment Insurance, Pension, Disability, Social services: health, education, and so on Source: Adapted from World Bank and IMF.

Table 6.5

Transition sequencing

Policy measures

Transition sequencing phases

Macro stabilization Currency reform Current account convertibility Independent central bank Small-scale privatization Price and market reform Large-scale privatization Autonomous banking system Other financial markets Fiscal reform Social safety net Institutional reforms Periods

intense continuing x x prepare execute x x continuing prepage execute prepare liberalize prepare apply as market develops create tax administration and budgetary procedures x institutionalization establish legal and regulatory institutions 1 2 3 4 5 6 7 8 9 10

Source: Adapted from World Bank and IMF.

State Intensive System: Economic Transitions 179

would depend on the state of the economy, the political situation in each country, and on the tolerance of the population at large who may lose from specific reforms versus the pressure exerted by the gainers. The early phase of transitions started with the two components of liberalization, following our terminology: deregulation of prices and quantity restrictions in the product markets, and the privatization of state-owned small enterprises. Any large-scale liberalization programme will temporarily lead to an output decline, inflationary pressure, and worsening of the internal (fiscal) and external (payments) imbalances. In due time, as a successful stabilization takes place, the economy recovers. Once the early phase of transition, which we shall call short transition, is successfully completed and the economy is reasonably stabilized, actions can be continued in other directions that take longer periods to accomplish with success. We call this phase long transition, see Table 6.6. The deregulation is extended here to the factor markets of labour and capital. After the necessary preparation the time is then ripe for a privatization of medium and large enterprises. In practice, some governments have hastened with large privatizations and executed them without serious preparation in the short transition. This was done under pressure of interest groups that have benefited from the chaotic situation. Legal and institutional reforms are supposed to commence in the short transition but to intensify in the

Table 6.6 Proposed discussion in terms of short and long transition phases SHORT TRANSITION in a couple of years Macroeconomic stabilization

real imbalances, unemployment, monetary balance, curb inflation fiscal balance, payments balance

Microeconomic liberalization

deregulation in the product market deregulation in the factor market (privatization of small enterprises)

LONG TRANSITION in about a decade 1 Conversion of state enterprises to competitive enterprises

privatize large state enterprises, institute financial markets, Introduce labour legislation

2 Promotion of market confidence

reduce hidden economy, combat corruption practices introduce modern, financial, and legal institutions

3 Internalization of externalities

industrial restructuring directed towards conforming with comparative advantages in an integrated world economy

4 Public goods provision

– replacement of full state by mixed provisions – start social security

5 Income maintenance transfers

– safety networks – progressive taxation

180

Economic Systems Analysis and Policies

long transition, noting that legislation is only a starting step. Setting up of the apparatus and skills to implement the law is a matter of training and learning by doing that requires more time to acquire. We reorder in this section the elements of transition reforms and their sequencing, and we find sense in grouping them under short transition and long transition reforms, that we discuss in more detail in the next section. In the real world, the short transition has taken from two to three years and for some countries a few years more, depending on how successful are the particular countries. The experience with the long transition is now about midway for some transition economies and is about just starting for many others. The long transition can take a decade or more. To facilitate the exposition in the next two sections we display the elements of the short and long transitions in Table 6.6. It is noted that the short transition focuses more on macro stabilization measures pertaining to the balance of revenue and expenditures in the state budget and to the balance of foreign payments as a result of related price liberalization in these two balances. The long transition gives due attention to the changing behaviour of agents at the micro level.

6.4

Short transition

6.4.1 Stabilization reforms Any large-scale liberalization programme is bound in its first months to destabilize the economy in the form of a steeply rising inflation and displaced businesses. Hence, liberalization programmes have to be coupled to stabilization programmes. Transition economies passed through a stage that is fully uncontrolled, and a stage to gain control. The uncontrolled stage started with freeing prices. Once freed, prices soared to unexpected levels. In the first year of the transition repressed inflation and hoarded savings contributed to an excess of money over the value of goods demanded and available. The monetary overhang drove prices up. The fiscal budget balance deteriorated due to falls in revenue and insufficient cuts in expenditures. At the same time the foreign payments balance was destabilized by huge currency devaluations. Among the highest is that for the Russian ruble which fell to one-tenth of its pre-transition level, pushed by political unrest and capital flight. Severe payments problems for interstate trade followed. The Russian central bank reacted by issuing extensive credits to former soviet republics for the purchase of Russian goods, which were in shortage anyhow. The first year was practically a lost year in terms of stabilization, and particularly for Russia. In the next phase firms needed finance and workers demanded more wages in the face of rising prices. Most of the BCEE transition economies did not give in to the demand for issuing more money, and kept wages within temporary control. They held tight credit and sharp cuts in subsidies. The maximum annual inflation was restrained to 610 per cent in BCEE, and if outliers such as Baltic, Croatia, and Macedonia are left out, the figure is reduced to 126 per cent. These maximum inflation rates can be compared with much higher maximum rates in EXSR, 2430 per cent, and in Russia 1490 per cent, as shown in Table 6.7.

State Intensive System: Economic Transitions 181 Table 6.7 Stabilization programmes and inflation performance in transition countries Country

Czech Rep. Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Albania Bulgaria Croatia Macedonia Romania BCEE group Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyzstan Moldova Tajikistan Turkmenistan Ukraine Uzbekistan EXSR group Russia

Stabilization Year of Maximum Inflation programme highest annual in date inflation inflation, 1995, % % Jan 1991 Jun 1992 Mar 1990 Jun 1992 Jun 1992 Jan 1990 Jan 1991 Feb 1992 Aug 1992 Nov 1994 Oct 1993 Jan 1994 Oct 1993 – Dec 1994 Jan 1995 Nov 1994 Sep 1994 Jan 1994 May 1993 Sep 1993 Feb 1995 Not started Nov 1994 Nov 1994 – Apr 1995

1991 1992 1991 1992 1992 1991 1993 1991 1992 1997 1993 1992 1993 – 1994 1994 1994 1993 1992 1992 1992 1993 1992 1993 1994 – 1992

36 874 36 933 942 55 29 247 250 949 1467 1272 227 – 4107 1385 1945 7486 1472 830 945 1207 2773 3335 1239 – 1490

Inflation in 2005, %

GDP change GDP change billion billion US$, US$, 1988–95 1998–2005

17 31 27 28 46 41 10 25 10 63 5 17 35 25 161 546 662 163 161 42 39 346 195 416 371 323

1 6 3 9 6 3 3 4 4 4 3 3 12 45 3 10 17 8 18 7 7 9 – 20 16 11

–4.3 –2.0 –6.1 –4.8 –7.2 4.4 –3.0 –1.9 –0.4 –3.9 –6.6 –2.6 –10.0 –48.3 –0.5 –6.4 –5.5 –6.9 –10.9 –0.9 –2.1 –1.8 – –39.4 –2.0 –76.4

10.9 1.7 13.2 0.9 0.0 71.3 5.8 5.4 1.6 –1.0 1.0 –1.9 –0.6 108.2 1.4 –0.2 3.4 –4.9 2.8 –0.3 –1.7 –1.2 – –28.8 4.5 –25.0

144

20

–165.3

–55.1

Source, notes: Columns 1, 2, 3 are from International Monetary Fund, International Financial Statistics, World Economic Outlook, IMF staff estimates, as reported in Fischer and Sahay (2000). Columns 5, 6, 7, 8 are from World Bank at http://devdata.worldbank.org/query. Pre-programme inflation is inflation in the 12 months previous to the month of the stabilization programme. Columns 4 and 5 are GDP inflation deflators. Columns 6 and 7 give GDP change in billion US$ expressed in constant prices of 2000.

For most countries in the BCEE group the fiscal deficit went down to around 6 per cent. Currencies of successful reforming countries recovered in foreign exchange value due to remarkable export growth and trade surpluses. The EXSR group and Russia went the opposite way and were generous in the money supply growth and net domestic credit, which grew by 150-fold in 1992–94. The growth of this credit to dubious enterprises and clients at negative real interest rates in Russia has been interpreted in terms of rent seeking and corruption practices between a too closely linked government to enterprises. The result is an inflation reaching the above-quoted average maximum of 2430 per cent a year, a fiscal deficit of around 12 per cent, and a series of foreign exchange crises, the last of which in 1999. Russia had also difficulties in denying credit in lieu of pervasive arrears. Collection of tax arrears is still a problem. It

182

Economic Systems Analysis and Policies

2000

1500

1000

500

0 billions US$ –500 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 BCEE inflation rate

EXSR inflation rate

RUSSIA inflation rate

BCEE accumulated GDP change

EXSR accumulated GDP change

RUSSIA accumulated GDP change

Figure 6.3 Transition countries: Average annual inflation rates and the loss and gain in real GDP Source, note: World Bank at http://devdata.worldbank.org/query. Inflation rates are GDP deflators. The accumulated GDP changes, plotted along the x-axis, are in billions of US $ in constant prices of 2000.

took Russia and associated countries more years than first two groups of transition economies to reduce inflation and stabilize the economy. Figure 6.3 displays the inflation profiles in the three groups of transition countries over the period of 1988 –2005, and their association with the accumulated GDP changes. These are losses or gains obtained by deducting GDP in year t from t-1, and adding the change to the previous changes. The accumulated GDP change in year t is equal to deducting GDP in year t from GDP in 1988. Values are in billions of US$ in constant prices of 2000.7 Figure 6.3 shows countries with least inflation to have secured least losses and highest gain in the GDP. Even though the inflationary trend in Russia was lower than in the EXSR, the realized losses in the GDP were higher in Russia than in EXSR. In general, indicators of the stabilization effort such as the growth of money supply and credit, fiscal, and payments balance for the transition economies are not readily comparable. Fortunately, the result of the stabilization policies is readily observed from inflation statistics, which are utilized in Table 6.7 and Figure 6.3. The inflation statistics show the inflation rates in all transition countries to have been significantly reduced in later years. Most of the country figures for 2005 are comparable to those found in many developing countries. 6.4.2 Liberalization reforms Economic theory of competitive markets ascertains that the efficiency prices – that is, the right prices – are those formed by the free play of demand and supply forces. Once the right prices come into being scarce resources would move to

State Intensive System: Economic Transitions 183

activities with highest returns. Price reform is thus a crucial step in transitions. Hence, governments started with price liberalization of domestically traded and internationally traded goods in the product markets. The liberalization in the factor market followed later. The liberalization of domestic trade in the product market meant dropping subsidies for necessity goods such as staple food, rent etc., and abolishing price regulations for some other categories of goods. The price liberalization can lead to substantial price hikes, as the supply is inelastic in the short run. Besides, monopolists can exploit the deregulated situation. Hence, price liberalization had to be accompanied by strengthening competitive forces and the stimulation of a greater entry and exit of suppliers. Some countries went for a radical liberalization such as Poland in 1990 when they freed about 90 per cent of all prices simultaneously. At the same time Poland experienced an enormous growth of new businesses that were attracted by the newly emerging price structure, as evident from the fact that over half a million privately owned small firms have registered in 1990. Most other countries followed a more gradual approach that took four or five years to reach comparable degrees of deregulation and state trading monopolies. The liberalization of foreign trade started with the partial elimination of export controls and taxes, substitution of moderate import duties for import quota and high tariffs, and foreign exchange convertibility for current account transactions. Liberalization of foreign trade contributed not only to greater supplies of goods but also to mobilizing competition. The opening of the economy to foreign trade allowed the institutionalization of international prices and benefits of international competition, so that the authorities get more time to pass domestic laws to combat monopoly and prepare the machinery to execute them. The liberalization of foreign trade requires the right foreign exchange price for the national currency. One option is a floating exchange rate. Another option is the fixing of the exchange rate within a range, this is more desirable in view of its predictability, but its enforcement depends on the available foreign exchange reserves. The transition countries differed in their response towards choosing the terms for currency convertibility depending on their available currency reserves, among others. Turning to liberalization reforms in the factor market, it is easier to privatize small firms than large firms. Small firms have intermediate technologies, have simple management structures, and are concentrated in agriculture, food retail, and in processing and trade of other light consumer goods and services. Their privatization and active mobilization in the new competitive setting would enhance production and relieve consumer shortages during the short transition. Complex problems of valuation, transfer, and governance arise in privatizing large and infrastructural firms; these take time, which is why most countries reserved their privatization for the long trajectory. Widespread privatization of small firms was first achieved in Czech Republic, Hungary, and Poland, and was followed at high speed by the three Baltic countries and Russia. The transition economies followed different paths in the privatization of small enterprises. The Czech Republic used open competitive auctions that were locally administered. Hungary had already a large number of prospering small enterprises under leasehold arrangements with local and central authorities;

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this trend was continued for newly privatized enterprises together with sales to outside owners. Poland gave large concessions to employees who were allowed to take ownership over small enterprises. At the other extreme is Russia that transferred ownership of small firms in informal ways to firm insiders, consisting of a mixture of the unit manager, workers, officials, and intermediaries. For measuring the extent of liberalization in the short transition the World Bank developed an Index of Liberalization (WBIL) on the basis of various indicators of undertaken policy measures.8 Results are shown in Table 6.8. The highest scores are found among the newly acceding BCEE countries to the European Union with values ranging from 8.1 to 9.3 for 1995. The other BCEE countries score less, giving an average for BCEE of 8.2 for 1995. EXSR have an average score of 5.3, and Russia is in-between at 6.9. An annually updated and a more widely held comparative indicator of the extent of liberalization is the Heritage Index of Economic Freedom (HIEF) published by the Heritage Foundation. Table 6.8 shows the score of the transition countries on this index in 1995, 2000, and 2005.9 Figure 6.4 displays the differences between the three blocks of countries following alternative measures of the liberalized economy. At an aggregate level the two alternative measures show equivalent results: BCEE is most liberal followed by Russia and then EXSR; though in 2005 the Index of Economic Freedom shows

Table 6.8

Extent and pace of liberalization in transition countries Word Heritage Index of Bank Economic Freedom(HIEF) Index of liberaliza1995 2000 2005 tion (WBIL) 1989–95

Word Heritage Index of Bank Economic Freedom (HIEF) Index of liberal1995 2000 2005 ization (WBIL) 1989–95

Czech Rep.

9.3

71.8

71.6

66.6

Armenia

5.8

38.9

62.4

67.7

Estonia

9.3

65.2

74.2

76.6

Azerbaijan

4.3

–

47.1

52.5

Hungary

9.0

58.2

66.4

63.4

Belarus

4.8

41.2

37.8

45.3

Latvia

8.1

a54.6

63.0

63.0

Georgia

5.8

–

51.1

55.6

Lithuania

8.6

–

63.3

69.5

Kazakhstan

5.7

–

47.5

51.1

Poland

8.9

52.3

63.0

59.0

Kyrgyzstan

8.2

–

53.2

54.7 55.1

Slovakia

8.6

58.9

52.7

64.7

Moldova

6.8

33.0

58.1

Slovenia

8.5

a46.3

56.2

60.9

Tajikistan

3.9

–

42.9

49.9

Albania

7.4

54.3

51.0

56.6

Turkmenistan

2.3

–

36.8

43.7

Bulgaria

6.1

47.8

50.4

59.9

Ukraine

5.8

33.7

47.4

53.7

Croatia

8.5

–

52.7

52.5

Uzbekistan

5.3

–

35.5

44.2

Macedonia

7.3

–

–

55.6

EXSR group

5.3

36.7

47.3

52.1

Romania

7.1

42.9

55.3

50.8

–

–

–

–

BCEE group

8.2

55.2

60.0

61.5

6.9

49.7

50.1

50.1

Russia

Source, note: Column 1 is from World Bank (1997). Columns 2, 3, 4 are from the Index of Economic Freedom, published yearly by The Heritage Foundation. (a) = 1996

State Intensive System: Economic Transitions 185

90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 HIEF1995

WBIL1995

BCEE

HIEF2000

EXSR

HIEF2005

Russia

Figure 6.4 Transition countries: Extent of liberalizations as measured alternatively by World Bank Index of Liberalization (WBIL) and Heritage Index of Economic Freedom (HIEF)

Ratio of accumulated GDP 1989–2005 to GDP 1988

25

20

15

10

5 y = 0.0986x + 6.8499 R2 = 0.2426 0 0

10

20

30

40

50

60

70

80

90

100

WB index of liberalization measures 1989–1995 as of 1995

Figure 6.5

Transition countries: Liberalization and cumulative GDP

a reversal in the relative free market orientation of Russia and EXSR, with the Russian economy becoming less liberal than the EXSR. It was mentioned earlier that the empirical evidence on the explanation of different economic growth performances among transition countries pointed not only to differences in past and initial conditions that favoured the BCEE more than EXSR and Russia, but also to pursued policies with regard to income distribution, inflation control, and liberalization reforms.10 The empirical evidence

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Economic Systems Analysis and Policies

suggests that countries that introduced faster liberalization have recovered their lost output at a greater pace. Figure 6.5 displays the relationship between the World Bank liberalization index for 1975 against the ratio of the cumulative GDP over 1989 to 2005 to the initial GDP of 1988.11 Although many countries that lie across and in the neighbourhood of the regressed line in Figure 6.5, there are outliers: countries which did not liberalize as much but nevertheless showed high economic growth, as well as a couple of countries experiencing the opposite. When the Index of Economic Freedom is plotted against the ratio of cumulative GDP the result is a much weaker correlation, and statistically less significant, suggesting that the more specific World Bank index of liberalization measures it is better equipped in representing the extent and pace of liberalization in transition countries than the more general Index of Economic Freedom.

6.5

Long transition

Application of welfare economics to firm intensive economic systems distinguished five areas of market failures, or rather economic failures. It was noted in the chapters on FIM that there are technical and behavioural obstacles that result in the five types of economic failures. The areas were described as indivisibility, uncertainty, externality, collectivity, and distribution. The remedies to correct for these failures included five areas of actions by firms and government. They are respectively: promoting firm competition, institutionalizing good governance and reducing uncertainty, internalizing externalities, provision of public goods, and transfers to assure basic income maintenance. Although transition economies face the same five types of economic failures, and similar remedies suggest themselves, the situation is usually more complex in the SIM context than the FIM context. First, economic failures are more interlocked, concentrated, and severe during the transition period. Second, the inherited political behavioural patterns of the state regime reappear again during the transition, as has become evident in some of the transition countries, especially Russia. This comeback of a SIM-like regime prolongs behavioural traits characteristic of rent appropriation and political gains and brings into doubt the inevitability of an economically successful long transition. Consequently, questions arise about the ability and speed of particular countries to convert from SIM to FIM systems within reasonable times. In this section the responses of state agents and private agents to the five areas of economic failures in the long transition will be in transition economies. The responses point to a drifting away from the state-like dominant setting, or a likely moderation, in some transition countries;12 and to a possible rehabilitation of the state-like dominant setting in some other transition countries.13 6.5.1 Competitive entrepreneurships 6.5.1.1

General

Because of technological indivisibilities, and also because of other economic and non-economic reasons, all countries had at one stage some public enterprises that

State Intensive System: Economic Transitions 187

were state-owned. Under changing technological and other conditions these public enterprises were converted into privatized companies in the FIM countries. The situation is different in the SIM countries. One of the crucial principles for the functioning of the economic system in SIM countries is the state ownership of enterprises and of factors of production, and this is based on a declared and authorized political ideology. State ownership of enterprises in SIM countries is not based on an economic argument of technological indivisibilities but is based on a communist viewpoint of the optimal order. The fall of the communist regime implied that the primary and foremost basic changes that the transition countries have to introduce are (a) private ownership and the privatization of state enterprises, and (b) viable factor markets in which the private ownership in the privatized enterprises can be traded. These two elements are major constituents of the long transition. They will be treated in this section. 6.5.1.2 Privatization of state enterprises It was stated earlier that privatization of small sized public undertakings in agriculture, distribution, and services started immediately after the fall of the centrally planned regimes, and that the transition countries followed different forms of privatization of these small undertakings. More important is the massive conversion of medium and large state enterprises into private enterprises that started shortly after. This massive privatization was launched in Russia in July 1992, the European transition economies started at a year earlier, while the Asian transition economies a year or two later. There are four general features of this massive privatization: (a) the methods and modes of privatization followed were bent to institute insider rather than outsider governance of the newly privatized firms in most transition countries, but a few did otherwise, (b) the privatization was rapidly and chaotically implemented without the presence of required legal and institutional setups to guard against personal misuses by state agents and influential associates, leading to illegal captures and looting during and after privatization in many transition countries, (c) the contribution of the mass privatization towards a viable restructuring of the economy and freely competing private firms has not been realized in some of the concerned countries, due to additional limitations inherited from the past SIM, and (d) where there is a disappointment with privatization, such as in Russia; there is the reverse tendency for a re-concentration of top business decisions in major areas of economic activity in the hands of the state, and a virtual return to a state-like dominated economy. Before dealing with the experiences of individual transition countries in this massive privatization, some introductory remarks will be made on options regarding enterprise governance, privatization method, and privatization strategies. The first feature of the privatization of state enterprises in the transition countries is its inclination to insider governance rather than outsider governance, which has important consequences for the performance of privatization. There are basic differences in enterprise governance between state enterprises and private enterprises. The case of state enterprises is one in which the owners, i.e. the principle or the people, delegate their rights to such agents as politicians

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and bureaucrats who in turn install enterprise managers to lead the state enterprises, who are then monitored by bureaucrats. Since the interests of politicians, bureaucrats, and state enterprise managers overlap, and since there is no control on all three by the ultimate owners, the people, decision-making in state enterprises and governance become non-transparent and highly politicized. Governance in privately owned small firms is straightforward; owners are usually the managers. In corporations, the owner shareholders and company management are different, and the need for monitoring by the first of the second raises complex issues of governance designs. A more or less complete separation between shareholders and management and a tight monitoring by the first of the second is generally known as outsider governance. Where corporate management and major shareholders overlap and there is a little monitoring possibility of corporate management by minor shareholders, this is a case of insider governance. Entry and exit of firms, and therefore a more competitive market and competing firms, are generally more present when enterprise governance is of the outsider type rather than the insider type.14 When governments privatize policy, choices are made as regards the method of privatization. There is an association between the method of privatization followed and the enterprise governance that ensues after privatization. When government sells shares of the privatized company to the general public at the stock exchange, or organizes a competitive sale among contending buying companies, or a takeover in an investment fund, domestically or foreign, the resulting enterprise governance tends to be an outsider governance. When the method of privatization takes the form of management–employee buyouts, the resulting enterprise governance is an insider governance. This applies also in case of a partial privatization when the state owns a major share and mobilizes a selected financial group to own remaining shares. The privatization of state enterprises that occurred in the recent past in Western Europe were of the outsider type, privatization in the transition economies of Eastern Europe followed a mixture of outsider and insider governance with more emphasis on the latter. As Table 6.9 shows, Hungary and Estonia transferred about 40 per cent of state ownership to outside owners, which makes these two countries more inclined to outside governance than the other transition countries. The Czech Republic distributed equal-access vouchers to citizens, which is also primarily an outsider governance oriented policy. The new owners were encouraged to place their vouchers in competing investment funds that monitored the privatized companies. To the extent that the investment funds tend to collide, there is a reverse to insider governance. Poland emphasized ownership by municipalities and semi-public bodies and maintained strong links between management and state, and thus promoting insider governance. The Russian government’s choice for the insider owned policy is rationalized on the grounds that the transition economies have no stock markets to float initial public offers, the public lacks purchasing power, there are no high performing domestic companies to take over the ailing state enterprises, and selling to foreign companies is felt to be against the national interest and would raise unsolvable negotiations on asset valuation.

State Intensive System: Economic Transitions 189 Table 6.9 Privatization methods for medium and large state enterprises in six transition economies, by number and by value, per cent Country

Sale to outside owners

Equalaccess vouchers

Management– employee buyout

Restitution

Other(a)

Still in state hand

By number Czech Rep.

32

22

0

9

28

Estonia

64

0

30

0

2

10 4

Hungary

38

0

7

0

33

22

Lithuania

25

<1

70

5

0

0

Poland

3

6

14

0

23

54

Russia

0

11

55

0

0

34

–

–

3

40

By value Czech Rep.

– 5

–

–

50

0

2

–

Estonia

60

3

12

10

0

15

Hungary

40

0

2

4

12

42

Lithuania

<1

60

5

0

0

35

Source, notes: Adapted from World Bank (1997), p. 53. All data refer to medium-size and large firms and are as of the end of 1995. All figures are percentages of total based on capitalization values of privatized firms as a share of the value of all formerly stateowned firms, except for Russia and Poland where the base is the number of firms. (a) Other includes transfers to municipalities or social insurance organizations, debt-equity swaps, and sales through insolvency proceedings.

Faced with strong economic and political pressures, domestically and internationally, to take action, Russia implemented a sort of management–employment buyouts of state firms. These firms were anyway effectively controlled by their managers and responsible ministerial authorities. The state retained in most cases a share of about 20 per cent. Most economists hold the view that enterprise governance and performance after privatization are more successful if privatization is done through outsider instead of insider ownership, Aghion and Blanchard (1996). But a great deal regarding governance depends also on what happens to financial restructuring in the years after privatization. Earle and Estrin (1996) reported that the Czech Republic, after five years of privatization, was the only transition economy with a majority of firms characterized by outside ownership. At the other extreme is Russia where recent evidence from Filatotchev et al. (1997) shows insider ownership to continue dominating about two-thirds of ownerships, with a slight shift from employees to management, the share of employees being reduced from 47 to 46 per cent and that of management increasing from 19 to 20 per cent. The share of the state has fallen down from 23 to 14 per cent, and this was to the advantage of private individuals, industrial groups, and institutional external investors that increased from 11 to 20 per cent. The position of insiders was strengthened furthermore by the 1998 financial crisis, as their potential challengers – domestic and foreign outside investors – lost the ability or appetite to invest in Russian firms. Enterprises characterized by insider governance usually show the following weaknesses. They have little, if any, resources for investment other than the cash-flow

190

Economic Systems Analysis and Policies

generated. They tend to see their position more in terms of power than as economic agents, consider the company’s manager as the primary beneficiary, and undertake more defensive rather than aggressive restructuring. Insider ownership was good for preserving jobs but there are disadvantages for growth and fairness. Moving towards outside governance, and making managers accountable to shareholders, requires a corresponding advancement and openness in the financial markets and the stock exchange. The second feature of the massive privatization is its rapid implementation without the presence of required legal and institutional set-ups to guard against misuses; a situation that led to illegal captures in many transition countries. Table 6.10 gives an indication of the rapid pace of the privatization in the short transition in terms of the relative share of the value added of the private sector in the GDP. In Russia and the BCEE group the private share jumped from about 5 and 14 per cent in transition year 1990 to about 60 and 63 per cent in 1996 ; an advance of 50 percentage points in six years. In the EXSR group the privatization was almost half as much rapid, from 9 per cent to 36 per cent, or only 27 percentage points in the six years. They started later with the transition. Looking at the outcome in 2006, the BCEE group is the most privatized with a private sector share of 74 per cent, Russia is in the middle with a private share of 60 per cent, and the EXSR lags behind with a private share of 56 per cent. The transformation of the public sector into the private sector was very rapid in the short transition Table 6.10 Extent of privatization in transition countries as indicated by private sector share in GDP Country

Czech Rep. Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Albania Bulgaria Croatia Macedonia Romania BCEE group

Share of private sector value added in GDP, per cent 1990 10.0 10.0 25.0 10.0 10.0 30.0 10.0 15.0 5.0 10.0 15.0 15.0 15.0 13.8

1996 75.0 70.0 70.0 60.0 70.0 60.0 70.0 55.0 75.0 55.0 50.0 50.0 55.0 62.7

2006 80.0 80.0 80.0 70.0 75.0 75.0 80.0 65.0 75.0 75.0 65.0 65.0 70.0 73.5

Country

Armenia Azerbaijan Belarus Georgia Kazakhstan Kyrgyzstan Moldova Tajikistan Turkmenistan Ukraine Uzbekistan EXSR group – Russia

Share of private sector value added in GDP, per cent 1990 10.0 10.0 5.0 15.0 5.0 5.0 10.0 10.0 10.0 10.0 10.0 9.1 – 5.0

Source, note: EBRD at http://www.ebrd.com/country/sector/econo/stats/sci.xls. Short transition = 1990–96, long transition = 2006 and beyond.

1996 50.0 25.0 15.0 50.0 40.0 40.0 40.0 30.0 20.0 50.0 40.0 36.4 – 60.0

2006 75.0 60.0 25.0 70.0 65.0 65.0 65.0 55.0 25.0 65.0 45.0 55.9 – 65.0

State Intensive System: Economic Transitions 191

but slowed thereafter in the long transition. The pace and extent of the privatization in the period 1990–96 are even more remarkable when enterprise counts instead of value added is considered. Massive privatization was launched in Russia in July 1992. Within two to three years Russia and many BCEE transition economies were able to privatize about 60 per cent of their state enterprises. In an institutional vacuum none of the players in a privatized firm – workers, managers, creditors, investment fund shareholders, civil servants managing the state’s residual share – is interested in or capable of maintaining the long-run health of the assets. Mass privatization in Russia led to massive self-dealing by managers and controlling shareholders. The devolution of authority to managers enabled them to hijack the privatization programme and loot the companies over which they acquired control. Russia accelerated the self-dealing process by selling control of its largest enterprises cheaply to politically well-connected but doubtful businessmen, who used their wealth to further corrupt the government and block reforms that might constrain their actions. Various accounts of malpractices in the privatization process are documented in Black, Kraakman, and Tarassova (2000). Why the choice for a rapid and an unprepared privatization? The question is answered differently from different interests and viewpoints, and it is very likely that what happened is a combination of these answers. One answer lies in the pressure put by international financial institutions, which required governments of transition countries to privatize rapidly and extensively before competitive policies and institutional safeguards were put in place. They knew more of privatization drives than institutional setups. US and EU politics advocated also a quick shift of power from the state to the private sector assuring thereby an irreversible regime change. This view was also internally supported in Russia by those who saw private ownership of the means of production as the mechanism for the de-political transformation of the economic system, cf. Boycko, Schleifer, and Vishny (1995). An interest motivated answer to the question lies in the ill intentions of clever state agents, allied managers, and associate financiers who saw a golden opportunity to become the new private owners and gain most in a rapid and unprepared privatization process in which they were the most informed and in which they had a monopoly of decision-making. This behaviour is based on rent seeking, which is well established in a state intensive economic system as the Soviet Union and is not new to state agents in the Russian context. Among economists, advocates of rapid privatization argue that granting individuals the swift control of property would create a political constituency for the rule of law, which will protect the acquired private property rights. The new private owners will begin lobbying parliament and government to create marketsupporting institutions. Such institutions will follow private property rather than the other way round. The reasoning relies on a political Coase theorem that once property control is turned over to private agents, they will ensure political reforms that create the rule of law, Schleifer and Vishny (1998). This did not occur, however. The reason for this is the weakness of the political demand for the rule of law. So long asset stripping is feasible the new private owner’s demand for the rule of law remains low. Furthermore, uncertainty about the legal regime can lead to

192

Economic Systems Analysis and Policies

more asset stripping, and asset stripping can give agents an interest in prolonging the absence of the rule of law, Hoff and Stiglitz (2002). This response of agents is fully consistent with a strategically motivated rent appropriating behaviour that is learned and practised in state intensive economic systems. The third feature is the mixed performance of privatization in the transition countries. In the Baltic, Central, and some Eastern European countries, BCEE group, privatization is generally regarded to have succeeded in restructuring the economy, improving firm performance and promoting firm competition. However, evidence from the EXSR group and Russia shows that private ownership has not lead to enterprise restructuring (changes positioning the firm to survive and thrive in competitive markets), and that clear performance improvements are evident only in few firms with an outside governance, mostly sold to foreign investors, cf. Broadman (1999). What are the causes behind the relative underperformance of privatization in Russia and the EXSR group? We mentioned already that an insider governance of the privatized firms reduced performance, and that the ways privatization was carried out under an absence of a legal framework, and the continued uncertainties regarding rule of law, led to looting and the undermining of the privatization programmes. To these, a group of negative factors outside privatization can be added that undermine free and competitive entrepreneurship and limit entry. These are seller/buyer concentration in select sectors, high degrees of vertical integration and geographic segmentation, which are all inherited from the past regime. Profit incentives to restructure privatized businesses and to create new ones tend to be swamped by the burden on business imposed by a combination of a punitive tax system, barter transactions, official corruption, organized crime, and an unfriendly bureaucracy.15 These elements were more spread in Russia than the other transition economies. Besides, a concentration of power in Russia in financial–industrial groups aggravated the noncompetitive conditions under which the privatization took place. The fourth feature is that in some transition countries, especially Russia, there is a revisionist mode regarding liberalization and privatization, and a turnaround of economic power to the state. Disappointment with the results of privatization tends to work against further privatization and free market enterprises. Self-dealing politically discredits privatization as a reform strategy and undermines the social support for the reforms. While these disappointments can give a partial explanation for the revisionist mode, it is also plausible that the governing class and state agents have now recovered the politico-economic power they lost during the transition, and they are determined to keep it so. The re-emergence of a dominance of political motivations and a subordination of the economy to the polity was singled as typical of the SIM. Revisionist options debated in Russia range from a re-nationalization or realignment of disputable privatized firms, to a halt to privatization of the remaining portfolio, imposing discipline and competition on the remaining public enterprises, and applying a gradual shift to private ownership. Actions along the first option are apparent in the dissolution of Yukos and the amalgamation of its oil fields and operations in Rosneft, which is partially owned and virtually run by the state; in the backing down from exploration rights for Shell, centralized coordination of pricing

State Intensive System: Economic Transitions 193

and trade decisions in oil and gas, and a greater role of state agents in the structuring of ownership and corporatism in major sectors of production. Actions along the second option assume the existence of, or the willingness of the state to create, an effective legal and institutional framework. However, the second option can be at odds with the first option; this is a contradiction that was stated as characterizing the sub-functioning of the state intensive economic system; and this contradiction was reappearing again in Russia since around 2005. 6.5.1.3 Viable factor markets In the long transition major tasks for government policy go beyond the privatization of state enterprises and establishing the rule of law, and extend to include the liberalization and deregulation of the factor markets. This requires setting up and maintenance of competitive institutions regarding financial and labour markets. Compared to privatization of state enterprises, the liberalization of the capital market, finance, banking, and trading in modern stock exchanges16 can be even a more complex phenomenon that requires long years for building the required technical capacity, learning by doing, and abiding by accepted codes of behaviour and tradition. Finally, once the long transition is entered liberalization of the labour market can take place. The main steps concern the organization of trade unions and industrial associations, and the institution of collective bargaining rules. Introduction and implementation of these reforms is at a more advanced level in countries of the BCEE group than the ESAR group or Russia; given obligations undertaken by relevant countries in the BCEE group, and the EU support provided, to restructure their economies in the context of their accession to the EU. Box 6.1 Privatization rush in transition countries Recent history shows that it takes many years to establish a widely accepted institutional framework that enforces fundamental rules and safeguards, and maintains the right pace of privatization for US and transition economies. Successful conversion of state to private firms requires more legal institutions and more time than was done in the transition countries. The box gives the share of GDP derived from private sources. Figures show privatizations amounting to about 10 to 15 per cent of the GDP occurring in a duration of one year, compared to the US with an average of 1 per cent of the GDP per decade. Country

1980

1988

1994

1997

Czech Rep. Hungary Poland Romania Russia Slovakia United States

<1.0 3.5 15.6a 4.5 <1.0 <1.0 79.4

<1.0 7.1 18.8a – <1.0 <1.0 79.6

65 55 55 35 50 55 81.1

75 75 65 60 70 75 82.0

Source, note: European Bank for Reconstruction and Development, Reports of Bureau of Economic Analysis Various years. (a) = Almost exclusively agricultural production (Slay 1993).

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Economic Systems Analysis and Policies

Box 6.2 Undervaluation of assets in transition countries: The case of Russian companies Major Russian companies were acquired by Russian tycoons, oligarchs, and financial– industrial groups at a fraction of their international market value, indicating a hidden theft of these companies on a massive scale. The fourth column gives the national market capitalization prices (NMCP) of major companies for trade transactions in September 1999, converted in US$. These NMCP formed the basis for acquiring the assets in the case of an acquisition. The third column gives the imputed international market value (IIMV) of the companies, if run to maximize profit, taxed on that profit at a 33 per cent marginal rate, and permitted to sell their products at world prices. For example, IIMV for oil companies is based on $13 per barrel of oil reserves; and for steel companies at $148 per ton of capacity; etc. For all companies taken altogether, trades took place at an extremely undervalued price that did not go beyond 0.8 per cent of the real values. The oil and gas companies were extremely undervalued, with Yukos at 0.02 per cent and Gasprom at 0.21 per cent of their IIMV.

Company

Industry

Gazprom Luk Oil Yukos United Energy Systems Surgutneftegaz Tatneft Sberbank Tyumen Oil Mosenergo Irkutskenergo Norilski Nickel Rostelecom Bratsk Aluminium Krasnoyarsk Aeroflot Magnitogorsk Seversal Total (Per cent)

Natural gas Oil Oil Electricity Oil Oil Bank Oil Electricity Electricity Nickel Telephone Aluminium Aluminium Airline Steel Steel

Imputed international market value (IIMV), $ billions 1960 195 170 110 91 75 60 47 12 10 9 5 2.3 2.2 2 1.8 1.7 2754 (100.00%)

National market capitalization price (NMCP), $ billions 4 5.5 0.3 3.1 4.4 0.4 0.4 Not traded 0.8 0.4 0.5 0.9 0.03 0.08 0.09 0.04 0.08 20.8 (0.76%)

Source: Stanford Law Review Vol. 52, 1731.

6.5.2 Market confidence 6.5.2.1 General In the context of firm intensive economic systems, Chapter 3, we saw that uncertainty reduces efficiency. We focused on incomplete and on unequally distributed information as manifests of uncertainty. We mentioned technical limitations and

State Intensive System: Economic Transitions 195

behavioural distortions motivated by personal gains as the causes behind these information problems. Uncertainty shows itself in other respects than imperfect information – whether incomplete or asymmetric. Agent A can be uncertain as to how agent B decides on a problem of common interest. Similarly, B is uncertain as to the decision taken by A. In the firm intensive economic system the environment is usually competitive and all agents have equal options to move in or out of a transaction, so that the uncertainty is mutually balanced among all agents. In the state intensive economic system the uncertainty phenomenon is biased in favour of small pockets of handy and privileged agents and in the disfavour of the over majority of less handy and less privileged agents. In communist regimes the uncertainty phenomenon – and this applies more likely for behavioural than for technical uncertainty – tends to intensify and spread widely across the whole population, displaying a lack of trust among the agents at large. The dominant mode is inter-behavioural uncertainty in all circles, whether the behavioural setting is state offices, workplace, or a residence neighbourhood. This widespread behavioural uncertainty tempts handfuls of well-placed interacting agents to form a few closed pockets that benefit from coordinated certainties. The members of such ‘hidden clubs’, the insiders, succeed in coordinating their decisions, they expect and get intra-behavioural certainty from each other, and their solidarity and organizational ability allows them to extract a great share of the surplus that is generated in their transactions with large numbers of outsiders. The hidden clubs, while competing with each other, may also mutually exchange favours with each other, to their mutual advantage. In firm intensive settings there are market incentives not only to acquisition of information but also to the emission of signals and exchange of information among agents. In some instances, the buying and selling agents are pulled to each other in a collusive search for certainty, which often results in changes in governance structures. Competitive laws usually require that governance structures be transparent and socially efficient. Technically speaking, in SIM, more or less the same collusive processes occur between well-placed receiving and delivering agents, resulting in club-based gentlemen agreements. The crucial difference is that in SIM the closed clubs stand in the way of creating governance structures that are transparent and socially efficient for all. These collusions reinforce the skewed distribution of endowments and options among the population, which is typical of the SIM. Market failure due to differential certainties is often analysed in the framework of principal–agency theory, see Chapter 3.17 Adverse selection refers to markets where poor quality is likely to predominate, this due to asymmetry of information about product quality between traders and the tendency of traders to select for the cheaper price and lesser quality. In such circumstance the better-situated agents are tempted to create a separate high quality market. It can be plausible to interpret the formation of closed clubs in SIM settings in terms of the notion of adverse selection and rational response to it. To reduce the extent of adverse selection, the well-placed deliverers and recipients will have to deal with each other directly, establish closer links, and in time act as an exclusive club.

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Moral hazard refers to a situation where the agent hides information possessed and decisions taken from the principal, contrary to what was delegated, and that benefit the first at the cost of the second. Moral hazard is an instance of opportunistic behaviour. The notion of moral hazard applies readily to state intensive settings, and even more clearly than adverse selection. In general, governance structures that are non-transparent and that harm the principal for the benefit of the agent are more common in settings where state authorities and business interests collide. Adverse selection and moral hazard result in economically undesirable developments during economic transitions. Next to the prevalence of insider governance at the enterprise level, which we dealt with in the previous section; there is the prevalence of (a) corruption practices, and (b) the hidden economy, both of them undermining performance and trust. We shall deal here with each of these two developments, their perceived effects, the empirical evidence, and policies to mitigate them. 6.5.2.2 Corruption practices in transition countries To begin with, there are various types of practised corruption in transition countries. Some of this corruption has its origin in the past communist era, such as (a) administrative corruption, whereby the state agent enriches himself via bribes and kickbacks paid by the private agent or firm in the course of obtaining permissions, licences, waivers, etc. Other sorts of corruption have emerged in the context of the transition such as (b) capture corruption, whereby private agents and firms influence the formulation of laws, regulations, decrees, and government policy to their own advantage through illicit or non-transparent means, and (c) joint grabbing, whereby state and business close hidden rent seeking deals that benefit both at the cost of the remaining agents, or the community as a whole. There are also other forms of corruption and influence that will be examined. As will be shown, all types of corruption practices that emerge during transition are moulded by the rooted behavioural patterns of the past communist era as well. Although the height and mix of corruption practices differ among the individual transition countries, it will become apparent that the corruption practices are more spread and significant in Russia than the ESAR or the BCEE groups of transition countries. The first type of corruption is administrative corruption, which is activated and exploited by state agents. Corruption is conventionally defined as the abuse of public office for private gain. Behind this definition lies one type of corruption: an image of a predatory state seen as a large grabbing hand, extorting firms for the benefit of politicians and bureaucrats. This type of corruption is also known as administrative corruption and is associated with a strong role of the state in the economy. Administrative corruption is a frequent occurrence in SIM countries, and the practice is prolonged during transition. Although the state no longer uses plans and command to direct firms, direct relations inherited from the past between the state and firms continue to be close. These relations include state dictates in decisions of firms, obligations of firms to the state due to provision of state

State Intensive System: Economic Transitions 197

benefits to firms in the form of investment, subsidies and tax arrears, and bribery payments by firms to state officials. The transition process brought a change in the form of state intervention, but necessarily a reduction in the overall level of interaction with state settings. A significant part of firm time is being spent dealing with government official, next to hidden deals and bribe payments. Overregulation leads to administrative corruption and organizational failure. In Russia, an excess of rules imposes delays and non-responsiveness, as different public agencies must be consulted. Firms subject to high levels of administrative corruption score low in private benefits. These results are consistent with a ‘grabbing hand’ notion of state-induced predation, one where the discretionary power of politicians and bureaucrats in the application of regulations dominates their relationship with the enterprise sector – and thus is closer to extortion from the state apparatus (in contrast with the much less frequent (but vastly more damaging) state capture, where the firm does face a strategic choice to collude or not to collude with politicians or bureaucrats in purchasing the laws and policies of the state). The second type of corruption is state capture corruption, which is activated and exploited by business companies. The underlying assumption here is the subjugation of the legislative, executive, and judiciary branches of the state to business lobbies. Within the capture economy one finds the least secure property rights: state capture allows a few firms to create a zone of relative security, while increasing the overall level of insecurity for other firms. This fuels a vicious circle in which more firms have an incentive to resort to state capture to protect their rights and interests. This occurred when oligarchs were in absolute power, when Yeltsin was president. It has since then, with president Putin in power, shifted to the third type: a state-firm sharing of an appropriated rent. The third type of corruption is one in which there is a joint effort of state and firms, often hidden, to gain mutually from corruptive deals. Many firms engage in high-level corruption as a choice strategy and collude with state officials or politicians for the mutual benefit of both. There are other forms of corruption and influence. Some firms, by dint of their power and connections, have the capacity to influence the state (and benefit accordingly) without necessarily having to resort to overtly corrupt strategies. Indeed the privileged position of many older incumbent firms (such as many larger state enterprises where the directors may have colluded with politicians long ago to protect the position of such incumbents) do compel some new entrants to ‘purchase’ laws or regulations to enhance their competitiveness and property rights vis a vis such influentially protected incumbents. Indeed, it is found that there is a cadre of incumbent firms which are influential and do not have to engage in the purchase of laws, policies, or regulations. Furthermore, public procurement corruption, defined as efforts to secure public contracts through payment of kickbacks to officials, show firms engaged in these practices have greater gains than other firms. There are also more severe forms of corruption that involve crimes and mafia, Shelley (1999). For example, the most pernicious element of the crime phenomenon in Ukraine is the criminal–political nexus, the alliance among former Party

198 Economic Systems Analysis and Policies

elite, members of the law enforcement and security apparatuses, and gangs of organized criminals. Much crime in Ukraine combines government officials’ access to information or goods with the use or threat of force by organized criminals. The infiltration of Ukrainian legislatures by criminals became a serious problem. More than 20 members of the Parliament would be tried on criminal charges if they were stripped of their parliamentary immunity. Forty-four legislators, elected to local political bodies, also have criminal backgrounds. Drug traffickers, as well as other domestic and foreign crime groups, launder money through casinos, exchange bureaus, and the banks. And banks provide criminal groups with information about businesses’ profitability and assets, which they use to extort money from them. Criminals and public officials often collude in this effort. Criminals, for example, extort money from businesses by threatening to sell the information they illegally obtain from banks to the tax police. Tax officials are sometimes willing to share their information about businesses with crime groups in return for a share of the money they extort from businesses. 6.5.2.3 Multinational companies and corruption practices What is the influence of multinational firms and foreign direct investment, FDI, on corruption in the host country? Being subjected to legal rules on involvement in bribes, and often working under voluntary codes of corporate conduct, multinational firms might thus be expected to avoid corrupt practices, relative to their domestic counterparts. The empirical evidence is in variance with the expectation. Research findings by WB/EBRD (1999) show that multinational firms are just as likely to pay administrative bribes and try to capture the state as other firms and that multinational firms headquartered abroad are more likely than other firms to pay public procurement kickbacks. On average transactional firms pay just as high a percentage of their revenues in administrative bribe payments as do domestic firms without FDI. Administrative bribery by FDI firms is less prevalent in the BCEE than in EXSR or Russia. As for public procurement kickbacks, FDI firms whose headquarters are located abroad are most likely to pay public procurement kickbacks. However, the conducted studies find that administrative corruption does not pay: on average all types of firms (with or without FDI) that engaged in administrative bribery experienced lower sales and investment growth than those that did not. The fact that the majority of firms in these countries still engage in such practices supports the hypothesis that local bureaucrats in these countries exert significant pressure to exhort from the firms. As for state capture, extracted benefits from the state by corruptly influencing the execution of public laws, rules, and regulations, the evidence suggests that state capture is particularly prevalent when firms face insecure property rights, insufficient economic liberalization and competition, and only a partial liberalization in civil society and media activities, impairing their ability to effectively monitor the activities of the state. Despite the more stringent regulations governing their behaviour, FDI firms are involved in state capture

State Intensive System: Economic Transitions 199

just as frequently as domestic firms. Multinational firms with headquarters in the host country are more likely to engaging in state capture than firms headquartered abroad. A positive benefit of multinational bribery laws concerns the behaviour of potential investors. Multinational firms and foreign investors may avoid investing in countries with poor governance and high corruption. Reduced levels of FDI can thus indirectly exert pressure to improve governance within a country. Multinational and offshore companies can be involved in other corruption practices. They facilitate capital flight from transition countries that have economic and political uncertainties, to more secure havens in Europe and America. How big is the capital flight? And what are the mechanisms used in affecting this capital flight? Overall, some $350 billion in capital has fled the country since the fall of the Soviet Union, with nearly a third of it landing in the United States, according to intelligence sources. In an uncertain political climate where newly formed Russian companies and their brand new owners can face bankruptcy, prosecution, physical dangers and other risks, the motivation of the owners to preserve assets in Russia vanishes. Among the mechanisms used for capital flight is transfer pricing. A common practise is that Russian companies sell products at below-market prices to their offshore intermediaries. The intermediary then sells the products at the international price and the foreign currency proceeds never enter Russia. This practice has drained billions in profits from Russia’s core metals and oil companies into offshore accounts. Some groups sell their goods at below cost to a Russian intermediary company that is controlled by a few executives, thus depriving shareholders of the original company of their profits. These goods can then be exported at a fair market price. Another mechanism consists of bogus service agreements. These involve an offshore company – often set up by an intermediary that takes a commission for its efforts – that offers fake consulting services to its Russian ‘client’. This practice allows money to be exported, while the bills ‘paid’ by the Russian company reduce the domestic profits on which it is required to pay tax to the authorities. There is also a subtle relationship between corruption, foreign direct investment, and foreign capital inflow. Studies show that in countries rich in natural resources, such as Russia, and also Azerbaijan, Kazakhstan, and Turkmenistan, although substantive FDI was made, the capital inflows observed were weaker than they would have been had better governance prevailed, Hellman, Jones and Kaufmann (2000). 6.5.2.4 Magnitudes of corruption Several studies have measured comparative indicators of administrative corruption and capture corruption for transition countries. These are reviewed here for the period around 2000. Most of these measures are updated for later years and are published by the same sources, thus allowing tracing the progress of the magnitudes over time.

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Administrative corruption. The WB/EBRD Business Environment and Enterprise Performance Survey (BEEPS) carried out in mid-1999, and in 2002, provides firmlevel data on obstacles in the business environment in 22 transition economies in two different years. Administrative corruption is measured as the proportion of annual revenues paid to public officials to ‘get things done’. The results in Table 6.11 reveal an increasing share of firms paying bribe tax as one goes from

Table 6.11 Administrative corruption in transition countries: Share of time tax, share of firms paying bribes, and average bribe tax rate, 1999 and 2002, per cent Country

Share of time tax 1999 (a)

Share of firms paying bribe tax 1999 (b)

Average bribe tax rate 1999 (c)

Share of firms paying bribe tax 2002 (b)

Average bribe tax rate 2002 (c)

Czech Rep.

5.1

26.3

4.5

36.6

Estonia

7.3

12.9

2.8

42.9

1.1

Hungary

7.2

31.3

3.5

47.6

2.4 2.3

Latvia

–

46.6

12.9

23.2

4.2

44.0

1.9

Poland

9.5

32.7

2.5

40.6

3.4 2.6

Lithuania

–

–

2.9

Slovakia

6.5

34.6

3.7

62.9

Slovenia

5.9

7.7

3.4

14.9

5.4

Bulgaria

5.9

23.9

3.5

51.2

4.2

Croatia

3.3

17.7

2.1

24.6

2.6

Romania

7.7

50.9

4.0

54.9

4.7

Av. BCEE [(b) x (c)]

7.0

26.1

Armenia

9.8

40.3

6.8

21.6

4.8

Azerbaijan

5.7

59.3

6.6

52.9

6.0

3.4 [88.5]

42.5

3.0 [127.5]

Belarus

11.2

14.2

3.0

44.8

3.4

Georgia

11.3

36.8

8.1

65.5

4.4

Kazakhstan

15.2

23.7

4.7

58.4

3.8

Kyrgyzstan

11.2

26.9

5.5

64.7

6.3

Moldova

14.3

33.3

6.0

53.4

4.0

–

65.3

4.0

6.5

52.1

4.4

5.7

Tajikistan

–

–

Ukraine

16.8

35.3

Uzbekistan

12.5

46.6

48.1

3.2

Av. EXSR [(b) x (c)]

12.0

35.2

5.9 [207.7]

52.7

4.4 [231.9]

Russia [(b) x (c)]

12.7

29.1

4.1 [119.3]

64.6

2.3 [148.6]

Source, notes: WB/EBRD: The Business Environment and Enterprise Performance Survey (BEEPS). Figures for 1999 are reported also in Hellman, J. and Schankerman, M. (2000). Figures for 2002 are reported also in Fries S., Lysenko, T., and Polanec, S. (2003). (a) Time tax survey question: What percentage of senior management’s time per year is spent in dealing with government officials about the application and interpretation of laws and regulations? (b) Share of firms paying at least some bribes in per cent of responding firms. (c) Bribe tax rates are the proportions of sales paid in bribes averaged for all firms that made such payments.

State Intensive System: Economic Transitions 201

BCEE to EXSR and to Russia. This share has also increased between 1999 and 2002 for all countries. In 2002, the share of firms paying bribes reached 43, 53, and 65 per cent in BCEE, EXSR, and Russia, respectively. On the other hand, the surveys show a reduction in the average bribe tax rate between 1999 and 2002. As a rough indication of the trend in the bribe turnover the share of firms paying bribes and the average bribe tax rate can be multiplied by each other. Table 6.11 shows for transition countries a rising trend of the bribe turnover between the two years in spite of the reduced bribe tax rate. This trend is indicative of a spread of administrative corruption among many more firms and many more government officials. The table gives in the first column additional information on the influence of state settings on firm management. The table estimates the share of time that firm managers spend in consultations, negotiations, and administration with state officials. This is reported by firms to be around 7 per cent in BCEE, as compared to 12 and 13 per cent in EXSR and Russia. The picture that emerges from the survey results is that state bureaucracy and state influence in the transition countries still persists after transition, tends to increase over the reported periods, and is stronger in the ascending order of BCEE, EXSR, and Russia. State capture. The same WB/EBRD survey also allows for proxy measures for state capture. State capture is defined as the capacity to affect the formation of the basic rules of the game (laws, rules, decrees, regulations) through private payments to public officials. A cross-country index of state capture is constructed as the extent to which the six forms of corruption (by themselves or others) have had a direct impact on firms’ business.18 The transition economies can be divided into high capture countries versus those exhibiting a low (or ‘medium’) extent of capture, based on scores on the state capture index. It is noteworthy that there is no necessary tight correspondence between administrative corruption and state capture at the country level. Countries with low-to-medium prevalence of state capture include Albania, Armenia, Belarus, the Czech Republic, Estonia, Hungary, Kazakhstan, Lithuania, Poland, Slovenia, and Uzbekistan. This is an unusual collection of countries because it includes both advanced reformers and least reformed countries in the political and economic dimensions. In countries such as Belarus and Uzbekistan – where there has been minimal privatization, the private sector remains small, and important elements of the command system are still in operation – the capacity of private sector interests to capture the state might be expected to be low almost by definition, since the legacy of the past still suggests a state-led fusion. In contrast, the more reform-minded countries (such as Hungary and Poland) have achieved more progress in liberalizing the economy, strengthening bureaucratic accountability, and promoting political contestability – all factors that might be expected to place limits on the capacity of powerful firms to capture the state. The high capture countries include Russia, among others. While these countries have made progress in the liberalization and privatization fronts, lesser advance is evident in the complementary institutional reforms to support a legal

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and regulatory framework for the emerging market. Furthermore, while most countries have adopted the basic rules of democratic elections, the evidence raises questions about the concentration of political power, limitations on political competition, and constraints to full participation by civil society in many countries. The data suggests that state capture appears to thrive in such an environment of only partial economic and political liberalization. In countries with a very low level of civil liberties (where the state retains substantial control over the economy), state capture is limited (virtually by definition). At the opposite extreme of the civil liberty spectrum where civil society is developed and active in monitoring and applying pressure on politicians and public officials, the capture economy is also rather small (for very different reasons). And in sharp contrast with both extremes, countries with only partial exhibit extensive state capture. Although powerful oligarchs engage in state capture many new entrants do that too. These firms engage in state capture in part to offset insecure property rights and competition from secure, powerful incumbents. State capture allows these firms to purchase security of property rights a la carte from the state. In countries with a large capture economy – that is, where there is a large segment of the economy affected by capture and with a large market for firms to purchase laws, regulations, or decrees from politicians and bureaucrats – it is also found that ‘captor’ firms perform substantially better than other firms in terms of sales growth. Moreover, these private benefits to captors are bought at substantial social cost. On average the enterprise sector in the ‘capture economy’ end up with much worse performance than enterprises on average in low capture economies, despite the specific private benefits that the captor firms enjoy in the capture economy. Table 6.12 gives evidence of the spread of capture corruption as approximated by the share of firms affected and the share of captor firms. At the country group level the share of firms affected in 1999 was generally more spread in ascending order in BCEE, then EXSR and then Russia showing highest occurrence. The survey of 2002 shows a convergence, with the BCEE topping Russia as regards affected firms. The share of captor firms in 2002 is also higher in BCEE than in EXSR or Russia. 6.5.2.5 Other comparative results on practices and perceptions of corruption in transition countries Until recently, systematically measuring corruption in government institutions and assessing its economic and social costs was considered impossible. Data consisted only of general measurements of public and expert perceptions of aggregate corruption in a country. Recent research, however, has analysed cross-country perceptions of corruption and compared them with institutional and other correlates. There are in-depth studies that make use of new methods of measuring corruption by directly surveying the parties to corruption – including household members, enterprise managers, and public officials – and ask them about the costs and private returns of paying bribes to obtain public services, special privileges, and government jobs. When approached with appropriate survey instruments and

State Intensive System: Economic Transitions 203 Table 6.12 Capture corruption in transition countries: Share of firms affected by capture and share of captor firms, both regarding capture of laws and regulation, 1999 and 2002, per cent Country

Share of firms affected by capture, 1999 (a)

Share of captor firms, 1999 (not available)

Share of firms affected by capture, 2002 (a)

Share of captor firms, 2002 (b)

2.6

Czech Rep.

11.0

–

17.3

Estonia

10.0

–

13.6

6.5

7.0

–

12.9

6.0

–

8.5

Hungary

–

29.3

Lithuania

Latvia

11.0

–

18.6

5.1

Poland

12.0

–

15.5

3.6

Slovakia

24.0

–

23.0

4.7

Slovenia

7.0

–

20.7

6.4

Bulgaria

28.0

–

38.8

10.0

Croatia

26.0

–

18.2

11.2

Romania

21.0

–

21.4

4.7

Av. BCEE

15.7

–

20.8

6.3 3.5

Armenia

7.0

–

9.2

41.0

–

23.2

1.2

Belarus

8.0

–

7.2

3.6

Georgia

24.0

–

31.0

12.1

Kazakhstan

13.0

–

13.0

2.0

Kyrgyzstan

29.0

–

27.3

8.1

Moldova

37.0

–

28.8

8.6

Azerbaijan

Tajikistan Ukraine Uzbekistan

–

35.3

7.5

32.0

–

–

16.3

4.8 2.3

6.0

–

27.2

Av. EXSR

21.9

–

21.9

5.4

Russia

32.0

–

11.8

4.8

Source, notes: WB/EBRD: The Business Environment and Enterprise Performance Survey (BEEPS), organized by WB/EBRD for 1999 and 2002. Figures for 1999 are reported also in Hellman and Schankerman (2000), and in Hellman, Jones, and Kaufmann (2003). Figures for 2002 are reported also in Fries, Lysenko, and Polanec (2003). (a) The capture index is based on the average of percentages of firms that perceive at least minor impact by unofficial payments to affect six areas of laws and regulations and that are not themselves captor firms. The six areas comprise parliamentary legislation, presidential decrees, central bank, criminal courts, commercial courts, and party finance. The index is in per cent. Higher values of the index indicate more capture. (b) Defined as the share of firms that attempted to influence laws and regulations and by unofficial payments, and that are identifiable as captor firms.

interviewing techniques, respondents are willing to discuss agency-specific corruption with remarkable freeness. The in-depth surveys on corruption issues for Russia around the turn of the century, Rose (1999), have shown the following. First, a majority of Russians say that there is no need to pay taxes – the government will never find out. Three-quarters believe that a cash payment to a tax official enables someone to evade payment of taxes claimed. Altogether, five-sixths of Russians think that

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taxes can be evaded; they differ only in whether the best tactic is not paying at all or tipping tax officials to avoid legal obligations. Second, individuals report that they invest an unreasonable amount of time in pleading with and pushing bureaucrats to compensate for organizational inefficiencies. If bureaucrats offer to waive obstructive regulations in return for a side payment, a service is delivered. Among Russians, 71 per cent say that the national government is far from a law-governed state; 62 per cent think that laws are often hard on ordinary people; and 73 per cent endorse the belief that harsh Russian laws can be softened by their non-enforcement. In such circumstances, the result is that there is popular ambivalence about the rule of law. Third, confidence in financial security is low. Only 35 per cent of Russians think that the social security office will pay the claimants money to which they are entitled. Less than one in three expect to have enough financial resources to consider buying a house, and only one in six reckon they could borrow a few weeks’ wages from a bank. Fourth, confidence in civilian security is also low. Although only a minority of Russians are prepared to rely on the police – less than half think that the police will protect their house from burglary – even fewer think that nothing can be done to protect their home from crime. In conclusion, even though the communist era is closed in Russia, the findings show that the way the system is being run after more than a decade of transition still manifests a significant dependence and preoccupation of the population on/with state settings. At the same time, the expectations of the population on what the state can do for economic welfare have diminished to low levels. In-depth surveys on corruption issues in a few countries of the BCEE country group were conducted also around 2000, see Kaufmann, Pradhan, and Ryterman (1999). In Georgia, for example, the most common form of corruption is embezzlement of public funds. In Albania and Latvia the most common form is theft of state property. Bribery in procurement is common in all three countries. Institutional causes of corruption also differ across countries, suggesting different priorities for reform. In Albania a weak judiciary is one of the main causes of corruption; regulatory failures are less important. Regulatory failures are more serious in Georgia and Latvia, both in terms of excessive regulations and the discretion granted to regulators enforcing them. In spite of the country difference some common tendencies were found. First, corruption is costly for firms, and they would be willing to pay higher taxes if it were eliminated. Bribes account for 7 to 15 per cent of revenue in firms that admit to paying them. Second, corruption reduces the public revenues directly and indirectly via bribing officials to avoid paying taxes. Third, corruption disproportionately hurts the poor, as about 13 per cent of households admit to paying bribes are heavily concentrated among poorer households. Fourth, bureaucrats pay for lucrative positions. In some transition countries the price of obtaining ‘high-rent’ positions is well known among public officials and the general public. Higher prices are paid for jobs in agencies and activities that households and enterprises report as being the most corrupt, suggesting that corrupt officials rationally ‘invest’ when buying public offices. In conclusion, the survey data can help establish

State Intensive System: Economic Transitions 205

priorities for reform in each of these areas. For example, detailed statistics were collected on the bribes paid by enterprises to regulators in different agencies. This information can be used to determine which agencies are receiving the largest share of side payments. Box 6.3, towards the end of Section 6.5.2, draws the picture on perceptions of the rule of law. Box 6.4, also towards the end of the section, shows results of the poll of polls corruption perception index, CPI. This is a cross-country comparative study on corruption as a whole that has gained international status as a reference source on the subject. The CPI is a poll of polls, based on 17 surveys from a large number of independent organizations. The box confirms BCEE to be cleaner than EXSR and Russia regarding corruption. Empirical comparisons on a global scale using CPI data show that countries ranking high in CPI appear to be the least competitive countries. This is also borne by economic performances in BCEE as compared to EXSR and Russia. The correlation suggests that corruption is a major factor contributing to non-competitiveness, though it can be noted too that the opposite direction of causality is also feasible and theoretically founded: that corruption is a response to non-competitiveness, cf. Krastev (2000). 6.5.2.6 Policies for reducing corruption While it is helpful to list and recommend policies that governments in transition countries should introduce to curb corruption, the problem of implementation raises questions on motivation and persuasion. How do governments respond to these recommendations when government agents are better off without them? It can be expected that in those transition countries where the authority of the state and the interests of government officials are more paramount there is less chance that the recommended policies will be implemented. Recommended policies to address administrative corruption would include introduction of periodic mandatory public declarations of assets and income sources by government officials and their dependents. Where state capture has led to entrenched interests, the recommended policies lie in breaking up monopolistic structures and promoting the ability of new entrants to compete with powerful incumbents. Furthermore, there is a wide array of corporate governance reforms that have proven effective in curbing corruption. They include disclosure requirements to cross-holding, the establishment of strong penalties for insider trading and pyramid schemes, management disqualification penalties for gross abrogation of corporate rules, appointment of outsiders to boards of directors, exercise of creditors’ rights regular, published independent audits of financial accounts, creation of a market for corporate control, systematic use of professional watchdog and credit rating agencies, and the strong enforcement of ethical standards and conflict-of-interest laws. These measures require giving special attention to the needs of civil society, competitive media, and legislative bodies. Policy-makers can adopt a variety of measures to reduce grand corruption related to international transactions, in procurement kickbacks among others. They can make the relation between the state and firms with FDI more transparent by

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Economic Systems Analysis and Policies

striving for greater transparency in joint meetings, party financing, monitoring of oversee tenders, privatization deals, and large-scale procurement with FDI participation, establishment of foreign investment advisory councils and foreign business clubs, disseminating survey-based data on corporate practices of firms with FDI, and improving governance. Finally, there are actions at an international level that can pressure individual countries to follow suit in curbing corruption. Global transparency is being promoted through collective international actions such as expanding the WB practice of publicly blacklisting firms found to engage in public procurement corruption. There is also an increasing role of Transparency International in highlighting and ranking corruption among countries, and in advising firms on developing codes of corporate responsibility and ethics. 6.5.2.7

Hidden economy

A substantial amount of output in many developing and post-communist transition economies goes unreported. These hidden transactions are made up of underground, barter and, in some cases, criminal activities. What is the empirical evidence on the spread of the hidden economy? Most of the empirical research on the size of the hidden economy uses macro data, such as the discrepancy over time between trends of the official GDP and the amount of cash in circulation or electricity consumption. Survey estimates consistently show that countries with inefficient regulatory environments and widespread corruption have a hidden economy sometimes in excess of 40 per cent of the official GNP. Recent studies estimate that in 1995 the hidden economy in Russia and countries of the ex-Soviet Union, i.e. Ukraine, was around 50 per cent of GDP; in the BCEE countries, i.e. Poland, Romania, Slovakia, it was less than 15 per cent of GDP; cf. Johnson, Kaufmann, McMoillan and Woodruff (1999). What causes firms to operate in hidden economies? There are four explanations, each with distinct policy implications. First, entrepreneurs may go underground when tax rates are high and official regulations are lengthy. Second, government officials seeking bribes from business – will drive some businesses into hidden transactions. Third, where criminal gangs are active firms tend to hide their activities. Fourth, when it is hard to enforce contracts because of a soft judiciary system, firms are encouraged to do hidden transactions. Empirical evidence from transition countries supports these causes. A survey conducted among firms in transition countries shows that firms in their industry regularly pay for ‘protection’ of their activities. The firms suffer extortion not only from bureaucrats but also from criminal gangs. A striking 90 per cent of Russian and Ukrainian managers say it is normal for bribes to be paid to government officials. This percentage is lower in BCEE countries and falls within a range of 8 to 40 per cent. The firms’ tax payments are higher in Russia than in BCEE countries. Just over a half of the firms in Russia said they use courts to enforce contracts with trading partners, whereas in BCEE countries two-thirds or more said they could. All the firms in the survey are registered and operate in the formal economy, but many of them hide at least some output. There is a significant association

State Intensive System: Economic Transitions 207

between bribes and other corruption practices, and the hiding of output. Underreported sales are highest in Russia and Ukraine (averaging 29 and 41 per cent of total sales, respectively), and much lower in BCEE countries (between 5 and 7 per cent). Enterprise managers in Russia and Ukraine, then, face worse bureaucratic corruption, more mafia extortion, higher taxes, and a less effective court system. They also hide more of their output. Comparing averages across the countries, therefore, gives support to all four explanations for hiding. Barter exchanges in the transition economies associate with the extent of the hidden economy. It can be expected that barters flourish in settings with high uncertainties. Ordinary market economies and transition economies usually have a M2 (the wide money stock, consisting of cash and deposits) to GDP ratio of 60 per cent or higher, depending on characteristics of the financial system. In Russia the ratio of ruble M2 to GDP was never close to 20 per cent and was below 10 per cent in 2000. In addition to rubles, Russians hold an unknown but presumably large amount of dollars abroad, as a store of value. Also, a variety of quasi-monies – usually IOUs issued by the authorities, banks, and companies – are used. There are estimates for Russia and Ukraine that about half the industrial production is based on barter, Setula (1999). What are the handicaps of hidden economies? In general, a non-monetary exchange based economy has several handicaps. Barter arrangements are costly and cumbersome. The acceptance of quasi-monies avoids taxes and reduces revenue, to the detriment of fiscal policy effectiveness. The use of regionally based quasi-monies tends to destroy the unity of Russia’s economic space. The wide use of quasi-monies lowers enterprise cash-flow and contributes to tax and wage

Box 6.3 Transition countries: Consensus on subjective perceptions and objective indicators on the imposition of the rule of law.: Differences between country groups The box reflects on the institutionalization of the rule of law. It shows the Baltic, Central and Eastern European countries (BCEE) to be more advanced in this respect than either a sample of the ex-Soviet Republics (EXSR), or Russia. The table supports our positioning of the transition countries to the left and right of Russia, with Russia being closest to having a state intensive economic system, see Chapter 1, Figure 1.3.

Country group

(1) Percentage that believes legal system will ‘uphold any contract and property rights in business disputes’

(2) Rule of law index. (10 = best, 0 = worst)

BCEE group

41

7.2

EXSR group

60

4.4

Russia

73

3.7

Source, notes: Column (1) is from EBRD/WB survey. Column 2 is from Wall Street Journal. BCEE group includes 11 countries. EXSR group consists of Kyrgyzstan and Kazakhstan. Relating figures are also used by Hoff and Stiglitz (2002).

208 Economic Systems Analysis and Policies

Box 6.4 Transition countries: Poll of polls corruption perception index, CPI The Corruption Perceptions Index, CPI, is a useful measure of capture corruption. The index is an average of perceptions about corruption from various sources, and applies for 1999. As such, it may hide the wide diversity of opinion among these sources for a given country. The table includes the minimum and maximum scores for each country to show the diversity of opinion. The 1999 CPI score relates to perceptions of the degree of corruption as seen by business people, risk analysts, and the general public, and ranges between 10 (highly clean) and 0 (highly corrupt). CPI registers the evaluations of ‘cleanness’ given to specific countries by the officers of multinational corporations. All countries reported upon are subsequently ranked in descending order of cleanness. The results show the BCEE group to be cleaner than EXSR or Russia.

Country

CPI score

Max. score (a)

Min. score (b)

Slovenia Estonia Hungary Czech Rep. Poland Lithuania Slovakia Belarus Latvia Bulgaria Macedonia Romania

6.0 5.7 5.2 4.6 4.2 3.8 3.7 3.4 3.4 3.3 3.3 3.3

6.3 8.0 8.0 6.1 5.4 4.4 6.1 6.1 5.1 6.1 4.8 4.3

4.1 4.4 3.8 3.6 2.8 3.2 1.4 2.3 1.5 1.1 1.5 1.5

Average BCEE

4.2

5.9

2.3

–

–

–

–

–

–

Average BCEE (c)

3.8

5.4

2.1

–

–

–

–

–

–

Rank Country

25 27 31 39 44 50 53 58 58 63 63 63

Croatia Moldova Ukraine Armenia Russia Albania Georgia Kazakhstan Kyrgyztan Serbia Uzbekistan Azerbaijan

CPI score

Max. score (a)

Min. score (b)

Rank

2.7 2.6 2.6 2.5 2.4 2.3 2.3 2.3 2.2 2.0 1.8 1.7

3.9 3.5 4.3 3.2 4.2 3.0 3.4 4.3 2.8 3.7 2.4 2.4

1.5 1.4 0.5 2.4 0.6 2.1 1.8 0.9 1.8 0.6 1.5 1.1

74 75 75 80 82 84 84 84 87 88 95 96

Average EXSR

2.4

3.6

1.5

–

–

–

–

–

–

Russia

2.4

4.2

0.6

–

–

–

–

–

–

Source, notes: CPI by Transparency International at http://www.ncpa.org/pi/internat/sept98s.html. (a) indicates the maximum value given to a country by a source; (b) indicates the minimum value given to a country by a source; (c) excluding Croatia, Albania and Serbia.

arrears. An economy with several exchange systems is unstable and difficult to regulate by economic policies; with little money in use the possibilities of generating savings to be channelled into investment finance are modest at best. There can be other shortcomings. The hidden economy can obstruct growth and development in several ways. Firms operating underground cannot make use of market-supporting institutions – such as the courts – and thus are averse to risks and invest too little. Besides, doing business in secret generates distortions since the hidden transactions do not contribute to explicit market price formation and market clearance. However, notwithstanding the above disadvantages, there is a different and more positive view on the role and effects of the shadow economy in the context of a rent appropriating state and state-induced distortions. Choi and Thun (2002)

State Intensive System: Economic Transitions 209

show that fleeing to the shadow economy constrains the state’s ability to engage in rent seeking and economic distortions, and thus mitigates the situation. Which policies should the governments in transition countries (not) follow to reduce the extent of the hidden economy and barter exchanges? And do they do that? The causes that associate with the firm’s decision to enter into hidden transactions were shown above to relate to an arbitrary and substantial state intervention. Remedial policies are in the areas of cuts in taxes and red tape, eliminating bureaucratic corruption, better policing and enforcement of the criminal code, and investment in a commercial court system to deter unofficial activity. In summary, the remedies lie in a reduced role of the executive branch and an enhanced role for the judiciary branch. Is this happening? The observed evidence from a decade and a half of transition shows varying progress in these directions, with BCEE ahead of EXSR and Russia. 6.5.3 Internalizing externalities 6.5.3.1

General

The policy concern of externalities in a transition economy relates to internalizing economic interdependencies that are inherited from the past regime or emerge for the first time in the newly transforming exchange economy. The distinction between positive and negative externalities is relevant in this context. We shall review examples of both. The closed orientation of the transition economies to global trade and investment links in the pre-transition era is a main cause of unattended externalities in the past regime. Eliminating these foreign linked externalities in the transition economies implies greater global links. In this connection, we shall examine the comparative performance of the transition countries in creating greater global links in trade and investment. 6.5.3.2 Financial–industrial groups to realize positive externalities In general, to the extent that externalities are internalized in a centrally planned economy, the problem of externalities is less severe in SIM than FIM economic systems. As central planning was dismantled in the communist countries and a market economy was introduced during transition, the problems of externalities emerge rapidly and remarkably. The mass privatization and the break up of large operating units in smaller ones with diverging managements increase the degree of externalities. For example, in Russia, by mid-1997, about 130,000 state-owned enterprises – over half – had been privatized primarily via voucher privatization. This led to a large number of new owners with little experience in business making, resulting in a scattered and unmanaged ownership and control. Significant positive externalities would be gained by a reconsolidation of industry, ownership, and control. In its policy to consolidate industry, ownership and, control and industry, the Russian government thereafter decided to promote the financial–industrial integration of enterprises and financial organizations by the setting up of large financial– industrial groups (FIG). Although a logical action is to internalize on the emerging externalities, many analysts have questioned whether the FIGs were a curse or bless

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Economic Systems Analysis and Policies

in the wake of firm and state responses and interactions that accompanied the creation and growth of FIGs into colossal monopolies, cf. Popova (1999). A financial–industrial group, FIG, was to be formed around an industrial enterprise, research organization, bank, or trade firm. The 1995 law limited the participation of any bank or enterprise to a single financial–industrial group. FIGs received state support in various forms. A FIG may receive blocks of state shares. The state can offset the debt of a member enterprise and grant state guarantees for loans, basically for investments. The state also can provide investment credits for the group projects. A FIG can receive favourable treatment on customs tariffs. It can be recognized as a consolidated group of taxpayers with consolidated accounting. It can receive the right to define the period of amortization of equipment and accumulate the funds for its activity. It can receive financial support if it participates in federal programmes. The central bank can provide banks that participate and invest in FIGs lower reserve requirements and change other rules to increase investments. How did this policy influence the financial and industrial structure of the economy? In 1998, the 75 officially registered financial–industrial groups produced about 10 per cent of the Russian GDP and employed 5 million people – almost 30 per cent of the industrial workforce. In 1997, almost 40 per cent were located in Moscow and most of the rest in Siberia and the Urals region. The FIGs developed in different directions than was initially intended by the state. Many manufacturers were afraid of the dominance of the banks. Banks on their part found the rule of restricting their participation to one financial–industrial group frustrating. This has slowed the formation of officially registered FIGs and led to the quick spread of ad hoc, ‘unofficial,’ FIGs. Hundreds of unofficial FIGs were set up by industrial, trading, investment, and insurance companies, which also established their own ‘pocket banks’ to provide financing for the groups, work out investment projects, and take part in the management. What are the effects? Official and unofficial huge financial–industrial alliances came to fall under the control of a handful of oligarchs, with powerful influences on the economy and polity. They reached these positions in a remarkably short time because of wit, luck, and above all because of corrupt state practices, absent markets, and legal vacuum. Even after the financial shock of August 1998, which brought many losses to some, these oligarchs still controlled Russia’s oil, gas, and metal industries, employed millions of people, brought in the bulk of the country’s hard currency earnings, as well as affecting significant capital outflow, and excessively influenced Russia’s politics. Oligarchs are so called because they have monopoly power and state power. They wrote laws. They appointed ministers, often entire cabinets, and made sure that their interests were served. They corrupted the new governing, legislative and bureaucratic class of Russia, in the centre, in the regions, and abroad. What was meant to take advantage of positive externalities turned into monsters that distort the free functioning of the economy and polity. Such unexpected ex-post negative effects of an a priori well-intended policy, in this case to internalize externalities, was also encountered in our analysis of the privatization

State Intensive System: Economic Transitions 211

of public enterprise and in the establishment of market confidence. In all three policy areas of the long transition treated so far, opportunity state agents and influential firm agents appear to find each other in pursuing rent appropriating behaviour entrenched in the pre-transition political system. There is a differentiation in the agent response between the transition countries, with a less politicized behaviour of agents in the BCEE country group than either EXSR or Russia. Besides, the phenomenon of the FIGs and oligarchs is limited to Russia. Apart from the above account of the joint economic and polity failure of FIGs and oligarchs, the rise of all powerful oligarchs in a state intensive economic system appears to be contrary to the principles elaborated in the first chapter; and would require thus an explanation or otherwise a qualification. The influence of the oligarchs described above would mean that the balance of power in a SIM-type country would have shifted from the state to a handful of persons in control of the financial–industrial groups. This is not the case. The influence is of a temporary nature and is based on personal networks. The influence of the oligarchs was never institutionalized and could not be either, since the state apparatus is established all over the system and would not allow losing its authority and power to a handful of oligarchs. In spite of the weakening of the state apparatus immediately after the fall of the communist regime, the newly installed state agents consisting of politicians, bureaucrats, and other public sector employees have taken over vested authorities and interests to which they hold and want to keep. The future of Russia’s large conglomerates would thus depend on the willingness and power of the state to enforce effective antimonopoly policies in regulating official and unofficial financial–industrial groups, especially clipping the wings of the oligarchs. While the influence of oligarchs was highest when Yeltsin was president, this influence has ebbed down under the presidency of Putin. The presidential period of Putin saw a taming of the oligarchs power by the state; and furthermore, the interests and outlook for the top business tycoons appear to have become more chained and subjugated to the fortunes of the state and regency. The state under the presidency of Putin was willing and had the authority and power to recover back its political dominance not only on the oligarchs and their businesses but also in other major and lucrative areas of economic activity.19 6.5.3.3 Negative externalities from the past regime Countries in transition have inherited economic structures consisting of production capacities in the various sectors of economic activity that were based on political decisions, and not on the interplay of economic forces of demand and supply in an open economy that is well integrated with the world economy. There are many kinds of external effects – economic interdependencies – that the transition economies need to incorporate in their transformation process towards open economies with competitive international trade relations. Internalization policies would commonly have the objective of restructuring the inherited industrial structure towards a competitive one. This implies that internalization policies need to be devised for reshaping product use, resource use, production technology, complementary infrastructure, etc. As a result, industrial policy directed

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Economic Systems Analysis and Policies

towards internalization of the inherited negative externalities of the past regime, and towards incorporating world market prices in restructuring the economy become major areas of state intervention in the transition economy. This section reviews examples of inherited negative externalities from the past. It was remarked in Chapter 2 that the industrial policy of Eastern Europe in the pre-1990 years is an example of a heavily targeted policy that failed. Eastern Europe’s industrial policy was characterized by state ownership of economic assets, centralization of these assets, and a planning system to allocate their use. Furthermore, large-scale production was regarded as the only efficient way of production. The dominance of political, above-economic considerations has lead to an arbitrary selection and concentration of industries, which has distorted the comparative advantage in Eastern Europe in the past and the present. Correcting for the failed targeted industrial policy of the past requires a reversed targeted industrial policy for the future that searches for an economic structure, which reflects the comparative advantage of the transition economies based on the holding world market prices. One relevant investigation of the implied industrial restructuring is by Hughes and Hare (1994) who investigated approaches for guiding industrial policy in Eastern Europe. They assessed the competitiveness of the different tradable industrial sectors in individual transition economies on the basis of world market prices. Due to political decisions, together with quantitative restrictions, taxes and subsidies, measures of the value added in domestic prices for the various industrial sectors in transition economies are bound to be unreliable indicators of the real economic worth of the economic activities concerned. To assess the real competitiveness of a tradable industry it is essential to recalculate its value added in terms of world market prices. The real domestic resource cost (DRC) for industry j is thus definable as DRCj = j / j where j is value added of sector j in domestic prices, and j is value added of sector j in world prices. In the longrun sectors that achieve a DRC = 1 are the sectors that prove to be competitive. Among these the most competitive are those with a small positive DRC. Hughes and Hare obtain values of DRC for metal product industries averaging 1.19 for Hungary (with a range of 1.10 to 1.27), and an average of 1.12 for Poland (with a range of 0.91 to 1.42). The least competitive sectors are: (a) those with high values of DRC, indicative of large amounts of domestic resources to generate a unit if GDP at world prices, and (b) those with negative value of DRC due to a negative value added at world prices. The GDP measured at world prices would increase for these activities if they were shut down. Hughes and Hare obtain very high or negative values for DRC for the metal products industry in Bulgaria and the ex-Soviet Union. For example, DRC for transport equipment is 8.5 for Bulgaria, while DRC for fabricated metal products is negative at –3.2 in the ex-Soviet Union. As the transition countries are now much more open in their foreign trade than they used to be, it can be safely postulated that their industrial structures must have been moving in the indicated sectoral directions implied by the results of Hughes and Hare, and related studies. Of course, a review of the realized

State Intensive System: Economic Transitions 213

adaptations, by sector and country, would require a separate inquiry. Insight into the success of the various transition economies in restructuring their industry in a global context can be approximated by examining progress achieved in opening up the economies to international trade and finance, as is done below. 6.5.3.4

Performance in extending global links

The closed orientation of the transition economies to global trade and investment is a main cause of unattended externalities in the past regime. Greater global links in trade and investment in the new settings would eliminate the foreign externalities. How do the transition economies perform with regard to elimination of foreign externalities in trade and investment? And what are the patterns? A readily available indicator of success in internalizing foreign trade is the share of foreign merchandise trade (FMT) in GDP. Regarding foreign investment, an often-used indicator is the share of net FDI in GDP. Table 6.13 shows both indicators for three periods. While for other regions of the world there is a high and positive association between these two indicators, this is not borne by the data in the table. With the exception of Estonia that combines highest shares in both indicators, there is a very low correlation between these two indicators for the transition economies for the separate years or when all years are taken together. The R-squared in various regressions do not exceed 0.18, and the suggested relation between the two indicators is a negative one. The independent development and autonomous functioning of foreign trade and foreign finance in transition economies is explainable partially in terms of economic segmentation and path dependence. In case of energy and other resource-rich countries the focus of FDI is in that sector, and is not tied to merchandise exports. There are also cases where the FDI is directed towards supplying local goods and local demand. Furthermore, on the one hand, state policies in most transition economies are known to consider national ownership as the preferred mode of business finance. On the other hand, where prospects for the penetration of the world market for merchandise are moderate, and the investment climate is less secure due to political or governance uncertainties, the flow of FDI is discouraged. The table shows that the transition economies do not appear to capitalize on the economies of scale and scope from combining trade and finance. Taking transition countries as a whole, the results indicate a moderate to a weak internalization of global externalities. However, the incidence of the cited limitations varies among the transition economies making it possible to identify countries with most and with least success in internalizing global links. An average index of global integration over 2000–05 is constructed from the two indicators. For each indicator the country figures for 2000 and 2005 are combined to give average values. For each indicator country average values are expressed as proportions of the highest country average value. The two proportions are then averaged to give a final score. Estonia heads the list with a score of 1.00. After a distance there are five more countries with scores of 0.61 and above. At the lowest end there are eight countries

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Economic Systems Analysis and Policies

Table 6.13

Transition countries: Performance in extending global links, per cent

Countries

Share of foreign merchandise trade in GDP, per cent

Share of FDI in GDP, per cent

1995

2000

2005

2000

2005

2000–05

84

108

125

5

9

–

H 0.69

101

162

135

5

7

23

H 1.00

Hungary

63

128

117

11

6

6

H 0.61

Latvia

60

65

88

3

5

5

0.42

Lithuania

85

81

106

1

3

4

0.43

Poland

37

47

63

3

5

3

0.32 L

Slovakia

89

122

145

1

10

4

H 0.68

Slovenia

88

98

113

1

1

2

0.41

BCEE above group

65

89

97

4

6

6

0.51

Albania

38

37

39

3

4

3

0.24 L

Bosnia

66

83

95

0

3

3

0.40

Bulgaria

84

90

112

1

8

10

H 0.64

Croatia

65

67

71

1

6

5

0.42

Macedonia

66

95

91

0

5

2

0.43

Romania

51

63

69

1

3

7

0.39

Czech Rep. Estonia

1995

An index of global integration

Serbia

29

63

64

0

0

6

0.31 L

BCEE whole group

61

81

88

2

5

6

0.47

Armenia

64

62

55

2

5

5

0.36 L

Azerbaijan

43

57

94

11

2

13

0.50

Belarus

74

125

111

0

1

1

0.43

Georgia

20

34

53

0

4

7

0.33 L

Kazakhstan

44

76

79

5

7

3

0.43

Kyrgyzstan

56

77

73

6

0

2

Moldova

90

97

117

1

10

7

Tajikistan

127

149

97

1

2

2

0.48

Turkmenistan

132

150

106

10

4

1

0.51

Ukraine

59

91

85

1

2

9

0.48

Uzbekistan

46

40

60

0

1

0

0.19 L

EXSR group

69

87

85

3

3

5

0.42

Russia

36

58

48

1

1

2

0.23L

Source: World Bank at http://devdata.worldbank.org/query

0.29 L H 0.64

State Intensive System: Economic Transitions 215

with scores around 0.30 or less. Most countries falling here are very small, or have experienced civil violence. Two important exceptions are Poland and Russia with scores of 0.32 and 0.23, respectively. These are large economies with large domestic markets that can function as substitutes for global links. It is permissible to evaluate performance in these two cases in terms of normalized lower values of the index, if indeed the domestic markets are able to substitute and contribute sufficiently to economic growth at a comparable level with the more globally integrating transition countries. An evaluation along these lines would clear the case for Poland, which was found to have the highest GDP growth performances, as was shown earlier in Table 6.2. For instance, Poland had a rate of cumulative GDP in 2005 at 19.9 times, and the GDP change in 2005 stood at 56 per cent. The comparative GDP figures for Russia are 12.3 times and –14 per cent. This allows drawing the conclusion that the ability of Russia to internalize the inherited global externalities was particularly low. Finally, the degree of global links that a transition country is able to accomplish depends in part only on its manner of handling the transition process. Transition countries that are rich in energy and other mineral resources, especially Russia and Kazakhstan, have been fortunate and have succeeded in accumulating in the years 2001–07 large foreign exchange reserves from the export of oil at surging prices, and the trend may continue for more years. The foreign exchange reserves offer ample opportunities for extending global links and participation in multinational investment projects.20 6.5.4 Public goods provisions We have examined challenges that transition countries face such as reducing monopoly, corruption, and externalities. In many of these countries we noted weak responses and disappointing outcomes to these challenges, mostly due to a prevalence of rent seeking and politicized behaviours of the past SIM that re-emerges during the long transition. These responses and outcomes stand in contrast to those regarding challenges of collective and distributive actions. Most transition countries appear to have comparative advantages in resolving problems of public goods and income distribution. It is generally acknowledged that a centrally planned socialist regime is more prone to respond effectively towards these challenges than towards the more economically oriented challenges of perfect competition and market institutions. Already at the start of the socialist regimes in the Soviet Union and allied countries primary attention was given to meeting collective challenges by an ample provision of public goods. At the time, all SIM countries achieved significant progress in eradicating diseases, improving education, and assuring safety. Through accumulated public goods provisions in the past, the transition countries today enjoy higher levels of health and education than countries at a comparable level of income per capita. The shares of the GDP that go to health and education in the 25 transition countries are estimated at 3 and 4 per cent, respectively; and these are comparable or slightly higher than for countries at the same level of economic

216

Economic Systems Analysis and Policies

development, cf. Gupta (1998). While the financing of these allocations to health, education, and related community services in the transition countries are mostly via government budgets, and more recently household incomes; in Russia and a few other countries enterprises play a significant role in providing public goods to their employees and dependents. In spite of the general availability of these collective provisions the early years of the transition period saw significant but temporary deteriorations in health, public utilities, and other public services imposed by financial limitations on state, local, and enterprise budgets. Privileged use for better offs increased significantly and disparities in quality of services offered widened. There is no precise way for measuring the extent of public goods provided by the state. It is often difficult to reach consensus on whether certain public provisions would conceptually and operationally qualify to be considered as public goods. A very broad view of public goods would consider all government expenses as provisions for public goods. Government expenses contain current and capital expenditures required for running the operations of the public sector. Obviously, some of these operations may not qualify as public goods. Even if some of these operations can be identified costing them would involve much guesswork. Under the circumstances, the best one can do is to consider government expenses as the upper bound of state provisions for public goods. Table 6.14 gives government expenses as a share of GDP for the pre-transition year and central government expenditure as share of GDP for four periods thereafter. The figures on government expenses for 1988 had to be derived indirectly by deducting public income transfers from public total outlays. The figures for 1990, 1995, 2000, and 2005 are directly available. The available data show that state allocations to public goods, as being approximated by government expenses as a share of the GDP, declined significantly in the early transition years. In BCEE the average decline in public provisions from pre-transition to 1995 amounted to about 5 per cent of the GDP (i.e. 42.5–37.5). There is no sufficient data to assess the size of the decline in EXSR and Russia. The decline implies a cut in the provision of public goods by about 12 per cent in a period of 6 years. The cut continued through 2000, the relative reductions in public provisions being less in BCEE than in EXSR and Russia. The cuts explain in part the experienced deterioration in public services during transition. This was the price paid for balancing the fiscal budget. By international norms, other countries in the world at the same level of economic development as the transition countries have a share of public spending in the GDP that is lower than in transition countries in the years 2000 or 2005. Furthermore, for the years 2000 and 2005 a tendency can be observed among the transition economies towards a slight increase of this share. The state biased economic system is likely to be behind the relatively higher shares in the transition economies. If, furthermore, the well-being outcome of public goods provisions in transition economies is equivalent to that in countries at a comparable level of economic development, but the public provisions in the transition economies is greater than in comparable countries, this raises the issue of whether more efficient use can be made of state provisions for public goods resources in transition economies.

State Intensive System: Economic Transitions 217 Table 6.14 Transition countries: Performance relating to share of public spending in the GDP, per cent Country

Share of public total outlays in GDP

Share of public income transfers in GDP

Share of government expenses in GDP

1988

1988

1988

68.7

11.2

57.5

–

–

–

60.0

13.1

Latvia

–

Lithuania

Czech Rep. Estonia Hungary

Poland

Share of central government expenditure in GDP

1990

1995

2000

2005

36.2

36.8

35.8

22.1

35.5

31.3

33.2

46.9

52.1

51.2

41.4

43.0

–

–

–

32.5

31.5

29.4

–

–

–

28.9

24.5

27.8

28.3

48.5

8.7

39.8

–

40.4

33.2

36.3

Slovakia

–

–

–

–

42.4

40.5

34.9

Slovenia

40.6

11.1

29.5

39.9

38.4

–

Bulgaria

61.6

11.3

50.3

55.1

41.0

35.3

34.3

Romania

40.2

9.4

30.8

33.8

31.8

34.1

31.0

–

–

42.5

–

37.5

35.0

34.0

BCEE group Belarus

43.9

5.7

34.6

–

33.2

28.9

29.8

Kazakhstan

–

–

–

–

20.8

23.2

22.3

Kyrgyzstan

–

–

–

–

33.2

29.9

28.4

Moldova

–

–

–

–

35.7

29.6

30.0

Turkmenistan

–

–

–

–

–

–

–

Ukraine

–

–

–

–

–

28.3

37.5

Uzbekistan

–

–

–

–

38.7

38.9

29.5

EXSR group

–

–

–

–

31.8

28.9

29.5

Russia

–

–

–

–

27.4

22.9

20.0

Source, notes: The series are from IMF: Government Finance Statistics, October 2003, CD-ROM, and for 2005 from WB at http//devdata.worldbank.org/querry, and EBRD at http://www.ebrd.com/country/ sector/econo/stats/sei. See also Bokros and Dethier (1998) and Milanovic (1996) for comparative data on the pre-transition year. Columns 1, 2, 3 refer to the pre-transition year. Column 3 = column 1 – column 2. The expenditure items in column 3 are generally equivalent to those in columns 4 to 7, but not fully comparable.

6.5.5 Public income transfers Turning to distribution issues, SIM countries exhibited relatively low levels of income inequality when compared to other countries. But once they entered transition, the transition countries tended to take over profiles of income distribution typical of other countries at a comparable level of economic development; as was earlier reported in Table 6.3. In spite of the worsening income inequality in the transition countries, the shortfall in the incomes of the lowest income groups to a basic minimum identifiable with poverty was limited, as is shown in Table 6.15. In Russia, for instance, the shortfall concerned about 20 per cent of the population in 1993; the poverty line being defined as $120 per month per capita. The BCEE group had a similar

218 Economic Systems Analysis and Policies

poverty count of 20 per cent.21 In contrast, the EXSR group, which started later with the transition, showed 1993 to be a particularly difficult year with poverty headcount reaching 52 per cent. More recent data on the poverty headcount as measured here for around 2000 shows that this has been appreciably reduced for most and practically eliminated for other transition countries. Other more income demanding measures of the poverty line show poverty incidence in the transition countries at similar or lower levels than in countries at comparable levels of economic development; cf. Milanovic (1996). It is important to note that the notion of involuntary poverty is denied in a communist system that guarantees and provides work and income for all. A negative attitude was held towards the poor, who by implication are persons who do not want to work. These habits of thought tended to survive during transition, and had the effect of minimizing admission of poverty nationally and retarding a systematic approach to measure, monitor, or solve it. The poverty headcount is affected by many factors such as the poverty line income level, and the presence/absence of supporting networks for poverty relief. Next to supporting the poor, there are other needy population groups that fall under income maintenance schemes, which may overlap with the poverty headcount. Such groups are unpaid workers whose factor earnings were delayed or devalued due to budgetary difficulties, the non-earning unemployed, and the unpaid or poorly paid pensioners.How did the system of public income maintenance transfer react to the income redistribution needs of the unpaid workers, the unemployed, and the pensioners? Many ministerial offices in Russia ran out of funds and were unable to pay wages for enterprise workers and government employees working in education, health, and other public services.22 The arrears accumulated causing spending difficulties for many earning households. The responses were in increased home production, using ones’ savings, borrowing, and mutual support from social networks. Delayed payment of wages to workers was only sporadic in other transition countries. As regards income transfers to the unemployed, Table 6.15 shows unemployment rates in most transition countries to have fluctuated around 10 per cent and in some cases stretching towards 15 per cent, but temporarily. Seen in the light of the declines in the GDP, the fall in employment is moderate. The tendency to sharing of employment (and income) in public enterprises, at the cost of an increased underemployment, has been a basic feature of the SIM system that guaranteed employment (and income) for all job seekers. This feature has contributed to the modest rise in unemployment (and poverty). Russia has benefited relatively more from this feature. The closeness of workers to their enterprises and locality, that received special attention and promotion in the communist era, has assured a presence of social networks that offered material support to each other in times of need.23 As for pensioners although delayed and reduced payments in real terms to pensioners was a major problem, yet on the whole, pensioners fared better than other low-income groups in transition economies. Pensioners form a significant portion

State Intensive System: Economic Transitions 219

of the population as can be seen from the elders dependency rate in Table 6.13. Their interest was well taken care of before the pre-transition in some BCEE, where various legislations set the retirement age at 60 and the social security payments at almost half of the average wage. These legislations were not adjusted during transition and came thus to the advantage of the pensioners. Political parties were also eager to satisfy pensioners who have now become an important voting bloc in parliamentary elections during the long transition. The result is that pension payments as a percentage of the GDP remained at levels above 5 per cent and increased a few percentage points towards 9 per cent in BCEE group, 6 per cent in EXSR group, and 7 per cent in Russia. Table 6.15 shows the changing significance of unemployment benefits and other public social transfers versus paid pensions during transition. The proportion of these benefits in the GDP value has remained at about the same rate of 3.3 per cent for the BCEE group, increased somewhat to 2.2 per cent in EXSR and stagnated at 1.7 per cent in Russia. These proportions for unemployment benefits and related poverty transfers compare very poorly with those for pensioners. In global terms, these differences reflect the smaller magnitude of the unemployment problem and the greater influence of pensioners in terms of numbers and voting power. For the individual countries it is noted that where the problems of unemployment and poverty were relatively more severe a relatively greater proportion of public transfers went to unemployment and poverty benefits. This is true for the Baltic countries. Hungary was also relatively more liberal in increasing relative payments towards the unemployed than the pensioned. Looking at public transfers for income maintenance as a whole in the middle of the transition and across country groups, the conclusion is that while BCEE spent about 13 per cent of their GDP in public transfers, EXSR and Russia do not go beyond 8 or 9 per cent. But there are wide variations in the groups with Hungary and Poland leading the BCEE with about 18 per cent of the GDP passing through the state as public transfers. The exceptions in the EXSR group are Kyrgyzstan and Uzbekistan with rates of 16 and 13 per cent. 6.5.6 Size of the public sector in transition countries Comparable data for transition countries on the composition of public spending by items such as provision of public goods and other current and fixed expenditures on economic activities, administration and defence, public transfers for income maintenance, subsidy payments, and interest on the public debt are scarce. But Tables 6.14 and 6.15 give some clue on the composition, though very tentative. If for the period 1995–2005 the share of public spending in the GDP in BCEE can be estimated at about 35 per cent as in Table 6.14, and the share of public transfers (income maintenance) in the GDP can be estimated at 10 per cent, as in Table 6.15, then the total public outlays on exhaustive public expenses and on income transfers together should be reaching around 45 per cent of the GDP. This may be a rough sketch for the transition economies during the long transition. This sketch of the fiscal budget is generally consistent with data on the share of the value added accruing to the public sector in the GDP. The public spending

220

Economic Systems Analysis and Policies

Table 6.15

Needs for and realization of public income transfers in transition countries

Country

Need indicators for public income transfers Poverty headcount share, in per cent

1995 a 2005

Unemployment rate, in per cent

1995

2005

Elders dependency rate, in per cent

1995– 2005

Realized public income transfers to poor, unemployed, elders, etc./GDP Total, in per cent

Supportive benefits in lieu of columns 1–4, in per cent

1987– 1995 1987– 1995 88 88

Pension transfers to elders, in lieu of columns 5, 6, in per cent 1987– 88

1995

Czech Rep.

<1

<2

4

8

31

11.2

10.7

3.2

2.7

8.0

Estonia

41

<2

a10

8

34

10.8

9.8

3.9

4.2

6.9

8.0 5.6

Hungary

2

<2

10

7

34

13.1

17.5

4.1

7.1

9.0

10.4

Latvia

33

<2

a14

9

35

7.4

12.3

1.5

2.7

5.9

9.6

Lithuania

46

<2

a13

8

32

8.3

10.8

1.7

4.0

6.6

6.8 14.8

Poland

19

<2

15

18

26

8.7

17.8

1.6

3.0

7.1

Slovakia

<1

<2

13

17

24

11.3

11.7

3.9

2.1

7.4

9.6

Slovenia

0

<2

7

7

32

11.1

16.3

2.4

3.3

8.7

13.0

Bulgaria

33

<2

17

10

36

11.3

10.4

3.6

0.8

7.7

9.6

Romania

24

<2

a5

7

30

9.4

9.0

5.5

2.2

3.9

6.8

Average BCEE group

19

<2

10

10

31

10.2

12.6

3.1

3.2

7.1

9.4

Belarus

–

<2

3

2

5.7

6.9

0.0

1.4

5.7

5.5

Kazakhstan

50

<2

a11

8

31

5.7

4.7

0.0

0.2

5.7

4.5

Kyrgyzstan

76

<2

4

3

15

10.0

16.2

3.2

9.0

6.8

7.2

Moldova

65

22

–

7

27

7.9

6.2

0.8

0.3

7.1

5.9

Turkmenistan

48

12

11

4.4

4.6

0.4

0.0

4.0

4.6

Ukraine

41

<2

12

7

19

9.5

8.2

1.6

1.1

7.9

7.1

Uzbekistan

29

17

0.3

0.3

9

9.3

12.5

3.9

3.3

5.4

9.2

Average EXSR group

52

8

6

5

10

7.5

8.5

1.4

2.2

6.1

6.3

Russia

21

<2

10

7

18

7.9

8.9

1.7

1.7

6.2

7.2

Sources: Columns 1, 2. Poverty headcount data for years around 1995 are based on a poverty line of $120 per month per capita at 1990 international prices. Poverty headcount data for 2005 are based on a poverty line of $ 1 per day per capita. Source is World Bank at http://devdata.worldbank.org/gmis/mdg/ Goal1.xls; Columns 3, 4. Unemployment rates are from UNECE Statistical Division Database, compiled from national and international (EUROSTAT, OECD, CIS) official sources. Unemployment rates are based on labour force surveys following ILO definition. Observations marked with ‘a’ relate to one or two years around the reported year. Column 5. Elderly dependence rate is defined as population aged 60 plus / population aged 15–59, per cent, Transmonee 2007, database at http://www.unicef-icde.org/ research. Columns 6 to 11. Public income transfers for 1987–88 and closest year to 1995 are reported in Milanovic (1996) p. 192.

State Intensive System: Economic Transitions 221

share and the public sector share are different notions but are complementary in covering the picture. The first share considers exhaustive expenditures and income transfers budgeted and spent by government. The second share views the relative role of the public sector from the production and income sides and considers thus the value added produced and earned by state establishments. The most recent data on public spending shares, Transition Report WB/EBDR (2003), report that the more economically advanced transition countries of BCEE and Russia are in the region of 45–50 per cent. The size of the public spending share in the transition countries of BCEE and Russia is thus as high and tends to be higher than in US, Japan, or EU, that were treated in the FIM chapters (Chapter 4, Table 4.2), while these transition countries have barely more than half of the income per capita that is found in the FIM countries. In terms of normal levels of economic development the public spending share in these transition countries is very high. In spite of the huge privatization and decentralization efforts done towards converting the centrally planned system into a market-oriented economy, a big chunk of the economy is still under the control and auspices of the state. Cutting down the public spending share will require further privatization and significant reductions in the public sector share. Where are the limitations to and possibilities of reductions in public overspending in transition countries? First, the orientation of the spending is inclined more towards exhaustive public expenditures than public income transfers; and this needs to adjust. The public transfers for income maintenance guessed at 10 per cent of the GDP would require increases in the future to meet the rising pensioning needs of an ageing population. A proportion of 15 per cent is more in line with the collective needs.24 This reinforces the need for further cuts in the exhaustive public expenditures. Second, while government allocations to public goods such as health and education are in general lines with what other countries are doing at this stage of development, the introduction of more privatization and user charges in public service would help reduce the oversize of the public sector; besides, as was previously remarked there is scope for introducing cost reducing efficiencies. Third, given the small magnitudes involved, the contribution of a reduction of subsidies and interest on the public debt to a cut in the public share is negligible. Fourth, the answer thus to the question on where the public overspending can be trimmed directs the attention to central government current and capital exhaustive expenditures on economic activities, public services, public administration and law and order. These are also the sectors that create value added for state employees. These sectors were most protected under the past regimes, and many interests of state agents and government employees still hang there. The answer lies also in restructuring the inherited centralized fiscal system in transition countries towards a decentralization of the fiscal budget and a greater role for local administration.

6.6 Systemic inclinations of transition economies Can a SIM country convert totally to a FIM country? And what can be concluded over the transition results for the former Soviet bloc countries?

222

Economic Systems Analysis and Policies

The answer to the first question was treated in our introductory Chapters 1 and 2. Some countries may be able to convert fully if agents are able to move freely between the typical settings of the two systems and the FIM settings prove to be more fruitful than the SIM settings; but other countries may not convert because of barriers. These barriers can be involuntary, or can be voluntarily coordinated by state agents who benefit more from keeping the system in the sphere of a SIM or a quasi-SIM, than from pursuing a FIM or a quasi-FIM course. The answer to the second question involves empirical evidence. This chapter provided empirical support for distinguishing between different transitional responses by (a) the CEEE group of Baltic, Central and Eastern European countries, (b) Russia, and (c) the EXSR group of other ex-Soviet Republics. In relative terms, CEEE is ahead in conversion tendencies from SIM to FIM, helped by their historical background, proximity to EU countries and their eventual integration in the EU. In contrast, the evidence on the transition in Russia shows a re-emergence of influence and privileges for state agents that resembles a quasi-SIM situation. This is predictable given the historical background of Russian polity, the statefavoured monopoly over the country’s rich natural resources, and coordinated barriers by state agents to secure a governing monopoly and distract agents from abandoning the state intensive system. The case of EXSR is mixed. In some EXSR countries there has been a greater tendency to convert and move towards FIM, in other countries which are resource rich the SIM prospers, and there are a few remaining Asian Islamic countries that depict HIM influences. Figure 6.6 gives a graphical sketch of the apparent tendencies among the ex-Soviet bloc countries with respect to the transitional prospects. Of course, these reported tendencies are relative in place and time and are subject to change under influence of external and internal stimulus. Figure 6.6, giving the differentiation among SIM related countries is comparable to Figure 4.7 in Chapter 4 that gives the differentiation among FIM related countries.

FIM

HIM

ExSoviet republics EXSR

SIM

Russia

Figure 6.6

Systemic inclinations of transition countries

Baltic, Central, Eastern Europe CEEE

State Intensive System: Economic Transitions 223

6.7 Summary and conclusions After an examination of the magnitudes and causes of the transitional recession in the ex-Soviet Union and its ex-European associates, we gave a review of transitional reforms and their phasing into what is called short transition and long transition. The decline in the real GDP, measured from 1998 to lowest year of GDP, was smallest in the Baltic, Central and Eastern Europe (BCEE), amounting to 32 per cent, the decline in the ex-Soviet Republics other than Baltic and Russia (EXSR) was higher at 55 per cent. Russia’s GDP decline reached an intermediate position at 47 per cent. In many of the features of the transition and indicators of performance Russia tended to occupy an intermediate position between BCEE and EXSR, or exceeded EXSR in a negative sense. The chapter examined four groups of causes that contribute to an explanation of the magnitudes and course of the recession: statistical distortions, system disorientation, transition policies, and external effects. In the short transition, which has taken from two to three years and for some countries a few years more, reforms and policies focused on liberalization of the product market. Since liberalization reforms in a shortage economy is bound to lead to increased prices and heightened inflationary pressures, the liberalization reforms would have to go hand in hand with the macro economic stabilization of the real supply and demand, the monetary balance, the external balance, and the fiscal balance. Several countries in the BCEE group were more successful than Russia in implementing the short transition, but this is also partly due to the greater external assistance that the BCEE received, which helped them to ease the stabilization of the economy in a shorter period. The long transition was thought to take a decade, just the time required to permit the Baltic and Central European countries to introduce EU-like institutions before acceding to the EU. In practise, the duration of the long transition is taking a longer period. An ex-SIM related country undergoing the long transition is confronted with economic failures that appear also in the FIM related countries. These are economic imperfections due to the presence of indivisibilities, uncertainties, externalities, collectivities, and inequalities. The responses of firms and state settings to these economic challenges are different in the two systems. In contrast to FIM countries where firms orchestrated the remedies, the responses in most of the transition countries reflect a dominance of state interests that is consistent with the assumptions of the state intensive economic system. The chapter examined transition failures due to privatization errors, insider governance, corrupt practices, an extensive shadow economy, and rent seeking by oligarchs and state agents alike. In all these aspects the BCEE group did better than Russia. On some aspects the EXSR scored better than Russia as well. The chapter dealt also with integration of the transition economies in the world economy. Various indicators of global integration showed a greater success of BCEE countries in internalizing the inherited negative externalities of a past closed economy. The EXSR had least success. Russia occupies an intermediate position. The Russian economy, rich in energy resources, has been helped in its global

224 Economic Systems Analysis and Policies

integration by the surge in the world demand for energy and energy prices since 2001; turning it to a major holder of foreign exchange reserves in the world. Finally, in an assessment of the new role of the state, the chapter dealt with knotty problems of public spending. These appear common to all the transition countries. An assessment of demand for exhaustive expenditure (economic and social), and for income transfers (in lieu of unemployment benefits, income maintenance, and pension payments), against current patterns of public spending, showed gaps. Raising the share of public spending in the GDP to meet these demands would elevate the public share to abnormally high levels that do not match with their levels of economic development. The shares of public spending in the GDP in transition countries are already very high. The assessment suggests that public spending – which still reflects elements from the past state intensive political system – needs to become more efficient and undergo restructuring to meet collective demands in competitive surroundings.

7 Economic Systems in the Developing World: Regional Differences

7.1

Introduction

The prevalent view among most economists is that of considering the developing world as a comparable set of individual countries that pass through a common development process, though at different speeds. In this universalistic view, individual developing countries are approached analytically as a continuum of country observations in terms of their national income per capita, rates of economic growth, and related variables. The individual developing economies and polities are seen to change along universalistic development phases that would ultimately bring about higher levels of living and welfare. At the same time, academic interest for the developing world, influenced by policy considerations, has focused more on the individual countries as client cases, studied obstacles the countries faced in the development process, examined solutions, and recommended policies following universalistic recipes. As a result, less attention has gone into identifying and studying particular subsystems of economy and polity in which the individual developing countries can be grouped and positioned on their similarities and differences. Such a differentiated approach takes distance from the universalistic approach. The differentiated approach allows for a generalization of systemic features, and a fruitful search for generalized and common problems, solutions, and policies. While a universalistic view treats individual countries as an investigative set of comparable observations and results in the formulation of hypotheses on development that are subsequently empirically tested and defended on the basis of collapsed data from highly different countries; in contrast, a differentiated approach towards understanding the development process in developing countries is bound to be more historic and regional in scope and would focus more on shared structures of population profiles, information, institutions, and technologies. In considering a more historic and regional scope we have proposed in Chapter 1 to distinguish between six development regions: two Asian regions comprising East Asia and Pacific (EAP) and South Asia (SA) and; two Arab regions comprising the Arab Gulf (GCC) and the Middle East and North Africa (MENA); and the regions of Sub Saharan Africa (SSA) and Latin America and Caribbean (LAC). We 225

226

Economic Systems Analysis and Policies

positioned EAP and SA along the HIM–FIM axis with closer ties to HIM, more so for SA than for EAP. LAC was also positioned along the HIM–FIM axis but closer to FIM. The other three regions are located along the HIM and SIM axis, with SAA closest to HIM, MENA halfway between HIM and SIM, and GCC as an outlier that ties with FIM as well. There are several sets of related questions concerning the development process, and the responses to these questions differed among the six development regions. These questions are listed below. First (a) What are the major historical epochs pertaining to the polity and the economy through which developing countries passed and are passing? (b) For each historical epoch what were the effects on the six developing regions with regard to shaping their social, political, and economic systems and changing the roles and significance of behavioural settings such as of the household, state, and firm? (c) How did the economic systems in the six developing regions perform comparatively with regard to such development objectives as growth and equality? Second (d) The most prominent feature of the development economy being its dualistic structure and performance, what are then the characteristics, magnitudes, and impacts of this dualism in the developing world, and in particular in countries with very large-sized populations in rural areas and where dualism is eminent? Take, for example, China and Indonesia in EAP, and India and Pakistan in SA, where hundred millions people reside in rural areas and pursue traditional modes of employment and production. Can it be reasoned that the structure of the social system, with its economic and polity component systems, and the ways these systems change, are bound to be different in the large-sized population countries than otherwise, and if so, in which ways? Moving from development analysis to development policy what additional insights can development policy give regarding systemic patterns and prospective changes in highly dualistic economic systems? In particular, the question will be treated (e) with regard to macroeconomic development policy, and (f) with respect to microeconomic development policy. This chapter will treat the above topics in corresponding sections. Use will be made of selective country material in demonstrating the points made. The next chapter will focus on the six development regions and on individual countries and will review their changing economic systems.

7.2

Impacting development epochs

7.2.1 Political and economic epochs The developing world, or the South, as it is sometimes called, has passed through historical epochs in the past three to four centuries with endurable influences. The objective of this section is to summarize briefly several major historical epochs of enduring influence on the polity and economy, and to treat questions

The Developing World: Regional Differences

227

as to what are the impacts of these major historical epochs on shaping the social, political, and economic systems in the developing world. In particular, what are the effects of the historical changes on the relative roles of alternative settings, and associated behavioural types, in shaping the system? In our context the major settings of interest are the household, state, and firm settings, as well as traditional and modern settings.1 The relative role of a setting is approximated by the relative participation of agents and the intensity of their interactions in the setting as compared to alternative settings. As the participations and interactions reshuffle, these are accompanied by the redistribution and reorientation of behavioural types characteristic of the settings. Agent mobility results in some settings undergoing a decline in influence while others increasing their influence and concurrently some behavioural types become less frequent and other behavioural types become more frequent and dominant. Furthermore, where a hierarchical relation between settings de velops, the higher placed setting overrules, and its influence increases at the cost of the lower placed setting. We distinguish six historical epochs and speculate on their relative effects on major settings. The historical epochs are (1) Colonial rule, (2) Nation building, (3) Democratic reforms, (4) Demographic transition, (5) Economic Development, and (6) Global integration. Epochs 1, 2, and 3 are loaded with political events; while epochs 4, 5, and 6 are more driven by economic forces. Table 7.1 reflects on the most likely consequences of these epochs, the table shows which settings

Table 7.1 Historical epochs and their effects on major settings in the development process Development epochs

Traditional settings (i.e. rural, informal) House hold settings

State settings

Firm settings

Modern settings (i.e. urban, formal) House hold settings

State settings

Firm settings

––

+

+

–

++

–

Political epochs 1 Colonial rule 2 Nation building 3 Democratic reforms

–

–

+

–

–

+

+/–

+

+

+/–

+

+

5 State-led economic development

–

+

––

+

+

6 Firm-led global integration

–

–

+/–

+

Economic epochs 4 Household-led demographic transition

+

228 Economic Systems Analysis and Policies

have been strengthened, indicated by a plus sign, and which settings have been weakened, indicated by a minus sign. 7.2.2 Colonial rule Reference to the character of the colonial period and its impact on the colonized world regions cannot be done without referring to the history and practices of the colonizing agents. And, above all, the history and practices differed by colonizer and impacted world regions. Although the European colonization was driven by various motivations such as political, economic, religious, and discovery urges, the colonization history passed through many different processes, experiments, and adaptations in the different impacted regions. The resulting configurations are greatly determined by the different initial conditions present in the impacted regions. Climatic conditions, resource endowments, and geographical location of the host country, as well as the colonial resistance, cultural remoteness, and cheer numbers of the host population in relation to the colonial power have all played central roles in determining which configuration was realized in which country. The resulting colonial configurations between the colonizer and the impacted country can be described to have evolved over time towards four forms that ranged from (a) a fully absorbed commonwealth country, to (b) settled colonies, (c) occupied colonies, and (d) loosely linked strategic relationships with autonomous regions. The four forms will be described at more length, and with examples. To start with, (a) There are the fully absorbed commonwealth countries, such as US, Canada, and Australia. Very large European migrations took place to these countries, allowing them to form, in a relatively short time, the over majority of the total population. Soon afterwards, they went for nationhood and independence in the seventeenth and eighteenth centuries; and remained closely affiliated to their European ancestors and institutions. Ultimately, most Europe, and the newer countries of US, Canada, and Australia have come to share a common heritage with many similarities in their social, political, and economic systems. (b) There are the regions settled by migrants, and supported by armies, but nevertheless with substantial native populations working in mining and plantations, and residing in rural areas, such as in Latin America. The colonial epoch in these countries manifested regular conflicts between settlers and their descendants and the native population, leading to militant actions. Realization of nationhood and independence in these countries took more time to mature, i.e. in the nineteenth century. Understandably, the impact of European institutions on the socio-political and economic systems of theses countries is less than in the case of countries in category (a). (c) The third category took the form of army-occupied and annexed colonies and applied to many countries in Asia and Africa. There was no permanent role for colonial settlers, instead there were relatively limited numbers of foreign soldiers and related officials who maintained the colonial rule. Colonization took place later in time in this category, and consequently, national leadership and demands for independence took more years to develop. The colonial epoch endured longer

The Developing World: Regional Differences

229

in this category than in the other categories, and the accomplishment of political independence was mostly accompanied with resistance and wars of liberation. Where pockets of colonial settlers existed the armed struggle was heavier. In general, the transfer of European institutions has been much more limited in this category than in the other categories above, which is understandable in terms of both the initial conditions in the colonized countries that were not particularly receptive to colonial rule, and the low level of investment effort made by the colonizer. The two aspects are mutually reinforcing. The impact of the colonial epoch and colonial institutions on the social systems of the host countries in this category should not be overestimated, therefore. The systemic impact of the colonial epoch in case (c) is thus much less than in cases (b) or (a). (d) Finally, relationships of a more calculative nature emerged between the colonial powers and several autonomous countries that maintained their political independence throughout. Here one can include such bigger countries as Japan and China, and also smaller and distanced Islamic countries such as Iran and the Arab peninsula. The colonial powers and the above-mentioned countries stood culturally, ethnically, and religiously very remote from each other to sustain a relationship other than that of strategic interest. Besides, the sizes, densities, histories, and cultures of the populations in these countries would exclude the introduction of colonial rule. Hence, the systemic impact of the colonial epoch is least in category (d). It is somewhat striking that in spite of the absence of a colonized history in these countries, their economic systems have undergone more fundamental changes than others due to other historical interactions such as the global integration of Japan, the communist revolution in China, and oil discovery in the Middle East and the Arab Peninsula. The impact of the colonial epoch on the socio-political-economic systems of the host countries was in no way uniform. Focusing on the developing world, we have argued above that the colonial epoch had its largest impact on host countries in category (b), much less in (c), and very least in (d). Furthermore, it can be stated that in most host countries, there was likely more interaction between the colonial rule and the modern segment in the host countries, with only some, little, or no interaction with the traditional segment, depending on the country category. Table 7.1 gives an indication of the above effects. Colonial rule carried a bias against the traditional and in favour of the modern. The traditional surroundings, undergoing little or no change, continued to centre in household settings in rural areas as they used to be for centuries. At the same time, some young people left the traditional (rural/formal segments) and joined the modern (urban/formal segments). In the modern surroundings the significance of household settings in establishing and maintaining behavioural rules deteriorated as interactions in state and firm settings grew more. The small elite groups managed to exit the traditional settings, enter schools, occupy leading positions in their communities, communicate, and interact with the modern world. The select elites were able to transform themselves, partly through skill mobilizations set into motion by the colonial regimes and partly through making use of their own inborn capabilities and kinship support. The select elites became the dominating actors in the next

230 Economic Systems Analysis and Policies

phases of nationhood, economic development, and global integration. Faced with similar challenges some common responses of the select elites emerged. This does not deny that having different profiles across the developing world the leading elites gave different shapes to the development of these phases in their respective countries. The emphasis below will be more on the common responses than on the differences. 7.2.3 Nation building Colonial rule had to give way to national independence. With the advent of national independence, in one country after another, political authority was transferred from colonial powers to national governments guarded by elite leaders. In contrast to the colonial period that stretched over centuries, the nationhood phase was a matter of a few decades only and likely with a greater impact on the social systems in most developing regions. Already in the colonial period political authority was gradually transferred to national elite leaders. Independence opened more opportunities for the national elite leaders and state settings, as defenders of national independence, identity, and integration. State settings increased their roles as focal points of interaction and as overriding authorities in shaping the social system. Notwithstanding, in many of the newly independent countries, the new political order was subsequently followed by challenges to these state roles in the form of civil divides and violent revolts. The actual effects of the civil divides on the significance of the state in its double roles appear to be mixed. The state gained influence in some countries and lost influence in other countries. Where it applied, the first national governments of newly independent nations faced the complicated task of nation building in the context of highly diversified population groups, destined to increase further in diversity as social and economic change intensifies. National independence, identity, and integration, usually described as nation building, was the driving force for the first round of governments in the countries concerned. During this round a significant role was created for the state. This happened via reorganization and creation of centralized governmental institutions and civil and administrative rules, an extension of the bureaucracy to assist and control, assignment of prominent roles for police and military defence capabilities, using media in focalizing the state and state officials, and emphasis on national sentiment and allegiance to the nation state. In some countries, these state actions generated counteracting forces that contradicted the very nature of nation building. Civil divides are caused by one or more of the following: ethnic exclusion, powerful military institutions, and interest groups caught in rivalries and collusions to realize their power potential, individual rulers clashing with each other or against popular aspirations for more democracy, and ideological confrontations. While these forces may increase the influence of the state in the short run they tend to weaken the focalizing of the state in the longer run. Running a government requires appointing officials that can be trusted. In the development context, these were often recruited from the networks of

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231

ethnic groups, regions, and kinships to which the political leaders belonged. 2 Not only the distribution of political positions but also the funding of development schemes and the allocation of rich licenses reflected the ethnic and regional divides. Sooner or later this was bound to lead to an intensification of ethnic divides. It is natural, therefore, that in some countries, the first rounds of national governments were challenged by political leaders from excluded networks of ethnic groups, kinships, sects, or regions. In the Asian region the foremost examples are in Sri Lanka, and the split up of Pakistan. Ethnic exclusion has been a major cause of civil violence in the Middle East with foremost examples being Iraq and Sudan. In some African countries, i.e. Nigeria, Burundi, Congo, Rwanda, this type of conflict led to civil violence and in some cases to civil war with winning and losing groups. It can be postulated that state institutions must have increased their influence among the winning networks and reduced their influence among the losing networks. In most countries, the nation building period led to the institution of strong military defence forces; and to the strengthening of interest groups based on big land ownership, business, industry, religious, and intellectual leaderships. The interest groups prospered and exercised increasing influence on their governments via informal or via parliamentary channels if present, resulting in many cases in vacuums of political leadership that could be filled only by an authoritarian military apparatus. Thus, many developing countries were governed by a military regime for some time, manifesting features of kleptocracy and the personal military ruler.3 The military rulers not only tended to suppress some interest groups but also relied on working together with other interest groups, in a divide and rule manner. Numerous examples can be given of shifting coalitions between the military rulers and interest groups. This contributed to the focalizing of state settings at the cost of other settings. Military regimes are not permanent, however. The military leadership can be peacefully transformed into a civil leadership,4 and legitimized by electoral vote. The alternative is mostly an instable cycle of military successions that can develop in civil unrest or ethnic wars. In some countries successions of military leaderships faced regular clashes with popular calls for stepping down, i.e. Myanmar and Pakistan in Asia, and Congo, Ghana, Ivory Coast, and Nigeria in Africa. In other countries the military disintegrated and collided with affiliated ethnic groups in self-defence or in search of dominance over others, i.e. Afghanistan, Cambodia in Asia, and Angola, Liberia, Mozambique and Somalia in Africa. These countries experienced substantial violence, and likely, in the longer run a reduction in the institutional influence of the state. It is also likely that the heavy violence was highly disruptive for household and firm settings. Finally, ideological confrontations between conformists and reformers disrupted the stability of national governments in the developing world and tended to have mixed effects on the focalizing of the state in the system. The confrontations between a ‘capitalist’ and a ‘socialist’ ideology were often reinforced by foreign military support in the context of the cold war, and this led to greater

232 Economic Systems Analysis and Policies

casualties, such as in North Korea and Vietnam. Countries handicapped by violent rightist–leftist confrontations included Laos, Nepal, Philippines, Yemen, Angola, and Mozambique, among others. The other major ideological confrontation is that between a fundamentalist and a modernist interpretation of Islam. This is a major challenge to governments in the MENA region, and in Asian countries with Islamic fundamentalist minorities.5 The political instabilities were reinforced by the fact that many countries of the third world are home to large diversities of population groups in terms of ethnicity, languages, classes, living conditions, modern knowledge, and many other identity attributes. In general, while the distribution of power associated with these balances tended to be relatively stable for long periods in the past, destabilizations in the balance of power occurred during the five decades of nation building. This was inevitable as the countries became more open to world events and external exchanges than they used to be and started facing unprecedented global changes in many aspects of life. This turned the nationhood phase in some countries into a difficult period of factionalism, disunity, and mounting violence. In some of the most affected countries, regaining of unity and stability required many years of voluntary and directed interaction between diverse factions to resume sharing of common characteristics for the population as a whole. The degree of instability in the nationhood phase varied significantly in the various developing regions, when civil war casualties are considered as a proxy measure of instability.6 This is borne out in Table 7.2, which shows civil wars casualties for the period 1945–2003. In absolute terms, regions and countries with largest populations such as in the Asian regions show high casualties, but when casualties are expressed in relative terms, per 1000 inhabitants of the year 2000, a different picture is obtained. SA shows lowest relative casualties of about 1 person per 1000. EAP is higher at about 4.7 per 1000. MENA occupies an intermediate position with about 1.9 casualties per 1000, with Iraq as leader in civil war casualties, with 7.1 casualties per 1000. Although there are no figures for the GCC these must be very low in view of the political stability of this region. Sub Saharan Africa appears to be the most instable region with casualties of about 9 millions over five decades related to a total population in 2000 of about 660 millions, giving casualties of about 13 persons per 1000 of the population. In the SSA region, figures show Nigeria as highest, with 2.2 millions casualties and a relative figure of 17 casualties per 1000. Table 7.2 gives also casualty figures as a result of foreign wars. The origins of these wars are diverse. Some were liberation wars that occurred towards the end of the colonial rule, such as in Ethiopia and Algeria. Some were inflamed by the cold war such as in Korea and Vietnam. And some were between bordering countries such as the Iraq–Iran war. Although national governments were installed in Latin America about a century earlier than for other regions, similar periods of nation building and civil divides followed each other and were caused by ideological confrontations based on uneven endowments between the ‘haves’ and ‘have-nots’, empowered at a

The Developing World: Regional Differences Table 7.2

233

War casualties in the developing countries

Civil wars 1945–2003 War casualties in whole region {Millions} [casualties per 1000 persons]

Region

Country with highest war casualties (a) {Millions} [casualties per 1000 persons]

Foreign wars 1945–2003 War casualties in whole region, {Millions} [casualties per 1000 persons]

Country with highest war casualties (b) {Millions}

{8.45}, [4.7]

China {3.19}, [2.5]

East Asia, Pacific (EAP)

{5.94}, [3.3]

Korea {3.00}

{1.24}, [0.9]

India {1.10}, [1.1]

South Asia (SA)

{2.04}, [1.8]

Afghanistan {1.01}

(c)

–

(c)

–

Arab Gulf (GCC)

{0.53}, [1.9]

Iraq {0.18}, [7.1]

M. East, N. Africa (MENA)

{1.79}, [6.5]

Algeria {1.00}

{8.77}, [13.2]

Nigeria {2.02}, [17.1]

Sub Saharan Africa (SSA)

{1.07}, [1.6]

Ethiopia {0.85}

{0.67}, [1.3]

Colombia {0.30}, [7.1] L. America, Caribbean (LAC)

68

Total number of countries

{0.01}, [0.02]

Honduras {0.006}

36

Source, note: Raw country data on war casualties are found in the database of the Centre for Systemic Peace, University of Maryland, at http://members.aol.com/cspmgm/warlist.htm. We aggregated war casualty figures into the regional groups. To obtain casualties per 1000 persons of the average population we use the population figures by region for 2000, shown in table 7.4. (a) = The displayed top five regional countries are followed by the following regional countries respectively: Cambodia, Sri Lanka, Iran, Congo, and Guatemala. (b) = The displayed top five regional countries are followed by the following regional countries respectively: Vietnam, Bangladesh, Iraq-Iran war, Angola, and Argentina-UK war. (c) = casualties virtually absent.

later stage by powerful interest groups in drug production and trafficking.7 It is generally true that the ideological camps of capitalists versus socialists, rightist versus leftist, and modernists versus fundamentalists, tend to coincide with the ‘haves’ versus the ‘have-nots’, respectively. In this respect, the distribution of endowments in the social system is crucial for understanding the stability and unity of the system. LAC shows low relative casualties of 1.3 per 1000 persons. In the LAC region Colombia had highest casualties. War casualties due to foreign wars were also least significant in LAC. Honduras was leading. 7.2.4 Democratic reforms Recently more countries have adopted parliamentary elections and majority rules, these being political solutions that are the most logical if violence is to be avoided in reaching political compromises between different factions. As Table 7.3 shows the share of authoritarian regimes has declined from 73 to 31 per cent, while the share of multiparty democracies increased from 15 to 53 per cent. By the turn of the century the shift towards democratic institutions is seen to be highest in the Latin American region, followed by the Asian, African, and Arab regions. What are the implications of the democratization tendencies for the relative dominance of alternative settings? No a priori answers can be given. A more democratic rule can shift focus from the state to individuals but this is conditional on

234 Economic Systems Analysis and Policies Table 7.3

Political regimes in the developing regions

Region

Authoritarian rule, % of countries in region 1982

2000

Restricted parliament, % of countries in region

Multiparty democracy, % of countries in region

Total

1982

2000

1982

2000

1982

2000

East Asia, Pacific (EAP)

67

38

14

10

19

52

100

100

South Asia (SA)

72

58

14

28

14

14

100

100

100

100

Arab Gulf (GCC) (a) M. East, N. Africa (MENA)

88

65

12

24

0

11

100

100

Sub Saharan Africa (SSA)

84

30

7

23

9

46

100

100

L. America, Caribbean (LAC)

88

5

6

5

6

91

100

100

Total number of countries

74

31

13

17

15

53

102

102

Source, note: Regional distributions of political regimes are aggregated and calculated in accordance with our regional classification from country data in Kidron and Smith (1983), for 1982, and from Freedom House (2000), for 2000. (a) = Our estimate, GCC is not documented but the region can be best described in 1982 and 2000 as having authoritarian rule.

the presence of many other social institutions with a controlling function on the state. As many of these state-controlling institutions are not yet there the impact of the democratization tendencies on the settings and configuration of the system is likely to be minor. Furthermore, the genuine practice of political rights is likely to be more prevalent in formal/urban settings than in rural/informal settings where, in general, more population is located. As was stated before, interactions and changes in the social system were much heavier in the nationhood period than in the colonial period. But, was the nationhood period different than the colonial period with respect to a promodern bias and a less focus on traditional settings? The main concern of the leadership in the nationhood period was political and the major population groups affected belonged to modern settings with urban/formal locations. The systemic changes that occurred in the nationhood period are likely to be concentrated in the modern settings and be characterized by a shift of focus from household and firm settings to state settings, while the traditional settings remain marginally affected. The impact of the more recent democratization drives on the system configurations are also likely to occur along the same lines. 7.2.5 Household-led demographic transition Demographic transition refers to the transition from high birth and death rates to low birth and death rates in the process of economic development. Works on the Demographic Transition Model (DTM), due in 1929 to Warren Thompson, and

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235

elaborated by many others,8 explained population growth and its changing composition relatively well in developed countries over the past two centuries. Demographic transition theory applies also generally to the developing regions of the present world. The initially high death rates decline significantly due to better hygiene and nutrition and improvements in well-being that accompany economic development. With birth rates remaining high, causing relatively younger populations and hence raising fertility further, and with death rates declining, the rate of population growth accelerates and reaches a peak. In due course, as households move from rural to urban areas, and become subjected to modernization, education, emancipation, rising incomes, and considerations of opportunity cost, the reproduction behaviour of households changes towards smaller size families; and thus causing birth rates to decline. The growth rate of the population retreats then gradually from its peak and tends in the long run towards a replacement rate. Although the DTM generally applies, the past demographic transition of the developed countries differs from the current demographic transition of the developing countries due to different encountered circumstances. Economic development of the developed countries, which happen to possess a firm intensive economic system, was spread over two to three centuries, the initial populations were relatively small, the urbanization was gradual and became evenly spread and standard for practically all households. In the economic analysis of developed countries it is commonplace to speak of the representative household as an urban/modern household, as the extent of rural/traditional households is very tiny. This stands in contrast with developing countries where there are distinctively rural/traditional households in significant numbers, separate from urban/ modern households. The rural/traditional are in an early phase of reproductive behaviour and demographic transition, the urban/modern households are in a later phase. The composition of the population between these dual households changes in the economic development process.9 Hence, the average death, birth, and population growth rates are better seen as the result of a changing mix between opposite types of reproductive behaviour than that of the representative household. Rates of population growth and their peaks in the developing regions are displayed next to trends in urbanization in Table 7.4. As Table 7.4 shows, the demographic transition in developing countries is squeezed into a handful decades, implying historically more significant and abrupt declines in reproductive household behaviour. The trend towards a smaller family size has been accelerated by government interventions in favour of birth control in countries like China and India, among others; which contribute to explaining an early peak 1965–70 at a low population growth rate in EAP and SA, 2.47 to 2.35 per cent per year; as compared to MENA and SSA where birth control was discouraged because of cultural and religious objections, leading to a delayed peak, 1980–85, and at a higher population growth rate of 2.87 to 2.93. The case of LAC is different. Table 7.4 shows that although the peak was reached in LAC in 1960–65, and the region is characterized by the highest urbanization rate, the population growth rate remained at higher levels than would have been

236

Economic Systems Analysis and Policies

Table 7.4

Developing regions: Population and urbanization trends

Population millions

Population annual growth rate, %

Region

2000

1950–55 Highest 2000–05 2025–30 period (b) (a)

Urbanization rate, % 1950

2000

2030 (b)

1806

1.98

2.47

1.28

0.62

East Asia, Pacific (EAP)

14.2

37.0

60.9

1351

2.05

2.35

1.63

0.92

South Asia (SA)

16.5

27.3

42.9

30

3.64

7.26

3.56

1.34

Arab Gulf (GCC)

48.3

81.0

89.6

276

2.50

2.87

1.91

1.17

M. East, N. Africa (MENA)

26.7

55.6

68.1

663

2.18

2.93

2.28

1.82

S. Saharan Africa (SSA)

11.2

32.9

48.3

515

2.65

2.75

1.42

0.73

L. America, Caribbean (LAC)

42.0

75.2

84.3

Source, note: First column giving population is from World Bank Indicators Database, April 2007, at http:// home.developmentgateway.org. Other columns are from UN Population Division, World Urbanization prospects: The 2005 Revision, at (http://www.un.org/esa/population/unpop.htm). (a) = Highest periods were 1965–70 for SA and EAP, 1980–85 for SSA and MENA, and 1960–65 for LAC. The highest period for GCC is 1970–75, caused by a high inmigration. (b) = projections.

expected. This is mainly due to religious objections that discourage birth control. As for the GCC region, the population growth of most countries here is more dependent on foreign migration than natural demographic growth. 7.2.6 State-led economic development Demographic pressure and low incomes in developing countries were ingredients in building up the desire for a speedy economic development. Immediately following national independence, the governing elite groups led their nations in a drive towards greater economic development and higher levels of well-being. Rich countries joined in the effort. The agendas of the specialized United Nations organizations in the 1950s and the next three to four decades reflected this preoccupation with the economic development of the developing world. Development planners, policy advisors, economists, and statisticians played an important role in defining and formulating five year economic development plans, strategies, policies, and spending programmes. Some common views emerged on the macro and micro prerequisites for a speedy economic development; these were influential and were implemented. In a nutshell, economic development required structural transformation from an agricultural into an industrializing economy, and from a closed to an open economy, with due attention to both the enhancement of agriculture and of building viable industries capable of becoming net exporters in competitive world markets. The structural transformation required raising and upgrading the factors of production of capital and labour to assure a greater production on the supply side, and an expansion of purchasing power to assure an equal balance on the demand side. Since resources of

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237

most developing countries were insufficient to meet these requirements, reliance on foreign assistance and foreign markets is required. The extent of realization of these requirements differed among the countries resulting into differentiated degrees of success of economic development. The successful implementation of the above requirements required active intervention by the newly installed states in the developing world. Some agents had to take the lead in initiating and managing the complex economic development process. Because the business sector in the 1950s was still relatively undeveloped, the state had to assume the responsibility of formulating development plans, financing and implementing them, next to implementing regulatory measures. As the capability of the private sector would increase during the economic development process the engagement of the public sector could then be phased out. Where the public sector did not withdraw in time and/or public mismanagement of economic development occurred, this has led to inflation and recession. The correction of such crises situations required implementing strict stabilization and structural adjustment programmes. We shall review the various requirements of economic development, the manners they were realized, and the division of labour between firms and the state that has emerged in the process. Next to a few basic common responses, there were also varying responses in the different developing regions that will be reviewed. It is well established that economic development is commensurate with the reallocation of resources from the low productivity agriculture to the highproductivity industry. Strategies for applying this structural transformation in developing countries were elaborated and followed.10 They focused on the low, zero, or negative marginal productivity of labour in agriculture. Removal of labour from agriculture to industry will not hurt agriculture and will moderate the wage rate in industry and attract industrial investment. The transformation from agriculture to industry was seen to require a shift of labour and capital (forced savings) from the first to the second sector. Building an industrial infrastructure and providing industrial capital requires taking capital (either voluntarily or via forced savings) away from agriculture and invest them in industry. When the capital is channelled voluntarily this would imply that rich landholders will from now get involved in industrial investments. When the channel is that of forced savings, this can be done centrally via state nationalization of agriculture, like in China, or in decentralized ways via tax levies and via state boards purchasing agricultural crops from farm producers at lower prices and selling at higher prices, like in India and other developing countries; the proceeds are then invested by the state in the development of industry. Because rich landholders in most developing countries at the time were not well prepared or willing for industrial entrepreneurship, this meant that the state had to take the responsibility of collecting forced savings from agriculture and investing them in industry. Once the analysis descends from aggregate shifts of labour and capital to specific forms of labour and capital that are required for the structural transformation it becomes clear that the opening up of the closed economy, and an outward orientation, is a prerequisite for sustained development. Industrial development

238 Economic Systems Analysis and Policies

requires technological skills, the installation and running of capital goods with embodied modern technologies and know-how, and a large range of intermediate goods that are not available domestically. All these have to be imported and paid for in foreign exchange. Exporting is the way to obtain foreign exchange and it is sustainable if the composition of exports reflects the comparative advantages of the developing country. Of course, foreign aid can supplement exports for some time, but the essence is expanding exports, and a key instrument here is an export promotion policy by the state. To allow the infant industry a chance of survival and to capitalize on its long-term comparative advantage, another key instrument is introduction of some initial protection and import substitution policies by the state. The striking of a balance between incentives for export promotion and import substitution, which generates high levels of net foreign exchange, is a major challenge for the state’s management of economic development. In principle, import protection and foreign trade regulations are supposed to be temporary and are to be phased out as the concerned industry realizes its comparative export advantage. The regulations were phased out in time in some countries, especially in some countries in LAC and in EAP in the 1970s and 1980s, and thus allowing their firms to shift to an export expansion phase. The regulations were prolonged but eventually reduced in the 1990s as in China and India.11 With a few exceptions, foreign trade regulations still exist in countries of MENA and SSA. Economic development requirements and policies to meet them were elaborated further beyond those of structural transformation and outward orientation. In particular, we review below important policy details for agriculture and industry, and their implementation in the developing regions. In countries where the state implementation of development policies went astray and a crises situation emerged, internationally guided structural adjustments were introduced. With respect to agriculture it was evident that given its low yield per acre, its production and export capacity are far below the levels of foreign exchange needed for industrialization purposes. Furthermore, in domestic terms, agriculture was unable to feed the unexpected rapid surge in the population in many developing countries. Surplus labour could be only generated if agriculture would become more productive and remunerative. Attention was directed to productivity and remuneration enhancing measures such as land reform and the green revolution, which were supposed to specially benefit such target groups as poorer peasants and small farmers, and relieve more workers for work elsewhere. Such benefits would materialize if the governments in charge are popular and committed to such policies, and if the institutional arrangements that exist are not biased against the target groups. As it has turned out in the SA region, particularly in India, land reform and the introduction of new varieties of seeds and cultivation evolved in unexpected ways and had unintended consequences. Although plans and schemes of land reform targeted a significant redistribution of land from large landowners to landless farmers and small landowners, the actual implementation was very marginal in a country where large landowners were politically strong and in a position to overpower the ‘soft state’.12 At the same time, the

The Developing World: Regional Differences

239

green revolution brought higher productivity to large landowners, elevated the price of cultivated land, and led to more landless farmers and urban migration. In the EAP region, particularly in China, the opposite took place. A strong state was able to break down the concentration of land ownership, even though it took the state many years of experimentation with the status and organization of land ownership before settling at a mixture between private and community ownership. The benefits of the introduction of new varieties of seeds and cultivation were also more equally shared. With respect to industry it was accepted by policy advisors that a take-off required next to skill formation and capital deepening, an investment programme across all industrial sectors that makes use of industrial linkages and economies of scale. There are many positive externalities that could be simultaneously exploited, design and implement a big push, and achieve an early takeoff.13 Such investment programmes have to be well timed and coordinated by well-informed economic agents. Given the initial backlog of the business sector in developing countries in the advent of the economic development epoch, next to the widespread existence of indivisibilities, uncertainties, externalities, and collectivities, the situation at the time can best be described as that of absence of relevant markets for initiating development. It was generally recognized that the developing world did not posses sufficient business resources or initiatives to engage in the risky and intricate investment programmes of economic development. Furthermore, given the small size of the domestic market and if the advantages of economies of scale are to be exploited, an export orientation of the industrial output is necessary. These arguments justified an extended interpretation of the role of the state, beyond policy incentives, that allowed the state to own, build, and run significant portions of the industrial sector. Many of these actions could be justified at the time as rational state responses to market failures, on the expectation that once established and well operating such state enterprises can be shifted in time and sold to the private sector. Under increased national and international pressure to liberalize the economies, privatization was implemented and is being realized in varying degrees in many developing countries, but it still remains true that state enterprises dominate major industries in as many other developing countries.14 Another requirement that increased the authority of state agents was the import protection of infant industries, referred to earlier. In relative terms, EAP, SA, and LAC can be described as retreating from foreign trade regulations, in contrast to MENA and SSA where they still exist. The conclusion that can be drawn on the differentiated state policies in the developing world is that in all countries the state played an imminent role in initiating the economic development process, and tended to retreat in a later phase of development, but in very different tempos. In some countries of EAP, SA, and LAC, the state retreated from public entrepreneurship, reduced regulations, and introduced liberalization, just in time to allow private firms to compete globally in open economies. Other countries, especially in MENA and SSA, were slower in liberalizing their economies. Economic growth did much better in the more liberalizing countries than in the less liberalizing countries.15 Worse for

240

Economic Systems Analysis and Policies

the latter, especially for many SSA countries, with overextended public sectors and regulations, encountered in the 1980s increasing problems in reducing inflation, avoiding recession, and balancing their state budgets and foreign payments. Furthermore, faced with increased oil prices the SSA experienced a fall in its GNP by about a quarter between 1980 and 1990.16 To fix matters for a troubled economy the International Monetary Fund (IMF) prepared in the 1980s a structural adjustment package (SAP) consisting of two components: stabilization and market liberalization with public sector reforms. SAP can be seen as the forerunner of the stabilization and liberalization measures that were proposed and implemented a decade later in the transition countries.17 To reduce inflation stabilization measures included controlling wages and raising the interest rate. To balance the state budget the measures included raising taxes, cutting expenditures, and real financing of budget deficits. To stabilize the foreign payments balance the measures included devaluation of overvalued exchange rates, to raise exports and reduce imports, and restructuring foreign debts. Liberalization measures required freeing prices in the product and factor markets, both domestically (abolition of subsidized prices) and in foreign trade (abolition of import quotas, tariffs, licenses); eliminating the monopoly of pricing boards in agriculture; and eliminating bailing out of unprofitable firms and projects in industry. As stabilization may lead to economic recession, the SAP accommodated for conditional funding of encountered financial gaps. About half of the SAPs were in support of the SSA region, the other half in other developing regions. The economic performance of countries that implemented the SAP improved, but in some cases the packages increased poverty. This was a reason for the IMF and WB to require assisted countries to develop poverty reduction strategies, and incorporate corrective measures in their assistance programmes. The issue of the impact of state-led economic development on the mixture of household, firm, and state settings and the shaping of the economic and political system can be addressed now in Table 7.5. Table 7.5 shows results of the structural transformation in terms of the distribution of economic agents (the labour force) and the value added generated in the three sectors of agriculture, industry, and services. A reallocation of agents and value added from agriculture that is mainly household based and rural to industry that is mainly firm based and urban, is a strengthening of firm settings and profit maximization behaviour at the cost of household settings and income sharing behaviour. The regional estimates in Table 7.5 show that the reallocation of agents from agriculture to industry and services over five decades ranged from 16 to 31 percentage points in EAP and SA, resulting in a concentration of about half the agents in agriculture in the year 2000, i.e. 45 per cent in EAP and 55 per cent in SA. In terms of the transformed GDP, the reductions in the share of agriculture in the GDP amounted to 26 per cent in both EAP and SA, bringing the share of agriculture in GDP in the year 2000 to 15 and 24 per cent in SA and EAP, respectively; the rest going to industry and services.

The Developing World: Regional Differences Table 7.5 Region

241

Developing regions: Changing concentrations of agents and GDP Distribution of employment, %

Distribution of GDP, %

Agriculture

Industry

Services

Agriculture

Industry

Services

EAP 1950 2000

76 47

7 17

23 36

41 15

25 45

34 40

SA 1950 2000

71 55

10 16

29 29

50 24

19 26

31 50

GCC 1950 2000

– 7

– 21

– 72

– 3

– 57

– 40

MENA 1950 2000

64 30

12 22

24 48

50 12

17 44

33 44

SSA 1950 2000

– 61

– 11

– 28

44 18

18 31

38 51

LAC 1950 2000

50 22

22 24

28 54

22 7

30 30

49 63

Source, note: World Bank at http://home.developmentgateway.org/cg/country-gateways/ dataandstatistics.do. Regional figures are averages of covered countries, which are fairly representative and complete.

How to interpret these figures in terms of the relative dominance of household and firm settings? What is the effect of economic development on the relative strengths of these two settings? It is generally recognized that while there is a high correlation and overlap between settings relating to households and agriculture (the household mode of production dominates agriculture), and similarly between settings relating to firms and industry (the firm mode of production dominates industry); in contrast, the units producing services in developing countries is a mixture of (a) informally operating households that rely mostly on self-employed and family workers, and (b) formally operating firms that maximize profit and where the mode of employment is that of employer–employee. Section 7.4 of this chapter elaborates on the size of (a) and (b). Rough estimates for the developing world suggest that the over majority of agents in services are found in the informal household settings relating to (a) and a minority in formal services relating to (b). On the other hand, due to productivity differentials the generated GDP per agent in the formal services is higher than in the informal services. The above gives ground for splitting the strength of agent interaction in services evenly or proportionately between (a) and (b), that is to say, households and firms, approximated here by agriculture and industry, respectively.

242 Economic Systems Analysis and Policies Table 7.6 Developing regions: Indicators of the relative dominance of agriculture/ household settings versus industry/firm settings, 2000 Region

Concentration of agents %

Agriculture/ household settings

Concentration of GDP %

Industry/ firm settings

Agriculture/ household settings

Industry/ firm settings

Indicative ratios of the relative strength of household settings to firm settings, % Agriculture/ household settings

Industry/ firm settings 51.0

EAP

73

27

25

75

49.0

SA

77

23

48

52

62.5

37.5

GCC

26

76

5

95

15.5

84.5

MENA

55

45

21

79

38.0

62.0

SSA

85

15

37

63

61.0

39.0

LAC

48

52

19

81

33.5

66.5

Source: Columns 1, 2 and 3, 4 are calculated from Table 7.5 on the basis of relative shares of agriculture and industry in the total sum of agriculture and industry. Columns 5 and 6 are derived from columns 1, 2 and 3, 4. For example, the relative strength of household settings in EAP is given by the average combined concentration of agents and GDP in agriculture (73 + 25) = 49. The result for firm settings follows directly at 51.

We distributed agent presence and transformed GDP in services proportionately,18 thus obtaining columns 1, 2 and 3, 4 in Table 7.6. We have postulated in Chapter 1 that the relative distribution of agents and the relative distribution of transformed value added in competing settings determine the dominant setting. We suggested starting in a preliminary way with assuming equal weights for these two relative distributions. By applying equal weights to columns 1 and 3 of Table 7.6, the percentages of the combined concentration of agents and GDP in 2000 in agriculture (proxy for household settings) are obtained. Doing the same for columns 2 and 4 gives the percentages of the combined concentration of agents and GDP in 2000 in industry (proxy for firm settings). The outcomes give an indication of the dominance of household settings relative to firm settings, or the opposite, in the economic system. The following indicative ratios of the relative strength of household settings to firm settings for year 2000 were found. EAP = 49%:51%; SA = 63%:37%; GCC = 15%:85%; MENA = 38%:62%; SSA = 61%:39%; and LAC = 33%:67%. We have used the term Index of Interactive Influence , see Chapter 2, Section 2.5, equation 4, to describe the above mentioned indicative ratios. The index incorporates for each competing setting the two arguments of the relative share of agents and the relative share of transformed commodities. The index highlights the relative influence and dominance of the competing settings against each other. The results show that agent interactions in household settings are strongest in the SA and SSA regions and are reduced in favour of firm settings as one proceeds to other regions. These results are consistent with the positioning of SSA

The Developing World: Regional Differences Table 7.7

243

Developing regions: Indicators of state influence, 2000

Region East Asia, Pacific (EAP)

Revenue/GDP, %

Defence/GDP, %

8.4

1.7

South Asia (SA)

12.3

3.1

Arab Gulf (GCC)

36.6

7.1

Middle East & N. Africa (MENA)

25.1

4.3

Sub Saharan Africa (SSA)

19.8 (a)

1.9

Latin America, Caribbean (LAC)

20.7 (b)

1.4

Source, note: World Bank at http://devdata.worldbank.org/query Figures are averages of available country data. The figures for EAP, SA, GCC, and MENA cover most countries in these regions and are more comprehensive than those for SSA and LAC. (a) = figure is based on 8 SSA countries; (b) = figure is based on 11 LAC countries.

and SA closest to household settings, and the other regions progressively away from household settings, with LAC and GCC more close to firm settings, as in Chapter 1, Figure 1.3. It is also important to note that the relative concentrations of agent interaction in the alternative settings in the developing regions do not reach the salient level of about 70 per cent generally found as necessary to assure full agent assimilation and assignment of the economic system to one type of settings.19 Even though we described the economic development epoch as state led, the extent and ability of state settings to bend agent interactions towards a behaviour that is typical of state-like rent appropriation has been limited. Rent seeking tended to concentrate in narrow circles that associate with state agents. The institutionalization of the state apparatus in most developing countries did not go as far as it did in the transition countries during the communist era. Table 7.7 shows two indicators suggestive of the influence of the state. One indicator is the share of public revenue in the GDP. This share ranged between 8 and 25 per cent, being lowest in the Asian regions and highest in the Arab regions of GCC and MENA, reflecting a greater influence of the state in the Arab countries than in other regions. Another indicator is that of the share of defence expenditure is the GDP. This ranged between 1.4 and 7.1 per cent, again with highest values in GCC and MENA, reflecting the greater influence of the state in the Arab regions. Although these two indicators do not convey the full strength of state settings, they can be quite indicative of the strength of the state in an environment where the abilities of governments to reform, regulate, and monitor their regulations are limited otherwise. In many developing countries the state has tended to be soft in the face of feudal, tribal, and religious interests and followers. Where the state-led economic development went too far in terms of state intervention, as, for example, in the SSA region, their economies fell in trouble and had to rely on SAP to get back on track. A side effect of the SAP in SSA was to constrain state power and strengthen market competition and firm interaction.

244 Economic Systems Analysis and Policies

7.2.7 Firm-led global integration It is generally established, and was argued above, that the economic development and the structural transformation of an initially closed developing economy require the economy to become more open and outward oriented. In particular, foreign exchange is required to import modern capital equipment and other inputs in the industrialization process, and selling outside enlarges the extent of the market and exploits economies of scale, next to other well-known gains in economic welfare from an open economy. These requirements were amply met in the EAP region by a significant expansion of the exports of manufactures that provided foreign exchange and bigger markets. EAP’s share in world exports of manufactures increased from 3 to 16 per cent in 30 years, and domestically the share of manufactured exports in the GDP moved from 2 to 42 per cent, Table 7.8.20 Next to some initial reliance in the EAP on Official Development Assistance (ODA) from the developed world, there was in a later phase an increasing reliance on foreign loans and foreign investment. Thus, national and multinational firms take the lead in the push towards an outward orientation, which is often indicative of a shift of agent interactions and decision-making from state settings to firm settings.

Table 7.8 Foreign trade patterns: Shares of manufactured exports by developing region, 1970–2000 Region

East Asia, Pacific (EAP) 1970 1980 1990 2000 South Asia (SA) 1970 1980 1990 2000 Arab Gulf (GCC) 1970 1980 1990 2000

Exports manufactures/ world exports manuf., %

3.2 5.7 12.0 15.8

0.7 1.3 2.8 3.1

– – – 0.5

Exports manufactures/ GDP, %

Exports manufactures/ world exports manuf., %

Exports manufactures/ GDP, %

2.1 8.2 17.4 42.9

Middle East, N. Africa (MENA) 1970 1980 1990 2000

0.3 1.2 0.6 0.6

2.2 2.0 4.6 5.7

2.0 4.0 8.1 12.9

Sub Saharan Africa (SSA) 1970 1980 1990 2000

1.2 0.7 0.9 0.9

1.3 2.2 2.2 4.7

Latin America, Caribbean (LAC) 1970 1980 1990 2000

1.6 1.7 2.7 3.6

0.7 2.0 3.7 7.4

– – – 5.7

Region

Source, note: Column 1 is adapted from World Bank (2002): World Development Indicators, CD-Rom. Column 2 is from World Trade Organization (2001): International Trade Statistics, WTO, Geneva, 2001. The size of world exports of manufactures in current US$ amounted to 8.8, 14.5, 20.5, and 23.8 millions in the four periods, respectively.

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245

The regions SA and LAC follow suit in terms of their relative shares in world exports. Each captures about 3 to 4 per cent of world exports of manufactures, these exports playing a greater role in the GDP in SA than LAC. The figures for the MENA region show a lower growth of manufactured exports, as compared to other developing regions, resulting in a decline of the share of MENA in world exports of manufactures, towards 0.6 per cent in 2000, in spite of a rising role for manufactured exports in the GDP, reaching 5.7 per cent in 2000. The Arab Gulf countries show a similar pattern to MENA as regards the position of manufactured exports in world exports of manufactures and in national economic development. The figures for the SSA region show a low global integration profile. Most governments here went for an overextension of the import substitution phase, a long duration of foreign exchange controls, and weak export promotion, with the result that the share of SSA in world exports of manufactures has remained at about one per cent for several decades. The importance of manufactured exports in the generation of GDP has increased, however. Turning now to financial flows, Table 7.9 gives the global picture and Table 7.10 shows the changing patterns of international financial flows by receiving region. The prominence of official development assistance in the early development decades gave way to foreign loans and foreign investment on the latter decades, as Table 7.9 shows. The flow of foreign loans, which was previously positive, reversed direction into net transfers of foreign debts from the mid-1980s onwards. Foreign investment has become by the turn of the century a dominant force in the global integration of developing regions. Table 7.10 shows the EAP and LAC to experience greater and rising shares of foreign loans and foreign investment than other regions. The greater openness of some of these economies to the international financial markets made them vulnerable

Table 7.9 Year

1970 1980 1990 2000

Foreign financial flows to developing countries, 1970–2000

Official development assistance

Net transfers foreign loans

Net transfers foreign investment

Total

Official development assistance

Net transfers foreign loans

Net transfers foreign investment

Total

$ mn

$ mn

$ mn

$ mn

%

%

%

%

6900 33500 57900 50300

3509 15136 –8258 –1540

1144 6795 20025 128408

11553 55431 69667 177168

59.7 60.4 83.1 28.4

30.4 27.3 –11.9 –0.9

9.9 12.3 28.7 72.5

100.0 100.0 100.0 100.0

Source: Columns 1, 2 on ODA are from OECD (2003): Geographical Distribution of Financial Flows to Aid Recipients 1960–2001, International development statistics CD-Rom. Figures are in current US$ million. Figures include all developing countries, as well as ODA that is not allocated by region. Columns 3, 4, 5, 6 on foreign debt and foreign investment are from World Bank (2003): Global Development. Figures are in current US$ million. Column 7 on Net transfers foreign investment/GDP is from IMF: International Financial Yearbook, various years.

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Economic Systems Analysis and Policies

Table 7.10 Foreign financial flows: S-shares of flow types by developing region, 1970–2000 Region, Official Net Net Region, Official Net Net years development transfers transfers years development transfers transfers assistance foreign foreign assistance % foreign debt foreign % debt % investment distribution % investment distribution distribution % distribution % distribution distribution EAP 1970 1980 1990 2000

19.0 8.0 14.4 17.4

23.1 22.0 –66.8 –43.9

27.9 17.7 53.3 39.8

SA 1970 1980 1990 2000

27.5 20.0 11.9 13.4

21.5 20.8 17.0 –1.0

GCC 1970 1980 1990 2000

– – – –

– – – –

MENA 1970 1980 1990 2000

14.2 24.2 20.6 8.9

0.9 18.0 7.1 –2.9

1.8 9.4 4.5 1.1

6.0 2.9 2.6 2.7

SSA 1970 1980 1990 2000

16.7 22.6 30.9 25.2

12.0 15.8 34.6 –2.8

2.6 –5.5 4.5 2.1

– – – –

LAC 1970 1980 1990 2000

15.0 6.7 9.2 9.9

42.5 23.4 –91.8 –49.4

61.7 75.5 35.1 54.3

Source, note: Same as Table 6.9. For ODA, for any year the sum of the per cent receipts by all regions do not add to 100 because of the unallocated portion. This portion amounted to 7.6%, 18.5%, 12.9%, and 25.2% in the four years, respectively.

at times to serious financial crises. In LAC, this occurred in 1982 when Mexico was unable to meet its obligations to pay foreign debts after an over-borrowing spree in preceding years. The risk of default payment was present in other developing countries that experienced mounting foreign debts. Subsequently, international lending banks reduced their financial flows to these and other developing countries. The gravity of the debt crises was accelerated by a surge in oil prices, leading to a slow economic growth in most developing regions for a couple of years.21 The vulnerability of the integrating developing economies in unstable world financial markets reappeared again with respect to EAP in 1998, when the devaluation of the Thailand currency was followed by other devaluations in the region, downfalls in stock markets, and withdrawals of foreign financial resources from the region.22 The confidence crisis was fuelled by the lack of transparency in corporate governance and state dealings, and a future economic outlook that was seen to be bleak against the background of over-expanded investment in construction and other production capacities. MENA had a relatively high share in total official development assistance, ODA, about 20 per cent, before declining to 9 per cent in 2000. The region experienced also a declining share of global financial inflows in loans and investment.

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247

GCC can be taken for granted to have had little or no ODA, while the inflow of foreign capital is outnumbered by an outflow of foreign exchange, created via oil exports, in international investments in the rest of the world. As regards SSA, official development assistance has been a prominent source of foreign finance compared to other regions. SSA received about a quarter of the total ODA in 2000. Nevertheless, given its pattern, its use, and its limited and diminishing size the contribution of ODA to the restructuring of the SSA economies is likely to have been marginal. In other respects, ODA can be assumed to have enhanced the role of the state in the receiving SSA country.

7.3

Comparative development performance

This section reviews the comparative performance of the six developing regions in the period 1950–2005 in terms of economic growth and income distribution. Table 7.11 gives GDP growth and GDP per capita growth over various periods. The data show the two Asian regions of EAP and SA to perform better than other regions in terms of GDP growth and GDP growth per capita. At the other end are the GCC, MENA, SSA, and LAC regions with lower economic growth

Table 7.11

Developing regions: GDP growth and GDP per capita growth, 1960–2005

Region, years

Annual GDP growth rate, %

Annual GDP per capita growth rate, %

EAP 1961–70 1971–80 1981–90 1991–2000 2000–05

4.7 6.6 7.6 8.4 8.3

2.5 4.5 5.8 7.1 7.3

SA 1961–70 1971–80 1981–90 1991–2000 2000–05

4.4 3.0 5.6 5.2 6.5

GCC 1961–70 1971–80 1981–90 1991–2000 2000–05

– 9.3 0.1 3.1 5.5

Region, years

Annual GDP growth rate, %

Annual GDP per capita growth rate, %

MENA 1961–70 1971–80 1981–90 1991–2000 2000–05

8.5 5.1 3.0 4.0 3.9

5.7 2.3 0.0 1.8 1.9

2.0 0.7 3.4 3.2 4.7

SSA 1961–70 1971–80 1981–90 1991–2000 2000–05

4.9 3.7 1.9 2.3 4.4

2.3 0.8 –1.0 –0.3 2.0

– 3.7 –4.9 0.4 2.6

LAC 1961–70 1971–80 1981–90 1991–2000 2000–05

4.9 3.7 1.9 2.3 2.3

2.6 3.2 –0.9 1.7 0.9

Source, note: World Bank at http://devdata.worldbank.org/query. Cols. 1 and 2 give average annual growth rates of GDP and GDP per capita in constant prices of US$ of 2000 for four ten year periods.

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Economic Systems Analysis and Policies

performances, the lower performance being due to different forces specific for the regions. The structural transformation of the MENA economy from agriculture to industry was noted to be stagnant. The region was also handicapped by political instability. The SSA region showed depressed performances: economic growth in SSA is lowest and has declined over time, partly due to increases in oil prices but also political unrest, civil wars, and state interventions aggravated the situation. There is a reversal in SSA as indicated by a moderate recovery in the years 2000–05. The better performances in economic growth in EAP and SA are partially accounted for by more significant structural transformations from agriculture to industry in EAP and SA, as well as early and stronger shifts from import protection to export promotion in EAP and SA; see previous sections. Economic determinants of the better performance of the two Asian regions, EAP and SA, as compared to other regions are highlighted also by an analysis of growth accounting factors covering the period 1960–94, in Table 7.12.23 For EAP, annual GDP growth of 7.0 per cent over the years 1960–94 is accounted for by annual growth in the labour and capital factors of production by 2.3 per cent and 3.4 per cent, and annual growth in total factor productivity for the remaining 1.3 per cent. The SA region enjoyed annual growth in total factor productivity of 0.8 percent. In the other three regions of SSA, MENA, and LAC, productivity growth was negative or slightly positive: –0.6, –0.3, and 0.2, respectively.24 The results of differences in demographic growth and economic growth show up in comparative figures of GDP per capita in US dollars, GDPpc (US$); Table 7.13 gives the regional figures for the year 2000. The exceptional position is that of the Arab Gulf countries, GCC, with GDPpc (USD) at about 25 times that of South Asia and Sub Saharan Africa. In between with a long distance from GCC are the regions of LAC, MENA, and EAP. The table gives also GDP per capita in purchasing power parity dollars, ppp $. A purchasing power parity exchange rate equalizes

Table 7.12

Developing regions: Economic growth accounting

Region

Growth rate of output

Growth rate of labour

Growth rate of capital

Growth rate of total factor productivity

East Asia & Pacific (EAP)

7.0

2.3

3.4

1.3

South Asia (SA)

4.2

1.6

1.8

0.8

–

–

–

–

Middle East, N. Africa (MENA)

4.5

2.3

2.5

–0.3

Sub Saharan Africa (SSA)

2.9

1.8

1.7

–0.6

Latin America, Caribbean (LAC)

4.2

2.2

1.8

0.2

Arab Gulf (GCC)

Source, note: Adapted from (Brookings Papers and Proceedings) 2: 135–91. The economic growth accounting equation is the same as in other chapters, i.e. growth rate of output = growth rate of labour + growth rate of capital + growth rate of total factor productivity. The equation is applied to various regions for the period 1960–94.

The Developing World: Regional Differences Table 7.13

249

Developing regions: GDP per capita in US$ and in ppp $, 2000

Region

GDP per capita

GDP per capita

US$

ppp $

index

index

East Asia, Pacific (EAP)

949

2.1

3747

1.7

South Asia (SA)

450

1.0

2209

1.0

11113

24.7

16474

7.5

1536

3.4

4764

2.2

Arab Gulf (GCC) Middle East, N. Africa (MENA) Sub Saharan Africa (SSA) Latin America, Caribbean (LAC)

515

1.1

1611

0.7

3852

8.6

7102

3.2

Source, note: World Bank at http://devdata.worldbank.org/query. Cols. 1 and 2 give GDP per capita for 2000 in US$ and in purchasing power parity. Both columns calculate indexes based on South Asia = 1.0.

Table 7.14 Developing regions: Poverty headcount at $1 a day ppp as per cent of total population, 1981–2004 Region

1981

1990

1999

2004

East Asia & Pacific (EAP)

57.7

29.8

15.5

9.1

South Asia (SA)

49.6

43.0

34.9

30.8

0.0

0.0

0.0

0.0

Arabian Gulf (GCC) Middle East & N. Africa (MENA)

5.1

2.3

2.1

1.5

Sub Saharan Africa (SSA)

42.3

46.7

45.8

41.1

Latin America & Caribbean (LAC)

10.8

10.2

9.7

8.6

Source, note: All indicators are calculated from http://devdata.worldbank.org/query. The figures are regional averages of country outcomes falling under the region. Country outcomes are averages of available yearly observations for the specified period. The figures are highly representative due to a sufficiently large coverage of countries and years.

the purchasing power of different currencies in their home countries for a given basket of goods. It is a better measure of standards of living between countries, rather than GDP per capita in US dollars. Because the share of non-traded goods and services, and their prices, are lower in countries with lower income levels, the standard of living of poorer countries is raised and that of richer countries lowered when ppp is used instead of USD. 25 As a result, there are marked differences when ppp is applied. The gap in the income per capita between the rich GCC region and the poorest regions of SA and SSA is reduced from about 25 times to about 7.5 times. The differences between LAC, MENA, and EAP are reduced significantly, too. Under comparatively equally distributed incomes, countries with higher GDP per capita can be expected to have a lower share of poverty headcounts in the total population. Table 7.14 gives the poverty headcounts share in the population

250 Economic Systems Analysis and Policies

at one dollar a day in purchasing power parity (PHS). As of the year 2004 the EAP region is shown to have reduced the PHS to 9 per cent of the population, at a GDP per capita of about 3747 ppp $. In contrast, LAC has a comparable PHS level of 9 per cent but at a GDP per capita that is about twice as much, i.e. 7102 ppp $. Other regions manifest intermediate combinations of national welfare and poverty reduction between the best and worst performances of EAP and LAC.26 How did, and how do, the developing regions compare with regard to performance on the dimension of income distribution. Table 7.15 underpins the trends in income distribution that occurred in the past 50 years. Among the two Asian regions, while EAP did better than SA in economic growth, it did so also with regard to restraining development trends towards income inequalities, as can be seen from the changes over some thirty years in three different indicators of income distribution: Gini index, and income shares of the top 20 per cent and bottom 20 per cent of the population. Nevertheless, SA had in 1950 as well as in 2000 a lower income inequality than EAP as measured by the Gini index, which is likely to be a reflection of the greater sharing character of a relatively more household intensive economic system. The case of the GCC region is quite different from the other regions. There are no readily available national surveys of household income distributions as the notions of the national and residential population overlap and the reference point is controversial.27 The MENA region, which was moderate in economic growth, has had also least changes in income distribution. Table 7.15

Developing regions: Indicators of income distribution, 1980–2005

Region, years

Gini index

Income share of top 20%

Income share of bottom 20%

Region, years

Gini index

Income share of top 20%

Income share of bottom 20%

EAP 1981–90 1991–2000 2000–05

41.4 42.6 43.3

50.0 47.8 46.6

5.8 6.6 6.9

MENA 1981–90 1991–2000 2000–05

40.5 38.7 38.1

47.7 45.9 46.3

5.9 6.8 6.7

SA 1981–90 1991–2000 2000–05

30.0 33.7 37.6

38.8 42.3 47.1

8.8 8.5 7.6

SSA 1981–90 1991–2000 2000–05

43.5 47.0 43.3

48.8 53.5 50.0

5.8 5.0 5.9

GCC 1981–90 1991–2000 2000–05

– – –

– – –

– – –

LAC 1981–90 1991–2000 2000–05

49.6 50.1 52.8

54.8 55.4 57.3

3.6 3.7 3.4

Source, note: All indicators are calculated from http://devdata.worldbank.org/query. The figures are regional averages of country outcomes falling under the region. Country outcomes are averages of available yearly observations for the specified period. The figures are highly representative due to a sufficiently large coverage of countries and years.

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251

The SSA region did not only have the least economic growth performance until 2000, but the increases in income inequality in SSA were also among the highest in the developing world. LAC entered the 1950s with a higher income per capita and a more unequal income distribution than other regions. This is also true for the year 2000. The growth tempo subsided, and the distribution profile stabilized. While the annual growth in per capita income shrank from 2.7 to 1.1 per cent over the years 1950–73 and 1973–2000, the Gini index remained between .54 and .53 in the 50 years. Decomposition of inequality changes along the lines of economic growth accounting is not feasible. It is much more complex to disentangle determining factors behind the differentiated income distribution and changes therein among the six regions.28 Irrespective of the direction and extent of the economic growth performance in the developing countries, income concentration has increased in all regions. However, the increase in the Gini index is smaller in EAP and SA than in GCC, MENA, and SSA. The Gini index in LAC, which is among the highest in the world, rose marginally. Other relevant indicators of income inequality show the gap in the income distribution between the richer top 20 per cent of the population and the poorer bottom 20 per cent of the population to have increased between 1950 and 2000. The increasing and significant gaps in the income distribution in the developing countries reflect persistent trends of dualism in the economy and low degrees of integration in the economic system. The material in this section gives ground for supporting the hypothesis that where economic growth was high the increase in income concentration was moderate to high, and the reduction in PHS was high. The material supports the general presence of trickle down effects of higher economic growth, in spite of the largely dualistic character of economic development. The case of SSA supports the hypothesis in its reverse formulation as it is a case where GDP growth was lowest and the increase in income concentration was highest. The next sections will elaborate on the magnitudes of dualism, the macroeconomics, and the microeconomics of dualistic development. We shall focus on the larger developing countries in terms of population size, as it will become apparent that the dualistic tendencies are more extensive in the larger countries.

7.4 Dualism in the economic system: Modern/traditional, rich/poor, in large/small developing countries The aggregate indicators of development performance in the previous section cannot show the significant dualistic trends that are hidden in the aggregates, even though the indicators on the distribution of income, and the relative population size of the rich and of the poor can give a hint on the extent of the dual economy. But a fuller picture on the extent and nature of the dualism is obtained when the location and activities of the richer and poorer populations are identified and the stickiness to these locations and activities are verified. The origin of duality is comprehended in Lewis (1954) and Kuznets (1956–67). The premises of the Lewis model are (a) a large population in the traditional

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Economic Systems Analysis and Policies

agriculture sector earning an income above marginal productivity, so that an outflow of labour will not affect production; (b) firms in the modern industrial sector, working with increasing capital intensity, will hire and train this labour surplus and pay a wage equal to their marginal productivity. The development process is then seen as a transfer of labour from the low productivity sector to the high-productivity sector. Because labour transfers are selective the better equipped labour moves to the higher productivity sector, the less equipped labour stays in the low productivity sector. Hence, a widening of the dualistic gap between the two sectors occurs. The work of Kuznets confirms that due to this duality, economic growth in the take-off stage of development would be accompanied by rise in income inequality. In the past five decades dualistic analysis was extended to cover the division between the formal and informal sectors, as well as emphasis on marginalization tendencies, and urban bias; for example, by Sethuraman (1981), de Soto (1989), and Lipton (1977), respectively. But the main contours distinguishing dualism in the developing country remained intact: the coexistence of a low productivity lagging sector housing the larger portion of a less skilled labour force, next to a high-productivity growth sector with skilled labour. Dualism in the developing world can thus be described as the coexistence of the materially better off population working and living in modern activities with high productivity, say the formal sector; and the materially least off population working and living in traditional activities with low productivity, often called informal sector. There is some mobility of agents between these two sectors, especially from the informal to the formal sector, but the magnitudes involved are relatively quite small and are restrained by entry and exit barriers. In the large developing countries, population-wise, the percentage distribution of agents between the modern (formal) and the traditional (informal) tends to stabilize along high levels for the traditional sector, with the consequence of high levels of relatively lower income earners, and households. The association between agents living and working in the informal sector and earning lowest incomes is sticky and forms the backbone of a dualistic economic system in the developing world. Development economists usually treat the dichotomy of formal/informal economy and the issues of income distribution and poverty incidence separately. The preoccupation with defining and measuring each of the two phenomena consumes much effort, leaving less attention to the interrelationships between them. However, the two phenomena are highly interrelated and significant in shaping the economic system and determining its development performance. More insight into the relationship between informality and poverty and its magnitudes can help detecting ways for improving welfare performance and development processes. We shall examine first the rudimentary data available on formal/informal and rich/poor in the developing regions before elaborating on a synchronization of the relationship and its quantification. Formal and informal sectors belong to the sphere of economic activities. Both operate in establishments that produce goods and services and sell them. While

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establishments in the formal sector have modern production technologies, register cost and revenue, engage in written contracts between employers and employees, pay taxes, and are larger in size, establishments in the informal sector use more traditional technologies, have limited registration, and are less forthcoming regarding contracts and taxes. They are also much smaller in size and rely in their workforce predominantly on self-employed and family workers. Analysts use the above-mentioned features in classifying whether an establishment belongs to the formal or informal sector.29 Problems in measurement get more complicated due to the overlap between the informal sector and what is known as the shadow economy.30 The generally accepted concepts of what forms the formal versus the informal sectors are not sufficiently operational to allow rigorous empirics on the extents and magnitudes of the formal versus the informal. This is also the expectation in view of the very wide differences in drawing comparable distinctions between formal and informal sectors in so many differing developing countries. We report in Table 7.16 aggregated data on the allocation of the labour force agents to the categories of formal sector, informal sector, and unemployed. The country data for 24 countries are aggregated to give regional averages. The country data follow divergent definitions of what constitutes formal/informal. This data refers only to urban areas, whose inhabitants in SA and EAP do not go beyond 30 or 40 per cent of the total population. To highlight possible association between informality and poverty, we include in Table 7.16, in the last column, the proportion of the population below the poverty line of $1.08 a day.31 Table 7.16 Developing regions: Indicators on distribution of the population by rural/ urban, and the urban labour force by formal/informal/unemployed status; and indicators of income distribution Region

Labour force indicators Rural population, 2000, %

Urban population, 2000, %

Distribution of the urban labour force by labour status, 1995–2000, % Formal

Informal

Unemployed

Poverty headcount at $1.08 per day 1999/total population

EAP

60.0

40.0

47.1

47.9

5.0

15.5

SA

70.5

29.5

40.2

55.6

4.2

34.9 0.0

GCC

19.0

81.0

–

–

–

MENA

43.6

56.4

55.3

36.5

8.2

2.1

SSA

62.0

38.0

27.6

59.1

13.3

45.8

LAC

24.5

75.5

47.1

41.9

11.0

9.7

46.0

46.8

7.2

Average

Source, note: The source for columns 1, 2 is UN (2001): World Urbanization Prospects, The 2006 revision, UN Population Division, New York. Website: http:www.un.org/esa/population/unpop.htm. The source for columns 3 to 5 is ILO (2002). The observations relate to later years in the period 1995–2000. Regional figures in columns 3 to 5 are obtained by averaging available country data. Columns 6, 7 on indicators of income distribution were already displayed in Tables 7.15 and 7.14, respectively.

254 Economic Systems Analysis and Policies

The following observations can be drawn from Table 7.16. In EAP, SA, and SSA, which house the largest populations in the developing world, the majority of the population live in rural areas, above 60 per cent. In these three regions the over majority of rural employment is primarily of the traditional, unorganized, selfemployed households, denoted together as the informal type.32 In the other developing regions the majority of rural employment is informal. Moving to urban areas, a simple average over all six regions shows an equal percentage distribution between informal and formal employment, 47 per cent and 46 per cent, with the remaining 7 per cent of the labour force as unemployed. Thus, the informal mode of employment, which is very tied to household settings, is predominant in the rural landscape and is dominant in the urban. Furthermore, Table 7.16, last column, shows a high coincidence between dominance of informal modes of employment and poverty incidence. Going beyond the above, any serious study of the quantitative relationship between the dichotomies of informal/formal and poor/rich (in the sense of materially better off) requires the synchronization of the two phenomena to each other. While the establishment is the measurement unit in the informal/formal sector distinction, the measurement unit for the poor/rich is the household. Households whose income falls below certain standards that coincide with the composition and needs of its members are identified as poor households. A first step in studying the relationship between informal/formal and poor/rich is to focus on a common unit for observing and measuring the two dichotomies. It is logical and practical to use the household as the common unit. Households can then be ‘described’ as belonging to the informal or formal sectors on the basis of the establishment status of their main income earners. The common measurement in household units allows further analysis of the synchronized relationship between the two dichotomies. The closing box to this chapter, Box 7.1, elaborates on this ‘description’. Furthermore, it can be postulated and verified that the synchronized relationship between informality and poverty follows different rules and has different outcomes in large countries than in small countries, where large and small are defined in terms of population size. It was already observed in the first chapter that in very large developing countries such as China and India with populations of more than a billion, and with more than half to three-quarters predominantly allied to rural areas and informal jobs, it is not feasible that such countries would manage to absorb more than half of their populations in the formal sector, in spite of the recent remarkable economic growth in both countries. Projected urbanization levels to 2030 point also to the same direction.33 In contrast, developing countries with smaller populations are more in a position to absorb a greater proportion of their populations to the urban areas and the formal sector and less to the rural areas and the informal sector, than larger countries. The empirical evidence from the smaller countries shows also that this is the case. Are there theoretical grounds for expecting the size of the poor population to vary with the size of the population among developing countries? In principle, the same percentage of poor people should occur in small- and large-sized countries, assuming that natural resources and population density are evenly distributed

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among the small and large countries. Other factors intervene to cause a variation. First, to the extent that there is more income sharing among households in rural areas than in urban areas then concentration of the population in rural areas implies less poverty. Larger countries with larger shares of the rural population may manifest a smaller size of poverty than smaller countries. Second, as the informal sector is more spread in urban than rural areas the incidence of poverty due to informality is higher in urbanized populations. As small countries are generally more urbanized than large countries, the implication is that smaller countries may manifest a greater size of poverty than larger countries. Both factors predict that the proportion of the population below the poverty line in larger countries such as China and India is lower than in smaller countries. This is generally borne by the observed data in this chapter. In elaborating the empirical relationship between informal/formal and poor/ rich we shall focus on the large country example, which is typical for the two Asian developing regions of SA and EAP. Making use of several estimates and assumptions for a large-sized developing country, see Box 7.1, we estimate that about 59 per cent of all households can be described as informal and 29 per cent as formal.34 The remaining 12 per cent of households would belong to the groups of unemployed and inactive households and household equivalents. These groups cannot be assigned to either informal or formal since they do not work in economically active establishments, even though they may be more allied to the informal sector. We summarize the main results in Table 7.17. It can be roughly estimated that the incidence of poverty amounts to about 20.0 per cent of all households in a large-sized developing country.35 Out of this

Table 7.17 Summary of cross-section between informal/formal and poor/rich in a large developing country Households by category

Distribution of households by category, % (1)

Poor

Rich or materially better off (mbo)

Share of poor by category, % (2)

Share of poor by category, % (3)

Distribution of poor, % (4)

Share of mbo by category, % (5)

Share of mbo by category, % (6)

10.4

17.7

52.0

48.3

82.2

Informal sector earners

58.7

Formal sector earners

29.3

1.5

5.1

7.4

27.8

94.9

3.3

2.3

70.0

11.6

1.0

30.0

Unemployed (a) Inactive All households

8.3

5.8

70.0

29.0

2.5

30.0

100.0

20.0

20.0

100.0

80.0

80.0

Source, note: Columns (1) and (2) from Box 6.1. Column (3) = Col. (2)/Col. (1). Col. (4) is per cent distribution of Col. (2). Col. (5) = Col. (1) – Col. (2). Col. (6) = Col. (5)/Col. (1). Figures are based on the approximate number of households falling in different categories. (a) = unemployed measured in household equivalents.

256 Economic Systems Analysis and Policies

poor 20.0 per cent we estimate that about 10.4 per cent can be found among poor households working and earning their income in the informal sector, and only 1.5 per cent is to be found among poor households that belong to the formal sector. The rest of the poor households are assigned to the unemployed, 2.3 per cent, and the inactive, 5.8 per cent. These results suggest that slightly more than half of all poor households in a large-sized developing country work and live in the informal sector, that is 52 per cent, as compared to only 7 per cent in the formal sector. The remaining poverty is found among the unemployed and inactive, 12 and 29 per cent, respectively. The above relative numbers on the cross-distribution of households between informal/formal and poor/rich apply mostly to developing countries with large populations. In assembling the above relative figures we relied on data for Indonesia and Pakistan, though the same configuration would generally and equally apply for other large countries in the EAP and SA regions, as well as Egypt and Iran in MENA, and Ethiopia and Nigeria in SSA. These are all countries with large populations of around 80 millions or above, and a great concentration of the population in rural areas and informal occupations. From a development policy perspective, in large countries the majority of households are attached to the informal sector, and the majority of the poor are found in the informal sector. They were roughly estimated at 58 and 52 per cent, respectively. Effective poverty reduction policies would require focusing on improvement of the productivity and earnings of the informal sector. The unemployed and inactive are also significant sources of poverty. Because these groups are likely to be more closely allied to the informal than the formal sector, the significance of the informal sector in a poverty reduction strategy is increased. Table 7.17 displays distributions of the population on formal/informal activities and of income on rich and poor. A missing link is the distribution of the product by formal/informal sector. This information is difficult to obtain. However, there are some scarce findings on the distribution of the GDP by formal/informal sectors for India that compliment the picture above.36 In contrast to the bigger countries, it can be expected that countries with smaller populations would have a more balanced distribution between rural/informal and urban/formal areas/sectors respectively, and likely a greater absorption of the population in urban/formal areas/sectors.

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Box 7.1 An accounting framework for informality and inequality in developing countries An accounting framework for poverty and informality is feasible if it can be based on the approximate number of households falling in different household groups. We distinguish between three household groups, and a household equivalent group. The criteria are the activity status of the head of the household, and/or of the majority of the earners in the household. We distinguish between households with formal sector earners, F; with informal sector earners, I; with inactive persons outside the labour force, N; and unemployed job seekers, S, converted into household equivalents. The sum of all four types of households gives total households T. Poor households with incomes below a minimum level are denoted as P. We estimate two crucial parameters per household group. These are a and b standing respectively for the share of a household group in the total number of households, and share of poor households in a household group. Inactive households, N, include retired, divorced, and the widowed. The share of N in total households is likely to vary from a low 0.5 to a high 0.15 in rural and urban areas, respectively. For the model country we examine, the aggregate share of N in total households is thus calculated at .083. Together, the shares of S and N give about 12 per cent. Deduction of the shares of the unemployed and non-actives leaves about 88 per cent of active households in the formal sector F and informal sector I. For the model country we examine the share of F is (.88) (2/3) = .59, and that of I is (.88) (1/3) = .29. Calculation of b. A relative poverty line definition that is becoming increasingly an accepted convention is half of the average (or median) income per household (or per capita). Holding to this definition and some other realistic assumptions, the poverty share per household group, B, can be determined. The majority of unemployed households, S, say 70%, do not enjoy an income and can be labelled as poor. A similar assumption is defendable for the inactive households N, although a somewhat lower poverty share than 70% is also plausible. The formally employed households, F, generally enjoy an income quite above the stipulated threshold, but a very small poverty share is plausible in case of oversized formal households. The poverty share here is not likely to exceed 5%. The poverty share for the informally employed households, I, is to be determined in several steps as a residual. First, multiplication of a by b for S, N, and F gives the shares of these groups in the national poverty, column 5. Second, in the average developing country there will be about 20 per cent of households whose earnings fall below the above convention, and can thus be labelled as poor. The poverty share thus equals 0.20 for the whole population. In a third step, the values for S, N, and F are deducted from the 0.20 value to give the poverty share of the informally employed households, at .1041, or about 10 per cent out of 20 per cent. Column 6 gives percentage distribution of the poor among four household groups. The values for S, N, F, and I are 12, 29, 7, and 52 per cent, respectively. More than half of the poor earn their living from the informal sector. There is still one parameter to be calculated and its validity checked against observed relationships. This is the poverty share of the informally employed households, b, found in row 6, column 4. Its value is obtained by dividing column 5 by column 3, resulting in an informal poverty share of 0.18. The results imply that the probability of an informal household being identified as poor is about three and a half times that for the formal household, i.e. 0.18/0.05. The difference in probabilities is very significant, and reflects the underlying shortfall of average income levels and productivity in the informal sector as compared to the formal sector. The observed magnitudes in the relative income and productivity levels of the formal and informal sectors are consistent with results obtained in the table. o

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Economic Systems Analysis and Policies

The above can be summarized in the form of accounting equations that identify household groups and decomposes poverty in accordance with these household groups. S 5 as T, N 5 an T, F 5 af T, I 5 ai T where Sa 5 1.0 P 5 bs S 1 bn N 1 bf F 1 bi I When the estimates are inserted, the following is obtained S 5 .033 T, N 5 .083 T, F 5 .293 T, I 5 .587 T, P 5 .7 S 1 .7 N 1 .05 F 1 .18 I As T is given, this allows calculating P and its decomposition. 1 Households falling in different groups

2 Symbols

3 Share of the group in all hh 5a

Active in informal sector

I

.587

Active in formal sector

F

Unemployed (in hh equivalents)

5 Share of poor in all hh = (a)(b)

6 % distribution of poor = [(a)(b) / S(a)(b)] 100

0.177

.1041

52.0

.293

0.05

.0147

7.4

S

.033

0.7

.0231

11.6

Inactive

N

.083

0.7

.0581

29.0

All households (hh)

T

Poor households

P

4 Share of poor in the group 5 b

1.00

0.20 0.7 S + 0.7 N + 0.05 F + 0.18 I

100.0

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259

Macroeconomics of dualistic development

Economic prosperity in the informal sector, in the sense of a higher income per head, and consequently a reduction in overall poverty, is dependent not only on the economic growth of the informal sector itself but also on that of the formal sector. The informal–formal sector relationship can be viewed within a macroeconomic framework. There are two main relationships that require emphasis. One is a direct relationship in the production sphere. The tiny and small establishments in the informal sector are deliverers of intermediate goods and other partially processed goods to the formal sector where they are processed further into final goods. Households associated with the informal sector deliver also labour services, mostly less skilled, to the formal sector. In both cases the formal sector is a major source of income for the informal sector and associated households. Correspondingly, the formal sector is able to produce cheaply by drawing on the goods and services of the cheaply priced informal sector. Even though the production dependence of the two sectors is mutual, the formal sector commands much more economic resources and has greater access to national and foreign financial and non-financial markets. Thus, the mutual dependence is not one of equals. The other relationship is an indirect one and relates to the income-consumption spheres. For labour and capital services used in the production sphere households get income earnings that they spend on consumption, thus funding back the production process. Households associated with the formal and informal sectors do not exclusively spend on the consumption of goods produced in their respective sectors. In general, the informal sector and associated households would secure a net gain from this mutual spending on consumption. Given the wide income differentials between the formal and informal households, it can be expected that there will be a relatively higher portion of spending by the formal households to the benefit of the informal households, than the other way round. A positive result of the consumption link is a rise in the incomes of the households associated with the informal sector and a reduction in overall poverty, the result is commonly known as the ‘trickle down’ effect. Again, the mutual consumption pattern implies also that the portion of the income of informal households that is spent on the consumption of modern or formal goods (goods produced in the formal sector) can be considered as a partial ‘evaporation upward’. It is not a complete evaporation because the informal sector and informal households would be once again engaged in the production process of these formal goods, and they will benefit from this participation. What are the magnitudes involved in the two above-mentioned relationships? This section will develop insights on these magnitudes, taking the cases of two of the larger developing countries, i.e. Indonesia and Pakistan, belonging to the EAP and SA regions, respectively. Although the empirics refer to large developing country of the 1980s and 1990s, the validity of the results for the developing countries as a whole and for current years is not in doubt, as witnessed by more recent studies.37 The analytical framework utilized is that of the Social Accounting Matrix (SAM) model, and has proven to be comprehensive and robust in modelling the above relationships in the production and the income-consumption spheres.

260 Economic Systems Analysis and Policies

The SAM is a transformation of the circular flow of economic activity into a matrix of transactions between the various agents. In the rows of such a matrix are the factors, the institutions consisting of households, firms and government, the activities and the rest of the world. The columns are ordered similarly. Transactions between these actors take place at the intersecting cells. The absolute values of transactions can be converted in proportional coefficients in terms of the column totals, giving a square coefficient matrix. This can be partitioned in an exogenous and an endogenous part.38 Inversion of the endogenous part results in output and income multipliers.39 These multipliers show the effects of changes in the exogenous variables on endogenous variables. SAM multipliers tell (a) what are the final effects of an

Table 7.18 The impact of formal and informal sector injections and of transfers on output and the incomes of poorer and richer household groups. Demonstration of results for Indonesia Actual percentage distribution (1975)

Output Multiplier

Impact of a unit injection in approximated sectors (a) Informal sector

Formal sector

4.9

3.6

Impact of a unit transfer to household groups (b)

Poorer households

Richer households

4.2

3.9

Percentage distribution of the output (multipliers) on sectors Informal sector Formal sector All sectors

36.1% 63.9% 100.0%

Income Multiplier

65.8% 34.2% 100.0%

53.6% 46.4% 100.0%

62.0% 38.0% 100.0%

39.3% 60.7% 100.0%

2.3

1.6

3.0

2.8

Percentage distribution of the income (multipliers) on household groups Poorer households Richer households All households

23.5% 76.5% 100.0%

22.6% 77.4% 100.0%

23.7% 76.3% 100.0%

49.5% 41.5% 100.0%

15.3% 84.7% 100.0%

Source, note: Biro Pusat Statistik Indonesia (1982), Cohen (1993). (a) The informal/formal sectoral distinction is approximated by combining the analytical results of traditional agriculture and small-scale manufacturing to represent the informal sector, and taking the rest of the economy to represent the formal sector (including among others commercial agriculture and large-scale manufacturing). (b) Poorer household groups include rural landless farm workers, and urban lower income earners; richer household groups include land owners and upper income earners in rural and urban areas.

exogenous injection in the formal or informal sector (due to government spending or foreign exports) on growth of output in both sectors, and on the distribution of income between the poorer and richer household groups; and (b) what are the final effects of exogenous transfers to for poor or rich household groups on their respective incomes and the output growth of the formal and informal sectors. The multipliers in Tables 7.18 and 7.19 give for Indonesia40 and Pakistan41 indications of the final effects of exogenous sector injections on output and income.

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For Indonesia, Table 7.18, an injection of a unit, of say a million rupiahs, in the informal sector gives a potential increase in total output of 4.9, two-third of which benefits the informal sector itself, and one-third benefits the formal sector. The injection generates a total income of 2.3 units, but only a minor share of this income, about 23 per cent, goes to poorer households and 77 per cent to richer households. This multiplier distribution reproduces the actual distribution in the country of the income between the two household groups. If the injection is done in the formal sector, the output and income effects would be less, 3.6 and 1.6 respectively, the informal sector will benefit relatively more than the formal sector, and the relative distribution of benefits on the Table 7.19 The impact of formal and informal sector injections and of transfers on output and the incomes of poorer and richer household groups. Demonstration of results for Pakistan Actual percentage distribution (1975)

Impact of a unit injection in approximated sectors (a) Informal sector

Output Multiplier

4.79

Formal sector

Impact of a unit transfer to household groups (b)

Poorer households

4.56

3.82

31.6% 68.4% 100.0%

49.7% 51.3% 100.0%

Richer households 3.51

Percentage distribution of the output on sectors Informal sector Formal sector All sectors

42.2% 57.8% 100.0%

Income Multiplier

53.0% 47.0% 100.0% 3.17

2.62

2.21

34.7% 65.3% 100.0% 2.04

Percentage distribution of the income on household groups Poorer households Richer households All households

31.1 % 68.9 % 100.0 %

30.9% 69.1% 100.0%

31.7% 68.3% 100.0%

36.6% 63.4% 100.0%

22.1% 77.9 % 100.0%

Source, note: PIDE (1985); Cohen, S.I. (1989). (a) The informal/formal sectoral distinction is approximated by combining the analytical results of agriculture, mining, small-scale manufacturing and diversified services to represent the informal sector and taking the rest of the economy to represent the formal sector (including among others largescale manufacturing, utilities, construction, transport, banking, and public services). (b) Poorer household groups include landless and off-farm workers in rural areas, and manual labour and self-employed in urban areas. Richer household groups include large, medium, and small land owners in rural areas and employers and non-manual labour in urban areas.

household groups will not be affected. Although the results show that the relative distribution of incomes between poor and rich households is neutral with respect to expansion of either the informal or formal sectors, the absolute levels of the income multipliers are higher in case of informal sector injections and expansion than the formal sector, and this would imply that more households are likely to cross the poverty line upwards. The policy growth and income implications are clear. First, whatever growth source is stipulated, the output

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Economic Systems Analysis and Policies

of the informal sector tends to grow more than that of the formal sector. So, the informal sector is there and its production activities can only grow further. Second, while growth of the formal sector reduces poverty, growth of the informal sector reduces poverty even more, but the relative income distribution is unaffected under both cases. Table 7.18 gives also the output and income effects of another type of instruments: income transfers to households. Government or rest of the world can make the transfers. It is noted that a transfer to the poorest group creates more output and income than a transfer to the richest group of urban upper income. The reasons lie in the intensity of the circular flows. Poorer households consume and spend most incomes they receive and given their numbers the incomes re-enter the circular flow more extensively and intensively than in the case of the richer households. There is a greater leakage in the latter case. The results show also that, in contrast to the policy of sector injections, the actual income distribution between the two household groups will be significantly affected by the direction of the income transfer. The poor households in Indonesia of the 1980s appear to end up with holding back in their own group about 50 per cent of the income transfer, which represents a higher share than their actual income distribution of about 24 per cent. Therefore, the ‘evaporation upward’ effect appears to be relatively weak. In similar ways, the results show also that the ‘trickle down’ effect is also very low, with only 15 per cent of a simulated transfer to rich households trickling down to poor households, the substantial portion of 85 per cent remaining with rich households. Of course, while it is possible that these magnitudes may be approaching each other over time, the gap is too wide to be reversed in two decades. Finally, a comparison of the results of injections in the production sphere with transfers in the income-consumption spheres allows for the following conclusion. In achieving economic growth, with poverty reduction and a more equitable income distribution, policies pursuing transfers to poor households in the income-consumption spheres are shown to be more effective than those of injections in the production sphere. Similar results as the above apply for Pakistan, in Table 7.19. First, injections in the informal sector bring more overall growth in output and income than injections in the formal sector, but each sector injection tends to benefit its own sector more. Second, while growth of the formal sector reduces poverty, growth of the informal sector reduces poverty even more, but the relative income distribution is unaffected under both cases. Third, public transfers to poor groups benefit the informal sector most and are very effective in reducing poverty. Fourth, in contrast, the benefits of public transfers to rich groups go mostly to the formal sector and the rich groups are linked to the formal sector; the informal sector and the poor groups encounter relative deteriorations in their positions from such transfers.

7.6 Microeconomics of dualistic development Economists and politicians dealing with development problems of the third world are anxious to know about the extent, nature, and consequences of displacement

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of traditional enterprises by the more competitive firms, and to gain insight into alternative collective mechanisms for handling the consequences. International development agencies are equally facing new challenges in designing development programmes that combine economic efficiency with social protection. In competitive markets, the more competitive and market-driven firms which produce better quality and sell their goods at relatively lower prices will increase their share of the market at the cost of traditional enterprises, which operate in the informal sector. Traditional firms that produce and sell goods that buyers consider as less competitive will eventually close down. Firms that close down lay off factors of production, capital, and labour, which can be used elsewhere, or not at all if they happen to be very specific to the closing firms. In such cases, capital is scrapped and labour remains unemployed. Without incomes most of these unemployed and their households fall under the poverty line. If this scenario is realized, then it would be the start of a pessimistic and a very problematic perspective. In general, equilibrating mechanisms and collective actions would then come into being to assure that the chronically unemployed will be in a position to cover their living expenses if negative externalities and the consecutive disruptions of the whole economic process and development failure are to be avoided, and a stable society is to be maintained. Do such equilibrating mechanisms and collective actions exist? And what are their forms, roles, and effects? In this section we assess the prospects of traditional enterprises in the context of the enhanced competitive market forces of the past decade both nationally and globally, and discuss the rationale for mutual coexistence of traditional with modern market-driven enterprises at micro level. Simon Kuznets and Arthur Lewis were among the earlier economists who saw economic development to be a competitive market process that reallocates physical and human resources from low productivity sectors to high-productivity sectors, whereby the redundant physical and human resources, that is, unemployed labour, will become unutilized and impoverished. Kuznets hypothesis states that economic growth in the early stages is accompanied by income inequality or even an increase in absolute poverty. In particular, traditional agriculture and cottage industry – belonging mostly to the informal sector – would include enterprises that close over time, while commercial agriculture, modern industry, and related services constitute the more productive segment of the economy, where new enterprise are initiated, grow and flourish further, i.e. the modern or formal sector. Compared to the informal sector, the modem or formal sector is less labour-intensive and more labour-skilled. The replacement of informal firms by formal firms would thus ultimately lead to a rise in unemployment of less skilled labour, and an increase in poverty is unavoidable. The empirical evidence shows that while for some EastAsian countries and a few other countries elsewhere the Kuznets hypothesis did not emphatically occur; there are many other developing economies that did/do manifest the above tendencies. There are also theoretical and empirical grounds for considering the displacement process of less productive firms and less skilled persons to be valid not only in the early phase of economic development but throughout economic growth and hence, in the rich countries, too. This is observable in the performance of most OECD countries in the past two decades.

264 Economic Systems Analysis and Policies

Kuznets hypothesis can be also interpreted to apply at a global level in periods of accelerated global trade and growth. Global economic integration in the form of intensified international linkages in trade and finance has accelerated over the past decade for some countries but lagged behind for others. This is especially due to trade liberalization policies, floating exchange rates, free mobility of capital, and increased incentives to foreign direct investment. Fast integrator countries have performed better in economic growth through greater competition, modern technology, access to foreign capital, and a restructuring of their enterprise profile. There is also the simultaneous effect that fast growth tends to promote a more open economy which is subjected to higher degrees of competition with the result that the marginalization process of the traditional enterprise sector described earlier may get more intensified. On the other hand, countries that are slow integrators perform less in economic growth, which is also detrimental for their informal sector and the workforce attached to it. Truly, the Kuznets hypothesis claims that the negative relationship between economic growth and income inequality reverses to a positive one at higher levels of economic development. This reversal is due, however, to the income redistributive function of governments and not to a reversal in the operations of the product and labour markets. The above pieces of development theory and evidence suggest a bleak future for the informal sector and the poverty reduction. The basic assumption behind these projections is that the conditions of one joint market in which traditional and modem enterprises compete for the same consumer demand exists and are continued. However, there are contrasting development theories and evidence that emphasize significant roles of structural barriers and collective actions in bypassing the competitive drive. These factors can seen as equilibrating mechanisms that convert the competitive dichotomy between the formal and informal sectors into a complimentary relationship, or in the least case, into a relationship of mutual coexistence in multi-equilibriums. A case can thus be made for a different reality in which modem and traditional enterprises, Em and Et respectively, are serving two different population groups which can be described as modern and traditional, thus Pm and Pt. In this segmented market, Pm and Pt are institutionally, and often spatially, detached from each other. The average income level of Pm is far above that of Pt and the personal valuation of the marginal dollar that Pm receives is lower than in the case of Pt. The spending habits of the two population groups differ substantially. The design and pricing of goods supplied by Em and the margins placed on them by the retail sectors are usually quite high and are directed for the use and purchase by Pm. Such goods, at the offered high prices, are too expensive for Pt to buy. Moreover, the retail trade for such goods is usually located in modem urban centres from which most of Pt, and especially in rural area, is practically spatially remote. In contrast, the traditional enterprises, Et, produce and sell mainly less sophisticated goods at low prices, primarily to Pt. Large countries with large rural populations have started the development process with a relatively large Pt and a small Pm and the above configuration

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fits particularly such countries as China, India, Indonesia, Pakistan, Bangladesh, Egypt, and Nigeria, to mention a few. In smaller countries, the size of Pt, and the supporting Et, may be relatively too small to stand firm against the purchasing power from Pm and the supporting Em, resulting in the inability of the traditional segment and tiny enterprises to survive as a distinct low income purchasing population with its own market providers.42 The rationale for the mutual coexistence of both an Et and Em in countries with large populations is, in fact, of a more basic nature. About three-quarters of the labour force in the countries quoted are engaged in self-employment, and only about a quarter are working as paid employers in the modem segment which includes both the public and private market activities. While the informal activities in Et are able to absorb self-employed populations of hundreds millions, the modem segment faces stable or diminishing employment output elasticities, inhibiting any substantial increases in labour absorption. In such a situation the existence and continuation of self-employment activities in traditional enterprises is a godsend. A very gloomy and politically unstable scenario can be sketched if employment opportunity for masses of the labour force would be solely restricted to the modem segment. It is evident that modem employment is not forthcoming in any neighbourhood of the required members. As demonstration of the mutual coexistence of the segmented producer market we refer here to field investigations of small enterprises in large to very large countries, including Bangladesh, Indonesia, India, and Pakistan, which were carried out in the mid-1980s, and whose validity about a decade later has been roughly checked and confirmed. For the sake of brevity and consistency with previous sections, we explore here the results for Indonesia and Pakistan. The Indonesian data belong to a survey of small-scale industrial (SSI) enterprises carried out in Banda Aceh, Indonesia, in late 1985, and revalidated a decade later. The sample covered 181 units, which constituted 5 per cent of the units existing in the area. The sample covered 996 workers making the average size of the enterprise equal to 5.5 workers. The sample is distributed over three modes of enterprises that can be described as cottage, tiny, and larger firms.43 Household production units that share the same roof as the household run the traditional cottage workshops. This would fit fully in the concept of the informal sector. The larger firms would belong to the modern sector, while the tiny firms would lie in-between. The employed questionnaire allowed estimation of total assets of the firm, among other aspects. It collected data on fixed capital and working capital and the value of owned premises. The average cottage firm was found to have an asset value of 1.3 million rupees as compared to 3.3 million rupees in tiny firms and 13.0 million rupees in small firms. We deducted from the owner’s income an equivalent labour income based on the average wage of hired workers for the whole sample to give the average imputed value of profits in the three modes, 0.73, 0.95, and 1.6 million rupees respectively. We then calculated three profit rates for the three modes of enterprise: 54, 29, and 12 per cent. The above results are displayed in Table 7.20. The material is plotted in Figure 7.1 to show profit values and profit rates that coincide with total assets at the three firm types.

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Table 7.20 rates

Indonesia: Average values of assets and profits in thousand rupiah, and profit

Average value of assets per firm

Cottage industry

Tiny industry

Larger industry

1347

3291

12977

730

956

1601

Average profit amount earned per firm Average profit rate achieved per firm (a)

54%

29%

12%

Source, note: Sample surveys carried by the author in the context of development assistance projects financed by the Directorate of International Cooperation, the Netherlands. (a) = Second row/first row.

Indonesia 1.8

60

Profit rate (%)

1.4 1.2

40

1.0 30 0.8 0.6

20

Profit value (mn. Rup.)

1.6 50

0.4 10 0.2 0.0

0 1

2

3

4

5

6

7

8

9

10

11

12

Assets in mln. rupiah Profit rate

Figure 7.1

Profit value

Profit rates, profit values, and asset values of SSI in million rupiah, Indonesia

The mutual coexistence of three significantly different profit rates among establishments competing in the same locality is remarkable. The phenomenon indicates a high degree of segmentation between different modes of enterprise. For some reasons small industry entrepreneurs with a profit rate of 12 per cent cannot or are not willing to move to tiny and cottage business where the profit rates are 29 and 54 per cent. First, one reason lies in the limited extent of the traditional market. Even though the profit rate in the traditional sector is very high, the turnover is too small to be attractive for modern business. Such limitations on turnover would not permit a modern business owner to earn profits beyond 730 or 946 thousand rupees, while with a lower profit rate of 12 per cent but a bigger market and turnover it is able to make a profit of 1601 thousand rupees. Second, modern entrepreneurs may realize also that overcrowding the cottage and tiny industry market can reduce both the absolute profit per owner and profit

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267

rates significantly, and hence the preference to operate in modem markets with a higher level of purchasing power but a lower profit rate. Third, the traditional firm may not like that the modern firms intrude in their traditional market and may act collectively to obstruct third party entry. Fourth, consumers are segmented into traditional and modern goods consumers given their income differentials and their distinguishable reference consumption patterns: one segment consisting mostly of households with income and consumption patterns below the poverty line, and the other segment is better off and has a larger purchasing power. The coupling of spending of traditional and poor households to the informal production of these and related households gives this segment an autonomy that allows it to survive and coexist with modern business. The above four reasons represent a combination of segregating, equilibrating, and collective mechanisms at the micro level that holds a dualistic economy in a stable balance and prevents the societal configuration from breaking up and shifting to opposite extremes and corner solutions. The above account does not mean that households and enterprises do not have an opportunity to move from the traditional to the modern sector. The Indonesian material shows the presence of an intermediate category of firms that can be placed between the two sectors. But there is no evidence found that a modern enterprise ‘now’ has evolved over time from a traditional enterprise ‘then’. In general, when upward mobility occurs for a particular household production unit from the informal to the formal sector, this would be mostly applicable for the second-generation youngsters.44 Table 7.20 and Figure 7.1 display evidence that support the rational coexistence of dualistic economic systems within the same country. Three modes of entrepreneurs that were investigated appear to be equally satisfied about their profitability position in spite of significant differences in their profit rates. This again substantiates the conclusion that these types are sufficiently detached and shielded from each other to avoid being competitive with each other. They produce differentiated products and serve different markets even though they may share similar problems and prospects in different degrees, as will be clear from additional results to be discussed further on in the section. The second set of similar results we present refers to a survey of small enterprises conducted in 1980 and 1981 in four cities of Pakistan: Lahore, Karachi, Peshawar, and Rawalpindi. The interviews, which covered enterprises active in manufacturing and not exceeding five workers per enterprise, produced 806 valid responses at establishment level, see Table 7.21 and Figure 7.2. The heterogeneity of the enterprises, and their positioning between formal and informal types, called for the subdivision of the sample into two sub-samples. The traditional segment contained family-based firms with forward and backward linkages usually to the local consumer market. In contrast, the modem segment employed non-family labour and maintained backward and forward linkages with the rest of the economy.45 The survey data for the four cities in Pakistan allow the construction of Figure 7.2, which is similar to that of Figure 7.1, for the Indonesian case. Traditional enterprises are on the left hand side, with lower average assets per enterprises,

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Table 7.21 rates

Pakistan: Average values of assets and profits in thousand rupees, and profit

Informal segment Average value of assets per firm

Formal segment

142

350

12

20

Average profit amount earned per firm Average profit rate achieved per firm (a)

8.5%

5.7%

Source, note: Sample surveys carried by the author in the context of development assistance projects financed by the Directorate of International Cooperation, the Netherlands. (a) = Second row/first row.

Pakistan 9

25

8

Profit rate (%)

6 15

5 4

10

3 2

Profit value (th. rupees)

20

7

5

1 0 100

0 150

200

250

300

350

400

Assets in th. of rupees Profit rate

Figure 7.2

Profit value

Profit rates, profit values, and asset values of SSI, in thousand rupees, Pakistan

the modern on the right hand side. It is noted that traditional enterprises report on average profit rate of 9.2 per cent while modern enterprises report 5.9 per cent. In terms of profit value an opposite picture is obtained. While a traditional enterprise generates on the average 12.4 thousand rupees, the modern goes beyond that to achieve 20.22 thousand rupees. There seems to be a rationale for the mutual coexistence of both types based on the combination of different performance criteria that are conditioned to two different entrepreneurial environments. Public policy that aims at enhancing pro-poor economic growth has a heavy agenda in the context of the formal–informal dichotomy. The evidence examined showed that the informal sector is bound to grow in production and income. Next to its own autonomous economic growth mechanisms, here is also the complementary growth due to the growth of the formal sector. Thus, economic growth of the informal sector is secured for the future and is not a problematic

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269

issue. The real problem is that the informal sector may be absorbing more people at a rate that overgrows the rate of its economic growth, resulting in a prolongation of poverty. Eventually, the issue is how to raise the average labour productivity in the informal sector to a level above that coinciding with the poverty line. Moreover, given the relative notion involved in the poverty line the ultimate aim is to narrow the gap between factor productivities in the informal and formal sectors. The previous section examined some macroeconomic policy measures that could raise productivity in the informal sector and promote thereby pro-poor development strategies. It was suggested that income (and asset) transfers to household groups associated with the informal sector are likely to be very effective. This implies a partial redistribution of the growth in national income from the formal to the informal sector. In development settings where the poor spend most of their income in the informal sector, this will advance the growth of the sector furthermore and contribute to a further reduction in poverty. Although belonging to a different realm of policy-making, any human resource development policy that lead directly or indirectly to reducing the family size of households associated with the informal sector, and restraints in population growth, will help raise productivity levels and reduce poverty. Policies aiming at raising the output level of informal enterprises are the other major area of state intervention. Microeconomic surveys of the informal sector in developing countries have highlighted several obstacles facing these enterprises. Policy directed towards removing these obstacles is a high priority. We give below selected results from the sample surveys of the targeted establishments undertaken in Indonesia and Pakistan. Establishments were asked to report on five types of difficulties that they faced at the time of the enquiry and which they felt were obstructing future growth, noting that the number of reported difficulties may exceed the number of surveyed establishments. A rough picture is obtained by ranking the problems encountered in the last column of the table, even though the picture hides important country differences. For instance, the difference in problems faced in the two segments appear to be more pronounced in Pakistan than in the Indonesian context, which draws attention to the requirement of elaborating distinct public policies and approaches in different countries. Giving due consideration to the above country differences, the overall picture that emerges is one in which limited financial resources and weak demand conditions are the two major obstacles in both sectors. Financial problems appeared to come up more frequently than demand problems in the informal sector, the opposite was observed for the formal sector. Lack of qualified skills is another important obstacle for the growth of the informal sector, reflecting its comparative disadvantage as a producer of technologically less developed products. Although there is a consistent continuum in problems faced by enterprises in informal and formal sectors, Table 7.22 shows the magnitude of specific problems to differ appreciably by country. Therefore, local diagnosis is necessary for coming up with effective local policies.

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Table 7.22 Indonesia and Pakistan: Share of difficulties reported by surveyed establishments, grouped by informal and formal market segments; per cent Country Reported difficulties

Pakistan

Indonesia

Average rank (a)

informal

modern

informal

modern

informal

modern

Weak demand, purchasing power

11.4

17.6

37.2

20.7

1.5

3.0

Location too small, unsuitable

15.5

16.5

4.2

1.1

1.5

2.0

Lack of financial resources

16.5

15.2

39.5

27.4

3.5

2.5

Lack of qualified skills, machines

23.7

12.7

12.6

29.7

3.0

2.5

Other

33.4

38.0

6.5

21.1

–

–

Source, note: Sample surveys carried by the author in the context of development assistance projects financed by the Directorate of International Cooperation, the Netherlands. (a) This column is found by ranking the four specified difficulties in terms of their frequency (highest 4, lowest 1), and by taking a simple average over the two countries.

Informal enterprises in the context of Pakistan perceived the lack of skills, finance, and demand as the major problems, in a declining order. The interviewed informal enterprises in Indonesia saw lack of finance and demand as more problematic than skill shortages. On the whole, the lack of finance, skilled labour, and raw materials next to a sluggish demand appeared to be on average the more significant problems. Modern enterprises, having more outward orientations, have a different perception of problems encountered, which draw attention to the requirement of elaborating distinct public policies and approaches towards the two segments. Finally, differences in problems faced by the two segments appear to be more pronounced in Pakistan than in the Indonesian context. Some of the obvious conclusions from the above are that more credit facilities and upgrading of technical skills would relieve the often-encountered shortages of finance and skills on the supply side. But to resolve the problems of low demand and a weak purchasing power that enterprises face in the informal sector would require increased earnings, and expenditures, of households allied to the informal sector as well as greater trickle down effects from the formal sector, and households attached to it, towards the informal sector. In a discussion of public policies towards the informal sector it cannot be avoided mentioning that public policies, already since the independence of most developing nations in the 1950s and 1960s were heavily oriented towards favouring the formal sector. The term ‘urban bias’, coined by Lipton several decades ago, is still generally valid.46 In spite of the greater attention given in state policies to the urban/formal sector as compared to the rural/informal sector, past and recent developments show that the rural/informal sector and the populations associated

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271

with this sector survive and are self-sustainable. There are significant potentials in the informal sector that can be realized with only moderate shifts from current development policies.

7.7 Summary and conclusions This chapter reviewed the main features of development change that has occurred in the six developing regions of EAP, SA, GCC, MENA, SSA, and LAC. The focus was on treating several sets of questions. What are the major historical epochs pertaining to the polity and the economy through which developing countries passed and are passing? We distinguished between three political epochs (colonial rule, nation building, and democratic reforms), and three economic epochs (household-led demographic transition, state-led economic development, and firm-led global integration). For each historical epoch what were the effects on the six developing regions with regard to shaping their social, political, and economic systems? The review went at more length regarding the economic-led economic development and the firm-led global integration. We speculated that the impact on settings and associated behavioural patterns differed appreciably by developing region. While overall household settings experienced an undermining of influence, the undermining was less in most EAP countries, and least in SA and SSA. Firm influence gained more in some countries of EAP, and much in GCC and LAC. State influence gained more in SA, MENA, and SSA. How did the economic systems in the six developing regions perform comparatively with regard to such development objectives as growth and equality? EAP followed by SA were the developing regions that performed better than others, with more success in growth than equality. This is mainly due to the strong performances of China and India. Sub Saharan Africa did worst in terms of both growth and equality. MENA and LAC occupied intermediate positions of moderate growth and relatively stable income distribution. The economic growth of GCC has been tied to energy demand and prices. Distribution performance in GCC is ambiguous and can be interpreted in different ways. The most prominent feature of the development economy being its dualistic structure and performance; what are then the characteristics, magnitudes, and impacts of this dualism in the developing world? In treating these questions the focus is shifted to the EAP and SA regions. Some of the countries here such as China, Indonesia, India, and Pakistan, are characterized by very large-sized populations in rural areas, informal modes of employment and production, affiliation with household settings and behavioural patterns, and a widening income gap with the formal urban segment that is also large but has absorption limits. There is a high natural population growth of the informal segment that cannot be possibly absorbed in the formal segment. The structure of the social system, with its economic and polity component systems, and the ways these systems change, are bound to be different in the large-sized population countries than otherwise. This hypothesis is elaborated further.

272 Economic Systems Analysis and Policies

Moving from development analysis to development policy, what additional insights can development policy contribute regarding systemic patterns and prospective changes in highly dualistic economic systems? Several aspects of macroeconomic development policy are found relevant and are elaborated upon. This is done in a framework of social accounting that distinguishes between traditional and modern sectors of activity. The applications are done for Indonesia and Pakistan. The chapter treated next aspects of microeconomic development policy relevant for dualistic development. Use is made of sample surveys of enterprises in the informal and formal sectors in Indonesia and Pakistan to explain the coexistence of both segments in spite of lower profitability of one on the other. The sample surveys point also to formal–informal differences in encountered problems.

8 Economic Systems in the Developing World: Country Profiles

8.1

Introduction

We have followed World Bank regionalization of developing countries into five groups: East Asia and Pacific (EAP), South Asia (SA), Middle East and North Africa (MENA), Sub Saharan Africa (SSA), and Latin America and Caribbean (LAC). We added the sixth group of Arab Gulf countries (GCC). The positioning of these development regions along the different poles of economic systems was displayed in Chapter 1, Figure 1.3; and it is recalled in this chapter in Figure 8.1. In this chapter we examine each of these regions, starting with the EAP and focusing on China, we move eastwards and take up the other regions. The positioning of the EAP, consisting of China, Asean countries, and Pacific islands, close to the HIM corner, but along the HIM–FIM axis, reflects both the fact that the majority of agents in the region are still in rural areas where household settings count; and that a sizeable population has already moved to and is living in urban cities during a relatively short period of high economic growth; this population manifests the impact of firm settings. The South Asia region, SA, consisting of India, Bangladesh, Pakistan, Sri Lanka, among others, is placed in the HIM corner, which reflects the relatively high dominance of household settings in this region. The region lies also on the HIM– FIM axis but affiliation with FIM in SA is less than in EAP. Most attention in this chapter will go to reviews of the economic systems of China and India. Given their relative sizes, these two countries are very influential in shaping the future development of the economies of many developing countries. We have emphasized the special positions of India and China regarding their very large populations and diversities and used the notion of a multipolar economic system to accommodate for these special features. It was argued that persuasion settings by active leaderships perform an important role in facilitating coordination in such a system. Turning to the other developing regions, it is noted that in contrast to EAP and SA that are positioned along the HIM–FIM axis, the Arab and African countries are positioned along the HIM–SIM. Although household settings are dominant, 273

274 Economic Systems Analysis and Policies

due to various historical and cultural precedents, state settings are relatively significant in these regions. The MENA region, practically speaking the Arab countries, are placed halfway the HIM–SIM axis, in view of histories and traditions that have largely stayed intact, and by which households voluntarily entrust state leadership, whether it is led by royalty, president, military, or religious council, with authorized and extended rights and obligations. The Arab Gulf countries, GCC, share a common history, religion, culture, and language with the MENA region, but have gone closest to firm settings in view of the emergence of a modern business segment that has become highly dependent on foreign labour. Sub Sahara African countries, SSA, are positioned close to the household settings, HIM corner, as kinship and ethnic ties are well known to occupy a central role in agent interaction in most African countries. SSA lies also on the HIM–SIM axis in view of the quick rise of state and military authorities as powerful players after gaining independence. Finally, Latin American and Caribbean countries, LAC, are positioned along the HIM–FIM axis, but closer to FIM than HIM, reflecting long periods of a significant impact of firm settings on the economic system, and a relatively higher degree of urbanization than other developing countries. Even though a couple of outlying countries can be sighted that do not fit the classification in Figure 8.1,1 the positioning of the six developing regions along the indicated planes of HIM–FIM and HIM–SIM meets global and average criteria and contributes to a rational and anticipated distinction between the developing regions and other world regions that distinctly lie in or along the axis of FIM and SIM. In the previous chapter we introduced an analytical subdivision based on the population size of countries: small developing countries whose populations are more prone to be absorbed in urban and formal entrepreneurial settings and large

South Asia SA

East Asia Pacific EAP FIM

HIM Latin America Caribbean LAC

Sub Saharan Africa SSA Middle East N. Af. MENA

Arab Gulf GCC SIM

Figure 8.1 Positioning of the world developing regions along axis of dominant systemic interactions

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275

developing countries with large populations living mostly and working mostly in rural and informal entrepreneurial settings. Next to these contrasts, there can be significant regional variations. Some of these variations can be systematized by introducing subdivisions to gain more reality and comprehension. In the current chapter we introduce more analytical subdivisions based on hypothesis that identify leader countries within a development region, with which other follower countries in the region are likely to associate and converge. The basic hypotheses are (a) among alternative settings, that setting which contains the largest number of agents and manages the largest economic transformation is more likely to dominate on other settings; and (b) furthermore, the intensity and extensiveness of interactions of agents and their outward communication to other settings, network externalities, and a common external environment matter in the prevalence and domination of one setting on others. The entity country can be substituted for the entity setting in the above hypotheses. If a few measurable indicators can be identified at the country level regarding the size of the agent population, the size of the economic transformation and the outward orientation of both the population and the economic transformation, countries within a region can be ranked to give an indication of leading country(ies) within a region. These are countries whose economic systems are likely to dominate the economic systems of the region. Focusing on the economic systems of these leading countries and understanding them is a richer alternative than reviewing the complexities and differences of tens of countries within the region. An application of the above strategy results on focusing on eight major countries, which constitute poles of attraction likely to dominate neighbouring countries in the identified region. These eight countries are also the focus of further treatment in Chapter 8. Next to highlighting basic features in China (EAP) and India (SA), brief reviews will be given United Arab Emirates (GCC), Egypt (MENA), Nigeria and South Africa (SSA), and Brazil and Mexico (LAC).2

8.2 East Asia Pacific (EAP) 8.2.1 Regional profile If we were studying economic systems around the 1950s or 1960s, the Far Eastern countries and/or territories like Japan, South Korea, Taiwan, Singapore, and Hong Kong would have fitted in a review of the EAP region. Since then, the economy of Japan and later the economies of the other Four Tiger countries as they have been named have gone through fundamental transformations and far-reaching economic development processes that brought them closer to the firm intensive economic system and elevated them to levels of income per capita comparable to other FIM related countries. The binding development formula of the transformation of these economies is outward industrialization. This required the ending of centuries of feudal agriculture, the swift reallocation of labour, capital, and purchasing power from agriculture to industry and related services, and the mobilization of these forces in

276 Economic Systems Analysis and Policies

expanding merchandise exports to the rest of the world, and especially the richer economies. States and firms in many current member countries of the EAP and other developing countries tend to see Japan and the four other Far Eastern countries, as well as the development formula they followed, as ideal models of economic development that are applicable and adaptable to their developing economies. Indeed, the economic developments of most EAP countries have and are generating outcomes in terms of investment, trade, growth, and distribution, similar to those of the Far Eastern forerunners. Although the end targets and the economic outcomes are similar, individual EAP countries have used different means and phasing paths towards realizing their outward industrialization. As is well known, in preparing the ground for the outward industrialization China pursued revolutionary and radical reforms. Once the basics for the take-off were established China encroached on a controlled stepwise outward orientation of its industrial economy and an extensive but controllable reliance on foreign trade and joint ventures. In a similar vein, Vietnam followed a largely calculated development course. Other major countries in EAP such as Indonesia, Philippines, Malaysia, and Thailand followed more spontaneous development courses and had less control on the pace of their outward industrialization. This permitted a greater dependence of their national economies on foreign finance, which made them more susceptive to risky international financial transactions. This showed itself in the Asian financial crises that started from distrust by international financial institutions in corporate and banking commitments in Thailand in 1997–98, and spread to other Asian countries, causing a recession in these countries, with duration of three to five years.3 The region includes other countries such as Cambodia, Lao PDR, Korea DR, Myanmar, Mongolia, and other small territories and islands that lag behind and that can be described to be still in the pre-phase of a take-off and are not yet in the stage of pursuing an effective outward industrialization.4 Table 8.1 aims at drawing conclusions on the relative dominance of the systemic features of one country on other countries of the region. Referring back to Chapters 1 and 2 we posed that the larger the number of agents and the size of the economic transformation in one setting the greater the influence will be of that setting in its interactions with other settings; and with very relatively very large numbers that setting will ultimately be able to dominate other settings. Table 8.1 considers the population and the GDP as the proxies for the number of agents and the size of the economic transformation, respectively. These numbers and their relative shares in the total are displayed for the countries of EAP. As was proposed in Chapter 2, Section 2.5, equation 4, combining these two shares relating to the concentration of agents and economic transformation gives an index of interactive influence. The higher the index of a setting (i.e. a country) is, the more likely that the systemic features of that setting (i.e. that country) would spread to other settings (i.e. other countries in the region). The tendency increases in probability once the index passes a threshold value of 2/3rd or 3/4th.

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277

Table 8.1 Population and GDP of EAP: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Country

Population Million

%

GDP US$ Million

%

Country Index of interactive influence  average cols. 2, 4

Total EAP

1806

100.0

1713600

100.0

100.0

China

1263

GDP per capita US$

GDP per capita ppp$

949

3747

70.0

1200000

70.0

70.0

950

3939

206.3

11.4

165000

9.6

10.5

800

2904

Vietnam

78.5

4.3

31200

1.8

3.1

397

2016

Philippines

75.8

4.2

75400

4.4

4.3

995

4030

Thailand

61.4

3.4

122700

7.2

5.3

1998

6319

Myanmar

47.7

2.6

9540

0.6

1.6

200

–

Malaysia

23

1.3

90300

5.3

3.3

3926

8570

Indonesia

Korea DR

21.9

1.2

6570

0.4

0.8

300

–

Cambodia

12.7

0.7

3700

0.2

0.5

291

1730

Lao PDR

5.3

0.3

1700

0.1

0.2

321

1505

Papua NG

5.3

0.3

3500

0.2

0.2

660

2343

Mongolia

2.4

0.1

950

0.1

0.1

396

1530

Others

1.8

0.1

3040

0.2

0.1

1689

–

Source, note: World Bank at http://devdata.worldbank.org/query As there are no available reliable GDP figures for Myanmar and Korea DR the estimates are made on the basis of comparable GDP per capita for low income countries at US$ 200 and 300, respectively. Others include unspecified ten Pacific island groups.

Now, China’s population in 2000 constitutes 70 per cent of EAP. Its GDP is also about 70 per cent of all EAP’s GDP. The country index of interactive influence for China at 70 per cent suggests an overwhelming Chinese influence in the region.5 The next country with some influence is Indonesia with an index of only 10 per cent. Given the above figures it is very likely that the future development of the economies of the EAP region will mirror the impact of the Chinese economy; and increasingly more systemic features of China will be adopted in the EAP region. Table 8.1 shows also the Chinese GDP per capita in US$ and in ppp$ to be about the same as the average for the whole region. This is an additional force for integration, as having equivalent levels of economic welfare can contribute to greater interactions between interacting agents. For practical purposes, therefore, an assessment of the economy of China is an assessment of the economies of EAP as a whole. However, because of the size difference between China and other EAP countries, there will be differences in the adaptation of several features of the economic system to differences in the size factor, as will be shown in due course. There are some descriptions that apply generally to EAP.6 The positive reciprocity culture that persons took over from the household setting tends to be

278

Economic Systems Analysis and Policies

extended to business and state settings. The prerequisite conditions for positive reciprocity are mutual trust, unchallenged authority, collective punishment, or simply favourable external conditions that can be of a temporary nature. These conditions reduce transaction costs and have thus economic advantages, but may cause other economic disadvantages such as non-transparency, insider governance, and non-warranted mutual financial support among the transacting agents. The size of government is kept low, product liberalization is well spread, trade barriers are minimal, and the infrastructural investment of the public sector is distributed across the board. On the other hand, industrial policy is of the targeted type with coordination between business and state at high levels and in specific sectors that are considered strategic. These sectors get also financial incentives, credit at soft conditions, restricted entry, subsidies, and procurement orders. The facilities tend to be given to influential families and business relations.7 Table 8.2 attempts to quantify some of the above tendencies. It highlights the relative influence of household, firm, and state settings as well as global links in the largest five countries of EAP for which the required data are available. Table 8.2 considers first household versus firm settings. As there are no available data on the intensity of interactions in household and firm settings a plausible approximation is to take sector activities in agriculture and industry as being closely associated with household and firm settings, respectively. This approximation was followed also in the previous chapter. In Table 8.2 a sector Index of Interactive Influence is constructed along the same lines of Table 8.1. The combined relative shares of agents and of the transformed Table 8.2 Economic structure and conduct in China and EAP: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Country

Indicators relating to relative significance and influence of household versus firm settings

Indicators of state influence

Indicators of global links

Labour ratio of agri: industry %

GDP ratio of agri: industry %

Total EAP (a)

73:27

25:75

49:51

63:37

13.0

1.7

59.7

China

69:31

24:76

46:54

64:36

7.1

1.8

39.6

4.3

Indonesia

74:26

25:75

50:50

58:42

–

1.0

66.1

0.8

Philippines

71:29

33:67

52:48

41:59

15.2

1.1

101.9

3.0

Thailand

73:27

18:82

45:55

69:31

–

1.4

106.7

2.7

Malaysia

36:64

33:67

34:66

38:62

19.2

1.7

199.5

4.2

Sector Population Public Of which Foreign Foreign index ratio of budget/ defence merchandirect of I I  rural(h): GDP, % spend- dise trade investaverage urban(f) ing/GDP, FMT/ ment FDI/ cols. 1, 2 % % GDP, % GDP, % 2.7

Source, note: World Bank at http: //devdata.worldbank.org/query. Col. 5: Public budget is average of public revenue and public spending. (a)  average of all EAP countries and referred years with available data.

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279

GDP in the two sectors are indicative of the strength of the household versus firm settings. The outcomes for China, very close to those for the region as a whole, show about an equal balance between agriculture (households) and industry (firms), with index values of 46 and 54 per cent, respectively. A country like Malaysia is geared less towards household and more towards firm settings, with index values of 34 and 66 per cent, respectively. The differences are partly due to the higher level of economic development in Malaysia but mostly due to size limits in China towards the absorption of vast numbers of agents working in agricultural household settings into commercial firm settings. These differences in absorption capacities between large and small countries are apparent also in the rural–urban distribution of the population. In China, in 2000, the share of the rural population, which is more oriented towards household settings, is 64 per cent, leaving 36 per cent for the urban and firm-oriented settings. In general, the smaller countries show reversed weights.8 Table 8.2 considers also indicators of state influence. If the object of an analysis is to determine the degree of state power in a given country context it will be necessary to consider many aspects falling under control of the state such as state budget, defence spending, foreign exchange financial reserves, property ownership, appointment rights, mass media, etc. This is outside our scope and is not feasible anyhow. To the extent that there is a positive correlation between controls in adjacent spheres, it can be reasoned that the selection of one set of indicators representing one sphere, i.e. the fiscal sphere in the present context, can nevertheless be a useful indication. The table shows two indicators: share of public budget in GDP and share of defence spending in GDP. In the light of comparative country statistics in this and previous chapters, the values of these indicators suggest a relatively low profile of the state in the economies of EAP.9 We consider next indicators relating to global links. EAP was shown earlier to be more outward oriented than other developing regions. Table 8.2 suggests that within the EAP the countries of Malaysia, Thailand, and Philippines have greater global links than China and Indonesia as indicated by a higher foreign merchandise trade as per cent of GDP. However, in evaluating the outward orientation of bigger countries it is necessary to keep in mind that the merchandise/GDP indicator, and the FDI/GDP indicator too, tend to be lower the larger the domestic economy, and higher at higher levels of economic development. When China is compared with large countries such as USA, Japan, Germany, Russia, or India, it is noted then that China has higher values for the two indicators than these countries; and should be described as being highly outward oriented and globally linked. This is shown further by the greater value of FDI/GDP of China when compared to other EAP countries; Table 8.3, last column. In the third table (Table 8.3), we elaborate on the comparative performance of main EAP countries. From 1981 onwards China achieved the highest growth in GDP and GDP per capita. The higher economic growth in China than in the EAP is found to associate with a higher rise in income concentration in China than in the EAP, which is common for all developing countries.10 Table 8.3 shows that in the periods from 1991 to 2005 the Gini index rose by 6.3 points as compared

280 Economic Systems Analysis and Policies Table 8.3

Comparative performances of the economies of China and the EAP, 1981–2005

Country

Average annual growth GDP %, in constant prices

1981– 1990

Average annual growth GDP per capita %, in constant prices

1991– 2000

2001– 2005

1981– 1990

1991– 2000

Gini index

2001– 2005

1981– 1990

1991– 2000

2001– 2005

Total EAP (a)

7.6

8.4

8.3

5.8

7.1

7.3

38.3

42.6

43.3

China

9.4

10.0

9.2

7.8

8.7

8.5

25.7

40.3

46.9

Indonesia

6.4

4.8

4.6

4.5

3.3

3.2

33.1

35.5

32.3

Philippines

1.8

2.8

4.7

–0.6

0.6

2.7

40.8

44.3

45.3

Thailand

7.9

5.3

5.1

6.1

4.0

4.1

44.5

44.4

42.6

Malaysia

6.0

7.2

5.3

3.3

4.5

3.1

47.3

48.5

49.2

Source, note: http://devdata.worldbank.org/query (a)  average of all EAP countries and referred years with available data.

to an average of 0.7 points for EAP. The table shows for 2005 a higher income inequality in China than in EAP. The next section, focusing on China, will touch upon more aspects of growth and inequality in China. 8.2.2 Systemic change in China 8.2.2.1 Background Knowledge over past China is essential for understanding the economic system of contemporary China, and how it may develop further. Our first subsection here will review background elements from the past that relate to the functioning of the three types of settings we are focusing on: household, firm, and state settings, and which in turn shape the sociological, economic, and political relationships in the social system. After this first subsection we examine in Section 8.2.2.2 the critical contours of the economic development of China from the 1950s onwards and how the era of economic development of China has shaped the economic system to its present form. Section 8.2.2.3 examines and evaluates the performance record of the economic system and the expected future outlook with an attempt to signal out critical issues of comparative performance that are relevant for the stable functioning and the sustained evolution of the system, currently and in the distant future. Section 8.2.2.4 concludes the review of China’s systemic changes with a reflection on the role of persuasion settings in streamlining multipolar currents of interactions within and between household, firm, and state settings. In reviewing the past, it suffices to go back to around the tenth century, when China was economically and technologically more prosperous than the rest of the world. Due to various attitudes and mechanisms in its past social system, China went through a relative decline over the past centuries. The communist revolution in 1949 initiated a reversal, and economic reforms since 1980 have transformed the Chinese economy to become among the very largest in the world. This section introduces the past decline. The following sections examine the recent rise. Around the tenth century, the population of China counted about 60 millions, compared to about 40 millions in Western Europe, and a total world population of

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about 300 million. With an estimated size of an extended household of ten members, it can be estimated that China had about 4 million households in the tenth century. About 95 per cent of these households were rural and about 5 per cent lived in urban areas.11 The rural farming population had the burden of feeding itself as well as the urban population. The latter consisted of imperial rulers, bureaucrats, military, craftsmen, and other court supporters. Furthermore, both the cultivated area and agricultural productivity were relatively low. These circumstances led the ruling class to pursue various forms of coercion that included serfdom and overwork at survival levels for many farm workers. At the same time, a significant shift in the concentration of households took place from North China where three-quarters of the population lived and where wheat and millet were the main crops around the eighth century, to the region below the Yangtse where rice cultivation dominated. This change permitted the population of China to double by the thirteenth century, release labour for handicraft production, and raise general welfare to among the highest income per capita at the time. Two sets of questions are relevant to review. How did the economy of some 4 million households operate? And, how was the polity managed in the context of the 4 million rural household settings, spread over vast territories, and under the auspices of one imperial ruler? Answers to these questions are important for our study of systemic changes in the polity and the economy. First, how did the economy of millions of extended households with varying riches operate? How did agents in extended households perceive participation in commercial entrepreneurship? There are two contrasting views on this matter. One view is that the Chinese extended family constituted an obstacle to entrepreneurship and economic development because family loyalties and obligations tended to dilute individual incentives to work, save, and invest. The other view is that Chinese family traditions oppose the full pooling of resources among family members, encourage rivalry among brothers, apply rewards for employed efforts, appreciate trust in business and non-business relationships, and esteem highly the success of individuals and their families. Hence, kinship settings in China do (did) not discourage commercial entrepreneurship, they rather function(ed) as driving engines of entrepreneurship and firm settings. Proponents of this view point to past and present evidence on the emergence of prosperous family-based largescale enterprises and new riches in China and by Chinese abroad, emphasizing that whenever the external circumstances were/are favourable such opportunities were/are seized by the more fortunate households; and their successes were/are hailed and aspired by more households. The ups and downs in the organization and expansion of firm settings in the past and present are thus more explainable in terms of the presence of favourable external circumstances than in terms of reserved attitudes.12 Second, how was the polity managed in the context of a vast country with millions of rural households and their catering economy? Already from the seventh century, the Chinese dynasty was recruiting professionally trained public servants on a meritocracy basis, admission was subjected to examinations, and advancement required evaluation. The bureaucracy was the main instrument for imposing political order in a unitary state over a huge area and a large population, and its

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procedures were perfected over time. The number of bureaucrats was small, and did not exceed 15,000 officials in the sixteenth and seventeenth centuries.13 They serviced the central, provincial, and district administrations. At the level of the district the magistrate was tax collector, judge, record keeper, and the local administrator, with a command on recruited clerks, policemen, guards and alike. The bureaucracy was a privileged class; their families enjoyed esteem and were exempt from many levies. Candidate bureaucrats, who qualified academically but failed to become officials, formed a supportive buffer stock, and enjoyed similar privileges but at a lower level. To discourage corruption, bureaucrats were regularly rotated. The bureaucracy functioned in a primarily agricultural economy with absentee owners. The bureaucracy invested enthusiastically and effectively in agriculture and got its due share in a growing agricultural income. They introduced hydraulic works and new crops, spread best techniques and innovations, resettled farmers in more fertile areas, and developed stockpiling to mitigate famines. The concentration of the bureaucracy and gentry of Imperial China on agriculture had the consequence of ignoring industry. The urban workforce employed in industry, trade, transport, etc., basically representing firm settings, was deferential to the bureaucracy and depended on their good will. These firm settings did not enjoy legal protection. Bureaucratic decisions could not be challenged. Furthermore, the reserved attitude towards foreign elements and towards trading with the rest of the world did not encourage the opening up of foreign markets and related commercial activities. The above biases failed to launch the country in the industrial age. Although between the tenth and fifteenth centuries China was the leading economy in the world in terms of income per capita,14 and was ahead of Western Europe as regards technology, productivity, and capacity for governing the largest population within one territory, the above-mentioned institutions that China possessed at that time fostered the well-being of a very small dominant ruling class living off-farms at the expense of a vast impoverished agricultural farm population. Moreover, the economy/society chose also to be closed to foreign interactions. The Chinese economy lagged further due to internal rebellions and external interventions involving wars with Japan, France, and the United Kingdom. 8.2.2.2 System development It took another five centuries for China to break with its past settings and engage into a full-fledged modernization. The modernization of China started with the communist takeover in 1949. Although an economic system of state ownership and a central planning comparable to the Soviet Union was installed in the immediate years, China went back on these and drew on its communal traditions and past history in handling matters of resource allocation. While the economic system was dominated by political motivations under the Maoist regime (1949 to 1978), economic considerations played increasingly a greater role thereafter, in the Deng and Zemin regimes. A series of economic reforms and a gradual introduction of private ownership pushed the economy to new heights, outperforming other major economies in the world.

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The transformation of China from a stagnant economy to a developing economy with an ambitious role for the state in this development endeavour started from about 1950, almost the same as for India. The communist party headed by Mao, was highly disciplined, kept tight control of the bureaucratic apparatus, mass movements, and persuasive propaganda were organized to bolster Mao’s views and policies. These were characterized in the beginning by a command regime following the Russian pattern. But in a big and diversified country like China, the command rule was modified within one to two decades to that of self-reliance at the regional level. India, in spite of being a parliamentary democracy with an exchange economy, was also impressed by Russian accomplishments, and it did increase state centralized decision-making in the first decade after independence. But being a federation of states, each with vast territories and populations, decentralized decision-making dominated here too, after a couple of decades. After a self-imposed isolation from the rest of the world and a number of risky experimentations, the communist regime in China started from 1978 on a path of cautious reform that relaxed political control and strengthened economic incentives. In the relatively short period of two decades China was transformed to one of the leading economic powers in the world. The economic development of China underwent successfully the four systemic changes that accompanied the economic success stories of Japan and Korea, some decades earlier. Practically speaking, these four systemic changes are basic for a sustained take-off in a development context; even though developing countries may differ in the ways they implement the four systemic changes. These are (1) an agricultural shake-up that allows freeing of resources for industry, (2) balanced physical, human, and institutional infrastructures that allow industrial structuring and industrial breakthroughs, (3) outward orientation of foreign trade and financial relations in harmony with circumstantial comparative advantages, and (4) restrained tasks for the public sector. This requires a greater reliance on communitarian resolution of collective needs, which is traditionally ample in household intensive settings. The ways in which the four systemic changes took place in China and their impact for the economy are reviewed below. (1) Agricultural mobilization. China went through an agrarian reform that confiscated about half of the cultivated land, belonging to landlords, and redistributed this land to tenants and landless farmers. The redistribution was violent with many killed and imprisoned. Soon after, peasant households returned to an old tradition of pooling their plots together for a greater common good. From the mid-1950s agriculture was collectivized in the form of cooperatives with an average size of 200 families. Collective income was determined by the sum of work points that farmers belonging to the cooperative receive for their work effort, skill and attitude, less takes, and investments. In their free time farmers can cultivate their own private tiny plots and sell them in limited free markets. These private plots did not count more than 5 per cent of the total arable land. The Great Leap Forward between 1958 and 1960 enlarged the cooperatives to 5000 families and was associated with food shortages and distribution of food on basis of work

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Economic Systems Analysis and Policies

points. Between 1962 and 1979 cooperatives reversed back to the other extreme of 20 to 30 families with about 7 per cent in private plots. Modern reforms started from 1979. The reform started from 1979 with (a) extension of the limited free markets to household products such as poultry, livestock and related, (b) introduction of the responsibility system, which tied more closely received rewards to the targeted work performed. In a few years the system developed into that of (c) collective units of individual households with cultivation rights for periods of about 15 years and (d) binding contracts on the collective units to deliver certain portions of the crops to the state/province at crop prices that were fixed by the state. As private incentives, (e) the state paid premiums for extra deliveries above the contract, and prices for attractive crops were raised. As transitional strategies, (f) the state introduced a dual system with a tendency for the official price to move towards widely known market prices.15 The results of the above reforms show up in significantly increasing shares of state agricultural procurements and retail sales executed at market prices exceeding 80 per cent by 1993, at the cost of deals at planned prices, which fell to 17 per cent, Table 8.4. At the same time, quota and negotiated prices for agricultural products converged towards market prices. By 1992, the market and negotiated prices for rice and wheat differed by about 10 per cent only, Table 8.5.16 An important side Table 8.4 China: Planned versus market components of agricultural procurements and retail sales Year

% of agricultural procurements at Planned prices

Market prices

% of retail sales at Planned prices

Market prices

1978

94.4

5.6

97.0

3.0

1985

60.0

40.0

66.0

34.0

1990

31.0

42.0

55.0

45.0

1993

17.3

82.7

16.4

84.6

Source: Price Yearbook of China, various issues.

Table 8.5 China: Convergence towards market prices: Rice and wheat Year

rice

wheat

Quota price

Negotiated price

Market price

Market price/ quota price

Market price/ negotiated price

Market price/ quota price

Market price/ negotiated price

341

595

726

2.13

1.22

1.70

1.06

1983

337

634

732

2.17

1.14

1.60

1.05

1986

464

635

715

1.54

1.13

1.17

1.05

1989

672

1356

1573

2.34

1.16

1.93

1.05

1992

718

1041

1140

1.59

1.10

1.45

1.14

1980

Source: Price Yearbook of China, various issues.

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effect of the convergence in prices is the reduction in corruption. As multiple prices promote corruption, the narrowing of the price gap contributed to a reduction in corruption. The reforms resulted in a rocketing of the growth rate of agricultural output from 4.3 per cent per annum in 1971–75 to 7.5 per cent per annum in 1980–82 to 13.0 per cent per annum in 1982–86.17 This significant growth in agriculture is fundamental for the industrial push that occurred. (2) Industrial structuring. Following the Soviet example, industrial enterprises became state enterprises in 1950. The objective of the enterprises was to maximize output subject to planned input constraints, the plans being specified from higher levels of decision-making, which can be in the central government or in the regional governments. The Great Leap Forward (1958–60) introduced more centralization and dogma, but the experimentation resulted in economic failures. The reaction to the failure was a substantive decentralization that took the form of a dominant provincial participation in decision-making, and this went further in the case of some industrial activities to a delegation of decision-making to the county level. Most enterprises obtained inputs from own province and sold output in own province. Trade between provinces was in the hand of state trading firms in the provinces.18 Production in strategic sectors remained in Beijing. The industrial reform proceeded from around 1980 onwards and can be described to fall into four components: (a) Creating product markets for inputs and outputs. (b) Making enterprise managers behave in accordance with market rules via the pursuit of profits, bankruptcy laws, government pre-determined rates of interest, creating boards of directors independent from bureaucracy. (c) Introduction of competition and abolition of monopoly power especially manifested in loosening the inter-trade between provinces that was until then run solely by state trading firms, and in liberalizing the organization and provision of services. (d) Setting prices in accordance with relative scarcities.19 In applying the above reforms the state continued long-standing practise of applying separate laws and regulations to firms operating under different ownership arrangements. Differentiated stimulation and reform policies were applied towards state owned and state-holding enterprises, SOE, and various types of non-state owned enterprises, non-SOE, that discouraged SOE but favoured non-SOE. This differentiation resulted in a decreased importance of SOE and increased importance of non-SOE. Table 8.6 reflects on the gradual pace of this structural change. Table 8.6 displays the changing composition of industrial output between the two broad types of ownership, showing a reduction of the share of SOE by about 25 percentage points between 1978 and 1990, and by another 17 percentage points between 1991 and 2003. Non-state enterprise ownership accounted for a majority of industrial output by the turn of the century. It can be calculated from the table that since the economic reforms the average increase in the share of non-SOE in industrial output has amounted to about 1.8 per cent every year over 25 years. This has gone with an increase in the employment share of non-state firms from 48.5 to 85.7 per cent between 1978 and 2003, which is equal to an average rise of employment in the non-sate sector of about 1.5 percent every year over 25 years. The extent of the re-allocation in terms of transformed output between the state

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Table 8.6 China: Distribution of output and employment by state and non-state ownership of industrial enterprises, per cent Year

Episode

Industrial output value

Employment

Share of state owned and state-holding enterprises

Share of non-state owned enterprises

Share of state owned and state-holding enterprises

Share of non-state owned enterprises

–

73.7

–

–

1949

Communist revolution

1958

Great Leap Forward

89.2

10.8

–

–

1966

Cultural revolution

90.2

9.8

–

–

1972

Reflective phase

84.5

15.5

–

–

1978

Economic reforms

78.5

21.5

51.5

48.5

1980

76.0

24.0

49.7

50.3

1985

64.9

35.1

45.7

54.3

1990

54.6

45.4

45.0

55.0

1995

50.9

49.1

40.0

60.0

2000

47.3

52.7

23.5

76.5

2003

37.5

62.5

14.3

85.7

Source: China Statistical Yearbook 2004. For years prior to 1990 see Qian and Xu (1993), pp. 167.

and the non-state sector is thus higher than the extent of the reallocation of agents between the two settings. The general tendency for greater shifts in GDP shares than in agent shares between competing settings was also noted in the context of shifts from agriculture to industry in the developing world, in Chapter 7. The tendency implies a relative deterioration in earnings per agent in the shrinking setting and a relative appreciation of earnings per agent in the expanding setting. This edge in earnings raises the incentive for more agents to move from the declining to the expanding setting, and fuels up the reallocation process. The shift from SOE to non-SOE was associated with a closing of the gap in money wages and in the profit/capital ratio between SOE and non-SOE to the advantages of the latter. Especially, the profit/capital ratio after taxes disfavoured SOE and favoured non-SOE. This is clearly shown by the available statistical trends since 1980 for a few types of enterprises, as summarized in Table 8.7. The categories of SEO and non-SEO in China cover a complex differentiation of enterprises by status of ownership and registration, see Table 8.8. The table refers to industrial enterprises above the designated size of annual sales over 5 million yuan. Small enterprises and self-employed are excluded. In substantiating the table with regard to the SOE sector, the following points can be noted. First, next to the purely state owned enterprises the state participates

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Table 8.7 China: Profit/capital ratios for different types of industrial enterprises, per cent Year

Profit/capital ratios before taxes (per cent) State Urban owned collectives

Average money wage (yuan)

Rural State Urban Rural State Urban Units of Town & owned collectives Town & owned collectives other types village village including enterprises enterprises foreign (TVE) (TVE) funded

1980

24.8

26.6

32.5

1984/85

24.2

22.3

1988/89

20.6

19.7

1992/93

9.7

15.6

2000/01

Profit/capital ratios after taxes (per cent)

16.0

18.5

26.7

803

623

–

24.6

14.9

13.9

15.2

1213

967

1436

17.9

10.4

11.3

9.3

2284

1681

2987

14.2

2.7

8.7

7.2

3955

2806

5225

9552

6262

10984

Source: Profit/capital ratios are from various sources reported in and recalculated from Jefferson and Rawski (1994) and Jefferson and Singh (1999). Average money wages are from China Statistical Yearbook, 2004.

in more enterprise forms as partner and/or shareholder. The gross output from the two sources was about equal in 2000, but there is more growth in the participatory mode as is shown by figures for 2003.20 The state is thus reducing direct ownership and increasing indirect modes of business ownership. Second, the sectoral distribution of state ownership of business has undergone fundamental changes. While there still remains a thin spread of state owned enterprises in many sectors of industry the bulk of state ownership has been shifted to the infrastructural sectors of energy, mining, electricity, water, communication, iron, chemicals, and tobacco. While the direct role of state owned enterprises diminished, the indirect role of state-holding enterprises, where the state controls a minority share, has become much more significant. The stateholding enterprises are active in the consumer and intermediate goods industrial activities, including production for domestic and foreign markets. Third, as shown in the table, state owned enterprises are highly decentralized and are affiliated to one of three levels of government: central, provincial, and county, with most of them being decentralized and under direction of the provincial and county governments. The Chinese economy is known to have multilayer and multi-regional features that are reflected in the management structures of enterprises as well, manifesting thus an M-form.21 Reforms have contributed to a further decentralization of the M-form and provided opportunities for carrying out regional experiments and adaptations. Fourth, the traditional small size of state enterprises in terms of the average employment per enterprise has been maintained, compared to larger sizes of public enterprises in Russia and other former transition countries in the pre-transition period.22 Although significant improvements were introduced in the corporate governance of the state owned enterprises there are pending problems ahead. Significant improvements included the shift in government controls of SOE from the monitoring of physical indicators to that of financial regulators, and the separation

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Economic Systems Analysis and Policies

Table 8.8 China: Distribution of the number of industrial enterprises above designated size and their gross output value, grouped by status of registration, per cent Units %

National total Domestic funded enterprises

Gross output %

2000

2003

2000

2003

100.0

100.0

100.0

100.0

82.5

80.3

72.6

68.8

State owned Of which under central government (a) Under provincial and city governments (a) Under county government (a)

26.0 5.4 44.4 50.1

11.8

23.5 26.7 60.9 12.4

13.0

Collectives Of which urban district and neighbourhood (a) TVE (a)

23.2

11.5

13.9 46.2 53.8

6.6

Cooperatives Of which Urban cooperatives (a) Rural cooperatives (a)

6.7

4.7

3.4 10.0 90.0

2.3

Joint ownership Of which state joint (b) Collective joint (b) Joint state-collective (b) Other unspecified joint enterprises (b)

1.5 16.7 29.3 38.0 16.0

0.9 25.6 27.2 32.6 14.6

1.1 18.2 3.2 5.2 73.4

0.7 29.2 12.1 5.3 53.3

Limited liability corporations Of which sole state-funded corporations (b) Other limited liability (b)

8.1 9.9 91.9

13.6 5.1 94.9

12.8 41.4 58.6

18.7 26.7 73.3

Share holding enterprises Private enterprises Other enterprises

3.1 13.6 0.2

3.2 34.5 0.2

11.8 6.1 0.1

12.7 14.7 0.1

Overseas funded enterprises (c) Foreign funded enterprises

10.1 7.3

10.8 8.9

12.3 15.0

12.2 18.9

P.M. All state owned and state-holding enterprises

32.8

17.5

47.3

37.5

P.M. All non-state enterprises

67.2

82.5

52.7

62.5

Source, notes: China Statistical Yearbook, 2002, 2004; supplemented by Qian and Xu (1993), pp. 168, 170 in case of (a). (a)  Percentage distribution within main category in 1985–90. (b)  percentage distribution within main category. (c)  Enterprises with Funds from Hong Kong, Macao and Taiwan.

of ownership from management via contracting-out agreements between government and management. However, the government/owner remains responsible for appointing and evaluating management achievements and business performance. Due to the well known information asymmetries the government is unable to determine in how far the business outcome is due to management effort. The correct rewarding and penalizing of SOE management is a major

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problem in the context of the subtle mix between the insider and the outsider governance that is common in China. Eventually, effective corporate governance would require the existence and functioning of an efficient capital market. China’s capital market started from 1995, see Table 8.11, but it is rife with uncertainties and speculations due to ambiguities in regulations, loose supervision, non-transparency, limited information access and use, and a short-lived learning experience. As regards the non-SOE sector, two important developments can be highlighted. First, in the first decade of the industrial reforms, roughly between 1980 and 1990, the emergence and growth of the collectives and cooperatives, especially township and village enterprises, known as TVE, was crucial for shaping the domestically oriented industrial structure. In TVE the means of production are owned collectively by the owners/workers, local government, and more funds can be raised from the public. TVEs are generally characterized by ambiguous property rights, in the sense that rights of owners are not guaranteed beforehand. Instead, owners/workers have to fight for actual remuneration, ex-post. The fight is kept within bounds due to presence of trust and sharing attitudes that are traditionally abundant in rural surroundings and household settings. It has been defended that in the immature market environment in China, ambiguous property rights are often more efficient than well-defined ones and might have been inductive for the observed growth of the TVEs.23 Second, in the second decade of the industrial reform and later, roughly from 1990 onwards, the driving force of industrial development shifted from the domestically oriented collectives and cooperatives to the outwards oriented commercial companies such as limited liability companies, share holding corporations, and foreign funded multinationals.24 Entrepreneurship in these companies focused increasingly on innovations, cost reduction, linking with exports, and FDI, and increasing their share of both the domestic market that hence commands a huge purchasing power, and the foreign markets. The industrial breakthrough cannot be achieved without crucial and appropriate expansion in the sectors of services and construction. A few brief notes on these two broad sectors are in place to complement the picture. Employment in trade and catering fell between 1950 and 1978 by about a third, from about 9 to 6 millions, but after the liberalizations in 1978, employment in these services increased to reach 62 millions in 1996. The boom in the construction and transport sectors in the past decade raises this figure to around 100 millions in 2000. The ownership structure in construction and services has shifted significantly from state and collective to private and other modes. While in 1978 state and collective ownership accounted for 90 per cent of these two sectors, by 1996 the situation reversed with private and other types of ownership accounting for 93 per cent.25 (3) Outward orientation of foreign trade and financial relations of China with rest of world. The Stalin–Mao agreements of 1950 made China heavily dependent on the Soviet Union for purchase of foreign capital equipment and technical skills, and Chinese foreign trade went also in the direction of the Soviet Union. But this

290 Economic Systems Analysis and Policies

relationship did not last long. Soviet-Chinese geo-political relations deteriorated in the late 1950s, leading to a withdrawal of Soviet technicians and capital, and uncompleted investment projects. The economic isolation of China from the rest of the world was reinforced furthermore by the Western boycott of China following its military manoeuvres in North Korea from 1950. As a result, foreign trade of China, which had a very limited scope in 1950, dropped further by a fifth in 1960–70. As the Western economic boycott of China was relieved gradually, ending formally in 1971, and as the new political leadership in China saw the benefits of an open economy as was demonstrated by Japan, Taiwan, Korea, Singapore, and Hong Kong, the Chinese government started from mid-1970s on relaxing foreign trade control, decentralizing foreign trade decisions and pricing, devaluating the yuan, setting up free trade zones with duty-free inputs and exports, and putting to use in the areas of production, trade, and investment the very close relationship between Hong Kong and China. The trade and investment relations of China with the rest of the world focused on accelerated exports as the source of foreign exchange income, the predominance of manufactured goods in these exports, and the increased alignment of these manufactured exports with foreign direct investment and joint ventures.26 Table 8.9 shows a positive foreign trade balance from 1990 onwards. The surplus of exports over imports intensified from 1995 onwards as the growth of merchandise exports became more closely attached to foreign funded enterprises and joint ventures empowered by large inflows of foreign direct investment, FDI. The rising role of foreign and overseas funded firms was noted in Table 8.8, and the related role of FDI is noted in Table 8.9. The phases through which China passed with respect to foreign finance are vividly shown in Table 8.9. The early reliance of the country on international borrowing Table 8.9 China: Foreign trade, foreign capital inflow, and foreign exchange reserves, US$100 million Year

Foreign trade

Realized foreign capital inflow

Total Total Balance Exports Imports

1980 1985 1990 1995 2000 2003

181 274 622 1488 2492 4382

200 423 534 1321 2251 4128

Loans

19 149 87 167 241 255

Source: China Statistical Yearbook, various years.

170 35 51 113 0 0

Balances of gold and foreign exchange reserves

Portfolio Foreign Gold Foreign investdirect (10 000 Exchange ment invest- fine troy Reserves ment ounce) (US$ 100 million) 14 4 4 6 88 18

31 17 35 375 407 535

1280 1267 1267 1267 1267 1929

12.96 26.44 110.93 735.97 1655.74 4032.51

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to finance investment in infrastructures comes to a stop in years adjacent to 1995. At the same time, portfolio investment and FDI increased dramatically, and together with a mounting positive trade balance, China was able to form by 2003 the largest foreign exchange reserve held by a single country. The situation required a sensitive management of the foreign exchange reserves to bolster the currencies of the importing countries, secure reasonable returns from these foreign exchange holdings, avoid the suspicion that the reserves would be abusively used to the detriment of the involved currencies and economies, maintain a stable and undervalued exchange rate for the yuan, dampen the domestic inflationary pressure which would follow from the consumption of these reserves, pay back foreign debts due.27 Finally, last but not lease, reverse from a capital importing to a capital exporting economy with due emphasis on development and possession and safeguarding future supply of natural resources for China from other developing regions abroad. The picture obtained on foreign finance from Table 8.9 needs to be supplemented by several points. The FDI value is the realized inflow in a specific year. Realized FDI is about 48 per cent of the contracted FDI for the covered period, and this indicates a continuation of realized FDI for many years to come and at higher levels. The export orientation of FDI would allow the prolongation of the positive foreign trade balance, foreign exchange reserves, and Chinese foreign investment abroad. We shall treat later related aspects regarding the future outlook in Chapter 10. The safeguarding of the supply of energy and minerals from abroad at payable prices is seen as a prerequisite for the anticipated high economic growth of around 10 per cent. This has shaped Chinese foreign investments abroad. Table 8.10 gives the profile of these investments. Accumulated total contracted Table 8.10 Year

China: Economic cooperation with Rest of World US$ 100 million Total all types

Development projects

Labour cooperation

Design consultation

Contracted Executed Contracted Executed Contracted Executed Contracted Executed value value value value value value value value 1990 1995 2000 2003

26.03 96.72 149.43 209.30

18.67 65.88 113.26 172.34

21.25 74.84 117.19 176.67

16.44 51.08 83.79 138.37

4.78 20.07 29.91 30.87

2.23 13.47 28.13 33.09

– 1.81 2.33 1.76

– 1.33 1.34 0.88

Figures for 2003 are distributed among recipients as follows, in US$ 10 000 China (a) Asia Pacific Africa LAC N. America Europe Others

256611 903868 8620 283269 70917 30912 141526 27670

201116 692664 5564 260125 64800 16105 116053 27309

Source, note: China Statistical Yearbook, various years. (a) China refers to Overseas China.

51622 208131 2979 22256 6090 14529 25042 232

3873 3073 77 888 27 278 431 129

292

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value for 1987–2003 amounted to US$ 20930 million, while the realized value was US$ 17234 million. For development projects the realization percentage has fluctuated between 70 and 80 per cent. The average size of contracts has increased appreciably. For example, in 1990 there were 920 development contracts giving an average development contract size of US$ 2.3 million. In 2003, there were 3708 development contracts giving an average size of US$ 4.8 million. For labour cooperation and design consultation the execution percentage is higher and the average size of contracts is much lower. The second part of Table 8.10 gives the pattern of recipient countries. Resource rich developing countries are the highest recipients. The outward orientation of the Chinese economy is also gradually felt in its capital market, Table 8.11. Trade is conducted in A shares and B shares. A shares are local shares and can only be bought by local (Chinese domestic) investors. B shares are only available to foreign investors. Only recently, Chinese are allowed to buy B shares, conditioned on the fact these purchases are done with foreign Table 8.11 China: Trading Summary for Stocks, shares in 100 million shares, values in 100 million yuan Item

1995

1998

No. of listed stocks A shares B shares Issued shares A shares B shares Negotiable shares A shares B shares Traded volume of shares A shares B shares Total market capitalization value A shares B shares Negotiable market capitalization value A shares B shares Traded market capitalization value A shares B shares Shenzhen Composite Index High Low Shanghai Composite Index High Low

381 311 70 766 704 62 235 179 46 705 681 24 3474 3311 164 938

931 1029 1174 1240 1310 1372 825 921 1010 1130 1199 1261 106 108 114 110 111 111 2345 2909 3613 4838 5463 5998 2204 2758 3440 4650 5284 5808 141 151 174 188 179 190 741 952 1233 1481 1680 1897 607 810 1078 1315 1508 1718 134 142 155 166 172 179 2154 2932 4758 3152 3016 4163 2093 2810 4558 2463 2859 3992 62 123 200 689 157 171 19506 26471 48091 43522 38329 42458 19299 26168 47456 42246 37527 41520 206 304 635 1277 803 937 5746 8214 16088 14463 12485 13179

791 147 4036 4319 78

5550 7937 15524 13345 11719 12306 196 276 563 1118 766 873 23544 31320 60827 38305 27990 32115 23418 31050 60279 33242 27142 31270 127 270 548 5063 848 845

Source: China Statistical Yearbook, 2004.

1999

2000

2001

2002

2003

170 113

441 317

525 311

654 415

665 439

512 372

449 351

926 524

1423 1043

1756 1048

2126 1361

2245 1515

1749 1339

1650 1307

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held capital. Foreign investors can buy A shares when they have official QFII status (Qualified Foreign Institutional Investor). The stock exchanges of Shenzhen and Shanghai had a traded value of shares amounting to 6.0 billion yuan (by) in 2000, falling back to 3.2 by in 2003, and more than tripling by 2006. China counts furthermore on Hong Kong, acknowledged as one of the top leading international financial centres in the world, for the use of a full range of financial products and services, next to being an important source of raising foreign capital for Chinese firms. For as yet, China mainland investors are not allowed to trade in the Hong Kong stock exchange. But there are policy intentions launched in mid2007 that anticipate the future integration between the three financial centres. (4) Restrained tasks for the public sector. In general, in the development context there are many functions that can be shifted to the state to take care of, but the institutions of the state are not advanced enough to execute these functions appropriately. A too large portion of the economy in the hands of the state can reduce economic growth. As Table 8.12 shows, China has been able to restrain the tasks of the public sector and limit the shares of public revenue, and public expenditure, in the GDP to the 20 per cent range.28 Furthermore, public revenue has become about equally divided between central and local governments, while public expenditure has shifted from the central to local levels. China makes use of extra public budgetary revenues and expenditures but the shares of these in the GDP have been falling down, and they are primarily meant to supplement the local fiscal balances. The budgetary deficit has been kept within the internationally respectable limits of 2.5 per cent of the GDP. Table 8.12 China: Shares of total government revenue and expenditure in the GDP, and their allocation between central and local levels Year

Government Government Central and local revenue/ expenditure/ revenue share GDP GDP Central % Local % % %

Central and local expenditure share Central %

Local %

Regular budget 1980 1985 1990 1995 2000 2003

25.7 22.4 15.8 10.7 15.0 18.5

27.2 22.4 16.6 11.7 17.8 21.0

25 38 34 52 52 55

75 62 66 48 48 45

54 40 33 29 35 30

46 60 67 71 65 70

– 41 40 13 7 10

– 59 60 87 94 90

– 41 38 15 6 7

– 59 62 85 94 93

Extra budgetary revenues and expenditures 1980 1985 1990 1995 2000 2003

– 19.4 14.6 4.1 4.3 3.8

– 17.6 14.6 4.0 4.0 3.3

Source: China Statistical Yearbook, 2004.

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Table 8.13 China: Composition of total government budget by revenue sources and expenditure functions Year

Share of revenue sources % taxes

Share of expenditure functions %

user charges

economic

social

defence

Administrative

other

58.2

16.2

15.8

6.1

3.7

1980

49.3

50.7

1985

101.8

1.8

56.3

20.4

9.6

8.5

5.3

1990

96.1

3.9

44.4

23.9

9.4

13.4

8.9

1995

96.7

3.3

41.9

25.7

9.3

14.6

8.5

2000

93.9

6.1

36.2

27.6

7.6

17.4

11.2

2003

92.2

7.8

30.1

26.2

7.7

19.0

16.9

Source: China Statistical Yearbook, 2004.

Table 8.13 reviews budget composition. While taxes remain the foremost source of revenue, user charges of public services, such as higher education, has become a regular item of revenue. On the expenditure side there is a gradual shift from economic to social functions, which is similar to what has happened in economically more advanced countries. However, income transfers and related social functions of government were kept to minimum in China, and hence China’s ability to realize a relatively small-sized government. In general, cooperative and sharing traditions at the local level in China reduce the need for significant public income transfers. Of course, there are other elements than the budget that are indicative of a strong state influence. The tied relationship between state agencies and China’s governing communist party influence is difficult to quantify, but the latter is crucial in the formulation of strategic development policies for the economy and the polity for the near future, as well as selection and appointment of officials for top positions to guard and implement the strategic development policies. 8.2.2.3 System performance Reasoning within the analytical framework that we have set in the first two chapters, it can be stated that ultimately sustained development in country x requires that the performance which agents in country x experience in terms of economic growth, and social welfare (i.e. income equality, and other desirable goals of social welfare) are comparable or exceed those obtainable by agents in reference countries ys, that are usually neighbouring countries. We shall continue our focus on the two goals of economic growth and income distribution in assessing the socio-economic performance of China. Since 1980, China has outperformed most countries of the world in economic growth, but the achievements in income equality are less remarkable than those in economic growth.

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(1) Economic growth. Due to discontinuities in economic data and multiple data sources the estimation and evaluation of economic growth in China in past years required supplementation of official sources by alternative measurements of economic growth. Table 8.14 gives two types of estimates for growth of gross industrial output, one is the official as published by Chinese authorities, and the other is based on indices of physical output. For the period before 1990 the difference was negligible. For the period 1990–2000, there is a difference of 4 per cent. The table includes in the fourth column the growth of the total gross domestic product as reported by the World Bank. For an analysis of the underlying factors behind the performance, Table 8.15 summarizes results of earlier and recent studies of the decomposition of economic growth. Economic growth accounting for China from 1953 to 1985 shows a stable contribution of the labour inputs, a rising contribution of capital inputs, and a fluctuating contribution of factor productivity that associates with political stability. Explanations of economic growth for the more recent periods Table 8.14 China: Average annual growth rates of real gross industrial output and real GDP: Official and physical output based estimates Period

Average annual growth Industrial output

1980–90 1990–2000 2000–05

Official data

Growth rates derived from trends of physical output

9.74

9.88

0.14

9.4

14.34

10.39

3.95

10.0

–

–

–

difference

Average annual growth of GDP

9.2

Source: Columns 1, 2, 3 are reported in Wang and Meng (2001), pp. 339. The authors measured growth of physical output by taking growth indices of freight turnover and industrial power consumption. Column 4 is from World Bank, World Bank Development Indicators, CD-ROM.

Table 8.15

China: Decomposition of sources of economic growth

Period

Growth rate of net Contribution of Contribution of Contribution of material product, growth in growth in labour growth in factor 1880 prices capital stock employment productivity

1953–57 (a)

6.61

0.84

1.67

4.10

1957–65 (a)

2.09

1.87

1.63

1.41

1965–76 (a)

5.11

2.81

1.68

0.62

1976–85 (a)

8.78

3.30

1.69

1.79

1978–93 (b)

8.8

2.5

2.5  0.2

3.6

1993–2004 (b)

9.6

4.2

1.2  0.2

4.0

Source: (a)  Rows 1 to 4 relating to years 1953–85 are from Perkins (1988), pp. 628. Perkins assumed capital and labour output elasticities at 0.4 and 0.6. (b)  Rows 5 and 6 relating to 1978–2004, are from Bosworth and Collins (2007), they use the same values of elasticities, but break up the contribution of labour input into that of quantity and education, as is consecutively displayed in the table.

296 Economic Systems Analysis and Policies

of 1993–2004 shows increasing and almost equivalent contributions of capital inputs and factor productivity, about 44 and 41 per cent respectively. The contribution of the increase in labour input to economic growth is relatively low, and amounts to the remaining 15 per cent. Growth accounting can be displayed in terms of sectoral contributions to aggregate growth. For 1993–2004, the contributions of the primary, secondary, and tertiary sectors – more or less agriculture, industry, and services – amounted to 8, 59, and 29 per cent, respectively. Industry is thus the highest. The remaining 21 per cent is due to reallocations between the sectors, mainly from agriculture to industry and services.29 The reallocation accounts thus for about 2 per cent annual economic growth of an aggregate growth of 9.6 per cent. Other economists tend to collect the determining factors behind the outstanding economic performance of the Chinese economic system in the past three decades into three groups: the initial historical and socio-cultural-political environmental features in which China was embedded, the systemic features that are well exploited by the state, and the policy features pursued by government with respect to the reforms in agriculture, industry, the foreign sector, and the public sector. First, specific features of the socio-cultural-political environment in China relate to strong family loyalties, strength of ancient roots of entrepreneurship, and a vast base of traditional and technological knowledge. These factors interact together to create a competitive extended familial base for economic activities that transcends the granting sphere of households and opens avenues for competitive firm settings. There are other overlapping factors belonging to the initial environment that have contributed to the successful performance of China. These include the rich historical, cultural, and innovative heritage that the population is able to draw upon. The attitude to conserve one’s culture, whereby newly imported forms of living are adapted to and integrated within the own culture. Furthermore, the relatively small size of ethnic minorities fostered a homogeneous cultural outlook. High population pressure on farmland imposed moderation in consumption and efficient resource use. Second, the communist leadership made selective and intelligent use of systemic features in the Chinese society that saved effort. Full use was made of the traditional bureaucratic proficiency in administrating matters of interest to the state. The communist regime relied on the geographically decentralized, competitively oriented, and rigorously selected party and non-party bureaucrats, in bolstering cooperation with the provincial rural population to achieve the most for the province, albeit distributing the outcome among the bureaucracy and the rural population under tacitly presumed sharing arrangements. The party/ bureaucratic machinery, combined with social control, was also essential in controlling birth and limiting the size of families. Other systemic features that were fruitfully utilized by the ruling regime include appreciation of cooperative forms of work and income sharing, provincial and county autonomy, stable forms of political participation, and scientific and knowledgeable authorities. Furthermore, in a vast social system as that of

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China there are immense opportunities for local experimentation with institutional and technological change. Successful experiments at one place become known are copied and get adapted elsewhere. The ruling regime has encouraged and has been guided by this selective approach in drawing up systemic changes for the future. Third, the policies pursued by the ruling regime from 1978 onwards were economically sound. As was reviewed above, the agricultural mobilization was swiftly followed by the industrial restructuring and by an outward orientation of foreign trade and financial relations, within restrained tasks for the public sector. Related circumstances supported the success of these policies. For example, the availability of capital and experience in hands of overseas citizens such as in Hong Kong and Macao fostered the outward orientation. Similarly, sharing networks, kinship relations, and a decentralized administration contributed to a low share of the public budget in the GDP. (2) Income equality. In measuring income equality in China we make use of two available indicators: the Gini index in Table 8.16, and the relative consumption expenditure per capita for various population groups in Figure 8.2. Comparative data on the Gini index, Table 8.16, shows that the concentration of income in the richer portion of the population has increased in the period between 1980 and 2005 at a greater rate in China than in EAP, i.e. 21 in EAP in China as against 2 points in EAP. The assessment of increases in income inequality cannot be done in isolation from the growth in income per capita, since both associate in the development context. And China did better than EAP in economic growth. A relative measure of performance is obtained by dividing the change in the Gini index between t and t-1 by the average growth rate of GDP per capita in t and t-1, which is found in the last columns in Table 8.16. Higher values of the relative measure are indicative of greater conflicts between equality and growth. China shows values that are much higher than EAP, moving from 2.6 times to 7.7 times higher. In absolute terms too, the Gini index in China is among the highest in EAP in 2001–05. Overshooting in income inequality is thus a negative performance of the past systemic changes in China. Considering the magnitudes involved the reduction of income inequality is a major challenge for systemic change in China in the future. Do the above tendencies show up in the indicator of the relative consumption per capita in urban versus rural areas? The rural and urban population seemed to keep track of each other in the period 1951–78, with annual growth rates of consumption expenditure per capita in constant prices at 2.2 and 2.8 per cent, respectively. In 1978–85, the rural did better than the urban with annual growth rates of 9.7 and 5.6, respectively.30 More relevant are the more recent trends following the economic reforms and the remarkable economic growth in the past two decades. Figure 8.2 shows the gap in consumption levels between rural overall and urban overall, as well as the highest urban and the lowest urban, namely Beijing and Henan. In 1997, urban overall consumption was 2.8 times rural overall consumption expenditure per capita, this increased in 2006 to 3.4 times. The gap between Beijing urban and rural overall is larger and has widened further over

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Economic Systems Analysis and Policies

Table 8.16

China: Economic growth and Gini index

Country

Average annual growth in GDP per capita %, in constant prices

Gini index, per cent

Col. 1 Col. 2 Col. 3 1981–90 1991–2000 2001–05

Col. 4 1981–90

Change in Gini index/growth of GDP per capita

Col. 5 Col. 6 Col. 7 Col. 8 1991–2000 2001–05 1981–2000 1991–05

EAP

5.8

7.1

7.3

38.3

42.6

43.3

0.67

0.10

China

7.8

8.7

8.5

25.7

40.3

46.9

1.77

0.77

China/ EAP

–

–

–

2.6

7.7

–

–

–

Source: Col. 1 to 6 same as Table 8.3. Col. 7  (Col. 5–Col. 4)/(Col. 1  Col. 2)/2. Col. 8  (Col. 6  Col. 5)/ (Col. 2  Col. 3)/2.

12000 10000 8000 6000 4000 2000 0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Rural overa ll

1017

1310

1572

1617

1590

1577

1670

1741

1834

1943

Urban overall

2851

3538

3920

4186

4332

4616

4998

5309

6030

6511

Urban Beijing

4134

5020

5730

6532

6971

7499

8494

8923

10285

11124

Urban Henan

2155

2674

3009

3378

3416

3498

3831

4110

4505

4942

Rural overall

Urban overall

Urban Beijing

Urban Henan

Figure 8.2 China: Annual living expenditure per capita in RMB: Rural overall, Urban overall, Urban Beijing, Urban Henan, 1997–2006 Source: Plotted from databank of ISI Emerging markets. EMIS databank at www.securities.com:80.

the years, moving from 4.1 times to 5.7 times. Among the urban conglomerates, the gap between the richest (Beijing) and poorest (Henan) has also tripled over ten years. These trends reconfirm a significant widening of the gap in economic welfare. Of course, the negative performance on income equality withstands despite the documented progress made in reducing absolute poverty. Measurements of absolute poverty show significant reductions in poverty, which is normal in view of the very high economic growth.31 In general, in a foundational analysis of economic systems and future anticipations of systemic change the monitoring of relative gaps in the economic welfare of competing large population groups, i.e. income equality, is more central than the poverty headcount share, PHS. This

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299

is more so especially when the proportion of the poorest in the total population is only a few percentage points.32 Future outlook. Studies on the future outlook of economic growth in China agree that the economic growth boom of China would continue for more decades. The studies predict the likely replacement of the US by China as the country with the highest GDP by the middle of the twenty-first century or some years earlier. Chapter 10 will examine these predictions. Whether China’s rise occurs smoothly or not is uncertain to predict.33 How would the problem of increasing income inequalities develop in the future, how would it be resolved or not resolved, and what will be the consequences are questions that go beyond the scope of this book. But these are crucial questions that come out in a foundational analysis of economic system Achieving economic growth with income redistribution, i.e. reducing the growth-inequality trade-offs is essential for the sustained development of the economic system. Converging tendencies in the economic welfare of agents belonging to the same national economic system is a necessary condition; since agents, rightly or wrongly and justified or not justified, do compare their lots with the lots of others. And if the gaps in living go beyond some reference range, agents will be inclined to object, voice, or exit. The result is that the sustained development of the social system is challenged and is at risk. 8.2.2.4 System coordination: Concluding remarks We described the bigger and highly dualistic countries of China and India as multipolar and emphasized the important role of persuasion settings in the coordination of their social system. Persuasion settings in these countries are able to bundle interests and strengths of firms and the state in growth and development policies and search for outcomes that become acceptable to diverse client groups. Leading agents in these persuasion settings have experience, affiliation, networks, and respected authority in household, firm, and state settings and are able to transform contrasting views into consensus. The consensus increases underlying trust, reduces transaction costs, and enhances economic performance. There is very little known as yet on these persuasive settings concerning the nature of the leader–followers relationship within an interest group, as well as aspects concerning inter-group leaders: their compositions, functioning, reach, and effects. These are very promising areas in the investigation of intra-group and inter-group economic transformations and national coordination. Although China does not have an active parliament that can contribute to persuasive outcomes, the country has developed other forms of persuasive settings. The Congress of the Communist Party, held every five years, is a major persuasive setting that outlines future actions to be taken in terms of institutions and policies, and appoints the right authorities to lead, defend, and implement the actions. Other very popular persuasion settings in China are councils of knowledgeable experts that attempt to reach consensus solutions to outstanding problems. A scientific outlook is emphasized in these deliberations. Because of the simultaneous participation of the party and government in these deliberations, the outcomes

300 Economic Systems Analysis and Policies

of these councils are better described as compromised commitments and not as counselling recommendations. Persuasive modes of coordinating actions have a long history in China and are closely inter-knitted in cultural tradition and social norms that foster positive inter-group attitudes.34 In general, a social system with divisions of labour among its members that conform to their abilities allow members of that system to recognize individual differences in ability and leadership, without ignoring the fact that the whole needs all parts. This outlook on social relationships, very common in China and very close to Confucius views on running society, forms the basis for bestowing due respect to each other, despite alignment with contrarian groups. This outlook on social relationships shares elements with Platonic views on work stratification in the economy and on leadership of the wisest in polity matters.35

8.3

South Asia (SA)

8.3.1 Regional profile The South Asia region, SA, comprises countries of the South Asian Regional Council, SARC, consisting of India, Pakistan, Bangladesh, Sri Lanka, Nepal, and Bhutan; next to Afghanistan and other territories and islands in the neighbourhood of India. The SARC countries share some common geographical, historical, colonial, and cultural features that tend to drive them towards having a comparable economic system. The significant role of the village society and rural settings which account for about three-quarters of the residence of the population, associate with a prominence of social interactions in household settings, large differences in household endowments, hierarchical relations, and low mobility. A common outcome is that intra-agent interactions within the village settings tend to be more dominant than inter-agent interactions between settings. India, being the biggest economy in South Asia, to what extent can the economic development and the economic systems of India be synonymous for the SA region? Table 8.17 aims at drawing conclusions on the relative dominance of the systemic features of the Indian economy on the other economies of the SA region. The approach followed is the same as that in Table 8.1 with reference to the relative dominance of China in the EAP region. Table 8.17 displays country figures for the proportional distribution of the population and of the GDP, these being proxies for the relative influence of agents and of the size of the economic transformation. Combining these two proportional distributions for a country gives a country index of interactive influence. The higher the index of a setting (i.e. a country) is, the more likely that the systemic features of that setting (i.e. that country) would spread to other settings (i.e. other countries in the region). The tendency increases in probability once the index passes a threshold value of 2/3rd or 3/4th. Table 8.17 allocates 75 per cent of the total population of SA to India, and 76 per cent of the total GDP, resulting in a country index of interactive influence for India of about 75 per cent, which is an overwhelming figure that predicts an eminent stronghold of the Indian economy on the SA region.36 The next country is Pakistan with an index of only 11 per cent.

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301

Table 8.17 Population and GDP of SA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Country

Population

GDP US$

Country’s index of interactive influence  average cols. 2, 4

GDP per capita US$

GDP per capita ppp$

Million

%

Million

%

Total SA

1351

100.0

608891

100.0

100.0

450

2209

India

1016

75.1

460200

75.6

75.3

453

2364

Pakistan

138

10.2

73300

12.0

11.1

531

1880

Bangladesh

129

9.5

47100

7.7

8.6

365

1543

Afghanistan

27

2.0

5400

0.9

1.4

200

–

Nepal

23

1.7

5520

0.9

1.3

240

1325

Sri Lanka

19

1.4

16300

2.7

2.0

858

3442

1

0.1

1071

0.2

0.1

1071

–

Others

Source, note: Population and GDP figures from World Bank at http://devdata.worldbank.org/query As there are no available reliable GDP figures for Afghanistan the estimate is made on the basis of comparable GDP per capita for low income countries at US$ 200. Others include Bhutan and Maldives.

Table 8.17 shows also the Indian GDP per capita in US$ and in ppp$ to be about the same as the average for the whole region, which is an additional force for integration, as having equivalent levels of economic welfare can contribute to greater interactions between interacting agents. On the other hand, deeply rooted cultural and political differences between India and Pakistan are likely to somewhat constrain the Indian dominance of the sub-continent. The SA economies have gone through major changes and shifts of emphasis since independence that eroded the dominance of agent interaction in household settings, and strengthened the roles of state and firm settings. The inward oriented economic development and the reliance on state enterprises, regulation and planning, typical of the 1950s–70s, resulted in shifted political power towards state agencies. This gave gradually way, starting from the late 1980s, to a more outward oriented outlook, and greater reliance on private enterprises and reduced state intervention.37 The deregulation reforms and the efforts towards global integration proceeded later in SA than in EAP, which saved the SA countries the negative effects of the external financial crises that many EAP countries experienced in 1997–98. Table 8.18 attempts to quantify some of the above tendencies. It highlights the relative influence of household, firm, and state settings as well as global links in the largest five countries of SA. Due to lack of data we follow the previously stated approximation of considering the intensity of interactions in household and firm settings to be close to those in sector activities in agriculture and industry, respectively. In Table 8.18 a sector Index of Interactive Influence is constructed

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Economic Systems Analysis and Policies

Table 8.18 Economic structure and conduct in India and SA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Country

Indicators relating to relative significance of household versus firm settings Labour GDP Sector ratio ratio index of agri: agri: I I industry, industry, average % % cols. 1, 2

Total SA (a)

77:23

48:52

Rural: urban ratio, %

Indicators of state influence

Indicators of global links

Public Of which FMT/ budget/ Defence GDP, % GDP, % spending/ GDP, %

FDI/ GDP, %

63:37

73:27

12.3

3.1

24.0

0.7

India

84:16

47:53

65:35

72:28

12.0

3.1

20.4

0.8

Pakistan

73:27

54:46

64:36

67:33

14.0

4.1

27.1

0.4

Bangladesh

86:14

50:50

68:32

77:23

–

1.4

32.4

0.6

Sri Lanka

65:35

42:58

53:47

84:16

16.8

4.5

77.2

1.1

Nepal

84:16

65:35

74:26

87:13

–

1.0

43.3

0.0

Source, note: World Bank at http://devdata.worldbank.org/query. Col. 5: Public budget is average of public revenue and public spending. (a)  average of all SA countries and referred years with available data.

along the same lines of Table 8.2. The combined relative shares of agents and of the transformed GDP in the two sectors are indicative of the strength of the household versus firm settings. The outcomes for India, very close to those for the SA region as a whole, show index values of 65 and 35 per cent for agriculture (households) and industry (firms), respectively. The outcomes emphasize a strong influence of agriculture/household settings. These differences in absorption capacities between large and small countries are apparent also in the rural–urban distribution of the population. In India, and SA as a whole, the shares of the rural population at 72 per cent and the urban at 28 per cent underscore the orientation of the system towards household settings. Table 8.18 considers next indicators of state influence. The table focuses on the fiscal sphere, with due recognition that for tracing state influence there are other adjacent spheres that can be also relevant. The table shows two fiscal indicators: share of public budget in GDP and share of defence spending in GDP. While the share of the public budget in GDP is about the same in EAP and SA, the share of defence spending in GDP is lower in EAP than in SA. The relatively higher defence spending in SA than in EAP is likely due to the armed conflicts between India and Pakistan, which required more defence spending in both countries. The implication is that there is relatively less public revenue to spend on the economic and social functions of the state in SA than in EAP, which is a shortcoming. Table 8.18 considers next indicators relating to global links. The outward orientation in SA is lower than in EAP. In both regions the larger countries are shown to be less dependent than the smaller countries on foreign trade in merchandise and FDI.

The Developing World: Country Profiles Table 8.19 Country

303

Comparative performance of the economies of India and SA, 1981–2005 Average annual growth GDP % in constant prices

1981– 1990

1991– 2000

2001– 2005

Total SA (a)

5.6

5.2

6.5

India

5.8

5.7

5.9

Pakistan

6.3

4.0

4.1

Bangladesh

3.7

4.8

Sri Lanka

4.2

5.3

Nepal

4.8

4.9

3.6

Average annual growth GDP per capita % in constant prices 1981– 1990

1991– 2000

2001– 2005

3.4

3.2

3.6

3.8

3.5

5.4 4.0

2.4

Gini index

1981– 1990

1991– 2000

2001– 2005

4.6

30.0

33.7

37.6

5.3

32.1

35.0

36.8

1.4

2.4

33.4

33.0

30.6

1.3

2.5

3.5

27.4

30.7

33.4

2.7

4.0

3.6

31.3

32.3

40.2

2.3

0.9

–

37.7

47.2

Source, note: World Bank at http://devdata.worldbank.org/query (a)  average of all SA countries and referred years with available data.

In contrast to EAP, in the context of SA there has been a significant role for Official Development Assistance, ODA, in financing economic development, next to Foreign Direct Investment, FDI. While the proportion of FDI/GDP in 2000 amounted to 0.7 per cent the proportion of ODA/GDP in 2000 was also equal at 0.7 per cent.38 Table 8.19 for SA is the counterpart of Table 8.3 for EAP. Economic growth performance in SA is lower than in EAP. The lower economic growth is explainable by the differences in the structure and conduct of the economic systems in the two regions, as indicated from a comparison of Tables 2 and 18 for EAP and SA. First, it was found that firm settings are more influential in EAP than in SA, while household settings are more influential in SA than in EAP. We have drawn earlier in Chapter 2 the conclusion that the economy of a more firm influenced intensive system tends to have a higher economic growth than the economy of a more household influenced intensive system. Second, the state’s share in the use of national resources is lower in EAP than SA, which can be a factor contributing to a higher economic growth in EAP than SA. Recall here the discussion on the negative relationship between the public share and economic growth in Chapter 4. Third, in general, the major countries in EAP were more quick and responsive in pursuing the target of outward industrialization, than the SA countries. There is a greater outward orientation in EAP than in SA, as can be gathered from a comparison of Tables 8.3 and 8.19. This explains for a part the better economic performance of EAP than SA. Finally, just as in EAP, so also in SA, the achieved economic development in countries like Japan and South Korea have been perceived as targets in both EAP and SA. Distance from the perceived targets does matter. Comparing regions as a whole, it is observed that the trade-off between growth and inequality is lower in SA than EAP, which can be indicative of the greater influence of household settings and sharing tendencies in SA than EAP. Among the SA countries, Table 8.19 shows India as the highest achiever in terms of growth of GDP and GDP per capita. Although the economic growth of India has been

304 Economic Systems Analysis and Policies

accompanied by a greater concentration of income, the rise in income inequality in India as shown by the Gini index is very moderate compared to other countries in the region. 8.3.2 Systemic change in India 8.3.2.1

Background

The analysis of systemic change in India will be organized along similar lines as was done for China. Section 8.3.2.1, our first subsection, will review background elements from past India that relate to the functioning of the three types of settings we are focusing on: household, firm, and state settings, and which in turn shape the sociological, economic, and political relationships in the social system. We then examine in Section 8.3.2.2 the critical contours of the economic development of India from the 1950s onwards and how this era of economic development has shaped the economic system to its present form. Section 8.3.2.3 examines and evaluates the performance record of the economic system in India and the expected future outlook with an attempt to signal out critical issues of comparative performance that are relevant for the stable functioning and the sustained evolution of the system, currently and in the distant future. Section 8.3.2.4 concludes the review of the systemic changes in India with examining the prospects of persuasion settings in streamlining multipolar currents of interactions between contrasting settings in a very large and highly partitioned social system. A starting point in the past is the emergence of an Indus Valley civilization, which dates to at least 5000 back. Aryan tribes from the northwest invaded the area 3500 years ago and their merger created the Indian culture. In the eighth century Arabs invaded the country, followed by the Turks in the twelfth century. Unification of the country occurred in the seventeenth century under the Moghul rule. While the involvement of European traders dates from the fifteenth century, British rule assumed political control by the nineteenth century. In historical terms, India shared with China the fact that they were once the largest economies in the world before being outpaced by others and falling back to the status of developing countries in the twentieth century. Both countries are entering the twenty-first century as major players in the world economy. The Indian society, for several centuries before 1600, and under the Moghul rule (1600–1750), and the British rule (1757–1947), has been consistently described as (1) a feudally organized traditional village society, with (2) outliers of urban society. What are the features of this dual configuration? How did they change and impact (3) the socio-economy, and (4) the polity? (1) The feudally organized traditional village society. In sociological terms, the feudal system divided the population into landlord households who owned land and peasant households who cultivated the land. Both landlords and peasants groups are very closely tied to village localities. The division was further reinforced by a caste system that prohibited inter-mobility and integration between the upper castes and lower castes, whereby landlord family members belonged to the upper

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class and peasant families belonged to lower castes but not the lowest. In political terms, the landed households enjoyed significant powers, pushed with their interests at all political levels and moulded state authority in what has been named the ‘soft state’.39 In economic terms, the feudal system tended to reproduce a very low growth of the rural economy with a few ‘haves’ and many ‘have-nots’. Adjacent to conglomerations of feudal villages, dispersed urban locations were maintained where industrial, commercial, and civil services took place. Although in more than a century of foreign occupations changes have occurred that affected the feudal system, the main characteristics of the feudal system remained intact and persisted until late in the 1950s. Our classification of the Indian economy in its early decades of political independence as a household intensive system that is segmented along lines of landlords and peasantry groupings is in agreement with thorough analysis made on India, all emphasizing the quasi-feudal character of rural life where about 75 per cent of the population lived.40 This configuration has deep roots in the past. At the base of economic life was the Hindu village which has changed little for some 2000 years. Extended households related to each other by kinship populated the thousands of villages. Villages used to be identified by family names. All generations of the family lived together, pooled their income, and consumed collectively. Because of the intra-household intensive relationships, inward orientation of the villages, poor transport, and a low degree of contact between villages, the villages were largely self-sufficient. Although the labour force in the villages consisted primarily of land operators some 20 per cent performed non-agricultural supporting activities. The cultivation unit has always been very small in the Indian village. This required cooperation between land operators. Possession of land is based on custom and not legal rights and is restricted to landlords. Landlords collected a land tax from the land operating peasants, most of the tax formed the income of landlords, and the rest went to a higher level of regional administration. The feudal system had as backing the institution of castes, which divided the population into rigid hereditary groups with clearly defined societal functions and ranked downwards from priests, to warriors, traders, farmers, and outcastes for carrying unclean tasks. Outcasts were excluded from socializing with other castes. The landlords belonged to the upper castes and enjoyed the privileges thereof, against the obligation to patronize land operators. By prohibiting inter-group agent flows and emphasizing rank, the caste system discouraged self-esteem, social mobility, and the development of strong nationalistic aspirations among the less privileged.41 At the same time, and quite paradoxically, the rigidity of the caste system prevented foreign rulers from integrating in the Indian social system with the result that foreign influence was contained and the domestic setting was able to keep its traditional features. The first major foreign invader – the Moghuls – dominated India from about 1500 to around 1700, established control on Northern India that consisted mainly of Muslims and Southern India that was mainly of Hindus. The Moghul regime introduced the royal court and a bureaucratic aristocracy that was considerably

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Economic Systems Analysis and Policies

foreign based. Moghul officials consisted of controllers, accountants, and judges installed at the level of collections of villages called jagir. They earned their incomes from revenues made by jagirs. The Moghul central government levied a land tax that was collected by controllers of jagirs, equivalent to about one-third of the crop production. The tax was used to support occupying troops and construction works. The Indian economy flourished during the Moghul rule, but political control on the various regions of India disintegrated by 1700 due to ethnic intolerance by Moghul rulers. The collapse of the Moghul empire led to a break up of India in independent regions mostly run by warlords. British rulers filled the political vacuum gradually, by conquering Bengal in 1757, and extending control to Madras and Bombay in 1803, and Punjab and Sindh in 1849. The British controlled India via a compact army of British soldiers and Indian mercenaries and an efficient bureaucracy that had a watchdog character. The zamindari played a crucial role as the watchdog. These were a group of landlords acting as intermediary between government and land operating peasants; the British created them in 1793 from the tax-gatherers in Mughul India with the purpose of using them for the collection of land taxes and for the exercise of political control in rural areas. The tax was used to finance army officers, justice, police, and only a minor part for agricultural development. The British rule started ambitiously with an urge to change traditional customs but the obstacles encountered were very heavy. Ultimately, the British gave up the attempt to change the country, and established themselves as a separate ruling caste. The British rulers became thus accommodated and integrated in the caste system. The episode is evidence of a high resilience of traditional custom to external influence. The other consequence of being a non-integrated external occupying force was the tendency to drain funds from India to Britain, resulting in a stagnating economy.42 (2) The urban outliers. Although village life and feudal features were paramount, some urban cities and towns in India under the Moghul rule experienced relatively high levels of industrious activities and economic welfare. The Indian cottage and textile industries were highly renowned at the time, and might have come close to a firm intensive setting, but they suffered significantly in terms of expansion under British rule. The region was also a magnet for regional trade in the eighteenth century, but again did not grow and lost much of its attraction in relation to other world regions in the nineteenth century and up to independence in the mid-twentieth century.43 (3) Slow socio-economic change over a long period. The distribution of agents in terms of locations, occupations, and activities, as well as the concentration of economic transformations in alternative activities did not change much over three centuries, as can be gathered from Table 8.20. Reference can be made to the societal structure towards the end of the Moghul Empire, around 1750, and at the end of the British rule around 1950. The positioning of the Indian sub-continent with respect to agent interactions would fit mostly in the settings relating to rural households and the village environment, with some weak link to the state axis via appointed zamindars and local

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307

bureaucracy. The relative magnitudes of the labour force belonging to different divisions in the social structures do not appear to have changed significantly in the depicted 200 years. Similarly, the shares of the national income that accrues to these divisions have not changed much. A stable pattern has thus survived despite historical events of two centuries. At about the time of national independence, and in spite of centuries of foreign occupation, the Indian economy in 1950 is best described then as consisting of a small rent receiving class that was all-dominant, and a large rural population of land operating peasants and other supporting workers that were more or less subordinates. The rent receiving class did not necessarily consist of ‘owners’ of the land but it had ‘superior’ property rights in the soil and this permitted them to extract a rent in kind from tenants. Within this powerful class there were the large and usually absentee landlords, and the rich but smaller resident proprietors who would also sub-let land. The absentee landlords, traditional in attitude, tended to hold land in more than one village. In contrast, the smaller resident landlords, although rich too and more modern in attitude, they typically held land in one village. Through a combination of factors like land reform, commercialization, and the green revolution, traditional agricultural structure in India went through major changes. In the early years of independence the central objective of land reform measures was the abolition of Zamindari. Fuelled by mainly nationalistic motivations, the abolition of semi-feudal intermediaries and the absentee landlords, who were allies of the British in British India, was successful. From the hitherto absentee landlords emerged a small group that was ripe for transformation into capitalistic farmers. Legislation during the 1950s and thereafter to eradicate feudal forms of tenancy was unsuccessful, and the mediumsized but resident landlords were able to devise new forms of tenancy, which successfully evaded the law. One of the effects of the legislation on tenancy abolition was to encourage these landlords to become rich and direct cultivators of their land, named kulaks.44 Legislation towards elimination of feudal tenancy had also the effects of increasing the more purely commercial tenancy where labour works for a wage and raising the amount of land rented by kulaks. As a result, the kulaks were well on the way to becoming the new masters of the countryside. Political and social power has shifted from the old-style landed gentry to the rich peasants, and rich peasants have shown themselves capable of exercising political power not only in the village but also at the level of district, state, and centre. Greater demand for agricultural products and cultivated land, and the green revolution increased the wealth of the already prosperous and powerful kulaks. Poor peasants and landless workers, however, have gained less from the above changes, and their means and ways of a household intensive social system remained more or less intact. Of course, it will be an oversimplification to maintain that the peasantry do not resist the rich farmers in a country as large as India. There are regions in India where the growing awareness of deprived sections of the rural society has slowly and steadily eroded the dominance of the landed classes. There are states like Kerala where a stronger leftist movement and a greater degree of consciousness and organization of the peasants have not only ensured a better

308 Economic Systems Analysis and Policies Table 8.20

India: Socio-economic structure under Moghul Empire and British Rule Socio-economic structure during Moghul Empire

Percentage of labour force

Class

18 Sub-total 1

Sub-total 17

Socio-economic structure at the End of British Rule

Percentage of national income after tax

Percentage of labour force

NON-VILLAGE ECONOMY

52

18

NON-VILLAGE ECONOMY

44

Moghul Emperor and Court Mansabdars Jagirdars Native princes Appointed zamindars Hereditary zamindars

Sub-total 15

Sub-total 0.06

British officials, military, capitalists, plantation owners, traders, bankers and managers

Sub-total 5

Sub-total 0.94

Native princes Big zamindars, jagirdars Indian capitalists, merchants, managers The new Indian professional class

3

Petty traders, small entrepreneurs, traditional professions, clerical and manual workers in government, Soldiers, railway workers, industrial Workers, urban artisans, servants, Sweepers and scavengers

Sub-total 30

Merchants and bankers Traditional professions Petty traders and entrepreneurs Soldiers and petty bureaucracy Urban artisans, construction workers Servants Sweepers and scavengers

Sub-total 37

Sub-total 17

Class

Percentage of national income after tax

3

3

Continued

The Developing World: Country Profiles Table 8.20

Continued Socio-economic structure during Moghul Empire

Percentage of labour force 72

Class

VILLAGE ECONOMY

Socio-economic structure at the End of British Rule

Percentage of national income after tax

Percentage of labour force

45

75

Dominant castes Cultivators and rural artisans Landless labourers Servants Sweepers, scavengers

100

TOTAL

Percentage of national income after tax 54

9

Village rentiers, rural moneylenders, small zamindars, tenants-in-chief

20

20

Working proprietors, protected tenants Tenants-at-will, sharecroppers, village Artisans and servants Landless labourers, scavengers

18

17

TRIBAL ECONOMY

Class

VILLAGE ECONOMY

29

10

309

3

7

100

100

TRIBAL ECONOMY TOTAL

12

4

2 100

Source: Reconstructed from data in Maddison (1971), pp. 24–33, 69, with granted permission from the author and publishers.

land reform legislation, relatively freer from loopholes, but also more effective implementation. Elsewhere, the ‘land grab’ movement in West Bengal during the late 1960s, in which some 300,000 acres were seized by peasants, and conflicts in South India between cultivators and landless labourers following increased yields from introduction of new high-yielding varieties of rice, indicate the capacity of the peasantry to carry out sustained mass action. The above implies that the socio-political and economic analysis of Indian development requires that India not to be treated as a monolithic whole, but that the country be divided into regions based on the character of social behaviour and the strength of political interests and the degree of their infiltration of regional governments.45 (4) How did the polity of India change over the years? The polity is concerned with the transfer of power from Britain to India, the written constitution that would

310

Economic Systems Analysis and Policies

govern India, and the composition, operation, and outcome of Indian administrations at the federal and state levels. Non-violent resistance to British colonialism under M. Gandhi and J. Nehru led to independence in 1947. Gandhi idealized and urged for a communal and a traditional village life as the most humane way of life, but this fell out of step with the modernization paradigm of Nehru. Other political leaders pursued the same development urge.46 Politically, the country has shown a relatively stable polity when compared with the developing world as a whole. The political system responsible for this stability is a well-established constitutional parliamentary democracy.47 Foundational steps of the Indian Constitution by leading Indian elites go back to the early twentieth century and were initiated despite the existence of the British colonial rule. The orientation of the constitution is towards a British-type parliamentary democracy for domestic affairs. The Indian constitution put into work after independence in 1951 strikes a balance between a strong central government and the autonomous governments of the nation-sized states, each with a distinctive culture and deep historical roots. The framers of the constitution constructed checks and balances among the executive, legislative, and judiciary branches at the federal level and the states, designed to provide national security and stability while maximizing state autonomy. Although the constitution allows for specific centralized powers that make it possible for the federal government to intervene in state issues, in the real world India is a federation of states where federal control over the states is relatively weak. This runs as follows. A main feature of Indian administrations is the uneasy but practical alliance of national bourgeois and state kulak interests. While the national bourgeois forces are more powerful at the federal level, it is the kulaks who are more dominant in state politics. The relatively weak sovereignty of federal over state interests is demonstrated by the diluted implementation of centrally legislated land reform at the states level. The weakness of the federal level is also transparent in laws that were frequently enacted with deliberate loopholes and exemptions at the states level designed to induce fictitious transfers of land to close and distant relatives and to keep the size of permissible retentions high. The federal and state laws were also executed by a local bureaucracy largely indifferent, occasionally corrupt, and biased in favour of the rural oligarchy. With the heightened pace of economic development, more education, and the growth of a new type of middle class the representation of the ‘have-nots’ in the administration at both federal and state levels has increased over time. The weight of the ‘have-nots’ in the administration increased with the heightened expansion of education, communication, and electorate votes. The changing class bases of the administration and its growingly professional character have emerged as factors favourable to legislation and implementation of structural changes in the economy, polity, and society. In a dual country like India with very large portions of the populations and regions not sharing common communication grounds with the ruling elites and the more educated, and not in a position to practice political participation, the installed parliamentary system is insufficient for coordinating the socio-political

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311

system. It is no surprise that the parliamentary system was supplemented from the start by extra political coordination mechanisms that foster harmonization among divergent populations and regions. We have already referred to the role of persuasion settings as a significant means of political coordination in a multipolar social system. 8.3.2.2 System development The economic development of India was hardly any world news in the five decades following independence. It was just before the turn of the century that the Indian take-off became big world news, when evidence accumulated that the economic growth of India is significant and sustainable, and that India carried the potential of becoming again one of the world’s giant economies. India’s potential became recognized a few years later than China’s potential. The two countries are often put to comparison with respect to the development strategies followed, outcome, and outlooks. The scopes and forms of the future development of these two vast and most populace countries of the world are of significant importance for the world economic systems in the future.48 As in the case of China and other success stories in the development context, India had its own version of tackling the four prerequisites of systemic change necessary for a sustained take-off. These are, it is remembered (1) an agricultural shake-up that allows freeing of resources for industrialization, (2) balanced physical, human, and institutional infrastructures that allow industrial structuring and industrial breakthroughs, (3) outward orientation of foreign trade and financial relations in harmony with circumstantial comparative advantages, and (4) restrained tasks for the public sector. We shall analyse the occurrence of these four systemic changes and their impact in India. The Indian experience has been different from that of China, and we shall point out some of these differences. Next to the discussion of these four systemic changes, several questions have to be clarified. The remarkable breakthrough in the economic development of India at the turn of the century came as a surprise. Several questions are raised: when did the breakthrough start? How did the breakthrough start? What were/are the features of the breakthrough? Why these features? What next? These questions will be briefly answered before we treat the systemic changes. It is generally agreed that the positive contribution of agriculture to industrial growth in India came later than expected. Furthermore, excessive state control and regulation of industry after independence retarded the industrialization effort. Internal and external reform came in two patches in 1980 and 1990. The breakthrough in economic growth is thought to be from 1980 onwards. The breakthrough manifested features that are unique to India. It was the export of modern services to US and EU and not manufactured merchandise that took the lead. How come? This is explainable in terms of circumstantial comparative advantages. What next? Having a comparative advantage in the export of services relating to information and information technology, IT, does not exclude developing comparative advantages in other areas of industry and construction. There are many future unknowns, though.

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Economic Systems Analysis and Policies

(1) Agricultural mobilization. While India experienced significant transfers of labour and enforced savings from agriculture to industry, the levels involved were below the expectations for a country of that size. The high expectations on the contribution of land reforms to increased agricultural productivity and industry transfers were not realized as most of the land reforms initiatives were aborted. The green revolution, whose effects came later in time, is generally seen to be more crucial than land reform in transforming agriculture and supporting industry. While the Indian government fulfilled a role in transferring resources from agriculture to industry via its fiscal and double pricing systems, other factors played crucial roles in the transfers of labour and capital. The demographic pressure, failure of land reform, success of the green revolution, and commercialization of agricultural land, all led to higher land prices compared to farm wages and compelled the out-migration of landless peasants to urban areas, and cheap labour was essential for starting industry. Capital transfer from agriculture to industry occurred with delay, as it accelerated only after second-generation rich landowners started redirecting their investment to urban areas of residence and industry when these started showing signs of attraction from the 1980s onwards. (2) Industrial structuring. In their effort to bolster national industrialization, Indian governments followed centralized policy-making and implementation.49 This took the forms of nationalized infrastructural sectors such as public utilities, transport, communications; permission of state owned firms to participate in and control iron and steel, cement, chemicals, electronics, and other major manufacturing industries; regulated markets and policies that reserve certain activities of small-scale production to the unregistered and registered small establishments and exclude large-scale production; and imposition of protective import substitution measures, high tariffs and non-tariff barriers, and foreign capital controls. Furthermore, in the1970s India nationalized banking, mining, textile mills, wholesale grain, and jute trade in rescue operations of failing private enterprises and threatened unemployment. During this and adjacent periods the share of public investment in total investment increased, and that of private investment fell down. Private investment was subjected to a hoard of licences and regulations resulting in cooling the investment climate. These shifts from the private to the public sectors in India contrast remarkably with opposite shifts occurring in China and other East Asian countries. In spite of the marginally greater resources put in the public sector, and despite the strong regulatory regime of the private sector, the annual growth rate of public sector GDP declined from 7.8 per cent in the period 1960–75 to 7.2 per cent in the period 1975–90; while that of the private sector rose from 2.6 to 3.7 per cent. 50 The differential performance of the public–private sectors and related imbalances became apparent in other areas than in the GDP in the 1980s and 1990s. Industrial restructuring suffered from an inadequate physical infrastructure in transport, communication, and energy. The human infrastructure that was built and supported by the state was more oriented to higher than middle and vocational education and not conducive to industrial development. The financial infrastructure necessary for modern industry was absent.

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313

Recognition of the above gaps, together with gained knowledge on the positive effects of favourable investment climates and export promotion regimes for a few East Asian economies contributed to a reversal of state policies in India. By late-1970s, economists on trade and development were able to show that import substitution measures were often overextended and obstructed export promotion and the flow of foreign direct investment (FDI), both of which are important ingredients of economic development. The newly elected Indian government in 1980, under Indira Gandhi, and later Rajiv Gandhi, made important openings to leading industrial firms and implemented targeted industrial measures towards major firms ranging from granting import licences to tax holidays, location waivers, and credit guarantees. The measures created a positive investment climate and are comparable to those introduced in Japan three decades earlier and to Korea two decades earlier. The timing in the early 1980s coincides with the initiation of industrial reforms in China. This policy has been dubbed pro-business reforms in contrast to the proliberalization reforms that was launched in 1990 by the next government and that introduced liberalization of domestic and foreign trade markets and export promotional reforms across the board and started implementing a modest privatization programme of state enterprises. Indian growth was triggered by an attitudinal shift on the part of the national government towards a pro-business approach from 1980, as opposed to a pro-liberalization approach that started in 1990. Reliance in the 1980s was on existing business interests while in the 1990s the emphasis was on restructuring and new entrants via liberalization.51 The pro-business policy of the 1980s focused more on internal than external reforms. It had the merit of capitalizing on existing activities and previously invested infrastructures rather than creation of new business, and thus avoided creation of losers. Of course, it is most likely that the performance of the 1980s would have run out of steam if the true liberalization reforms of 1990s were not implemented.52 The combination of targeted and neutral outward oriented economic reforms, and their phasing in that order, is not unique to India. It was done before by Japan and Korea and has been followed by many developing countries. What is unique in the economic development of India is that the effects of the outward oriented economic reforms, together with external circumstances, and internal properties of the Indian economic system, culminated in India showing higher comparative advantages in modern services than industrial merchandise. This stands in contrast with the general experience of the developing world. Exports of modern services include software development, and information communication technologies (ICT)-enabled services ranging from back office operations, revenue accounting, data entry and conversion, database development; to the processing of medical transcriptions, insurance claims, educational content and publications; remote maintenance and support; and call centres. These exports have become over time an important driving motor of the Indian economy starting around the mid-1990s. Of course, ICT-exports require ICTimports, but the share of the imported inputs has been falling as the ICT industry and services have become more self-supportive.53 Although the surge in the

314

Economic Systems Analysis and Policies

ICT industry and exports is sporadic and restricted to a relatively few number of urban locations,54 the impact of changes brought about by the ICT industry and services has been forcefully felt in many facets of the social system. The higher comparative advantage of India in modern services over industrial merchandise has come as a surprise to many. This was not intended by the policymakers and not predicted either by observers two decades ago. Ex-post, this comparative advantage can be viewed as a process of natural selection influenced by internal and external developments. Among the internal factors that offer an explanation is that there were likely less growth incentives in the heavily state controlled industry in India, and especially manufacturing, as contrasted with the less controllable services sector, and especially if they are electronically allied services. Already as early as 1960, the share of services in the GDP was higher than that of industry, i.e. 34.2 compared to 19.4 per cent, see Table 8.21. By 2005, services added another 20 per cent, while industry added 8 per cent only. There are several external factors that explain the comparative advantage. India was not in a position to compete with major exporters of manufactured merchandise, for instance, China or East Asian forerunners that have invested significantly in cost-saving, industry-oriented physical infrastructures and that were about a decade or more ahead in liberalizing their economies and utilizing extended networks of commercial relations and foreign funded industrial enterprises. In contrast, India was more prepared for exporting modern services at a cheaper cost than China and other East Asian countries.55 For instance, India’s stock of human resources leans more towards higher education than China’s. 56 Salary rates of ICT related operating jobs India are lower than elsewhere.57 Educational and training costs in ICT are relatively cheap in India. Knowledge and practice of English in India is a premium. Last but not least, the new age of the information economy and ICT induced a vast demand for a different package of tradable services that fitted with India’s supply, and that could be delivered on a large and wide scales that allow making use of benefits of economies of scale and scope. Table 8.22 highlights related aspects of the observed comparative advantage of China in industry as compared to that of India in services for the period 1993– 2004. Labour productivity in industry has grown by about three times higher in China than India. After deducting contributions of physical and human resource inputs, growth of industrial factor productivity in China is found to be about 5.7 times higher than in India. Turning to services, the opposite is noted. Growth in factor productivity in services in India is about 4.3 times as high as in China. The table emphasizes different paths that China and India have walked on. China’s path was a matter of choice and imitation. India’s path was more accidental and circumstantial. (3) Comparative advantages reflected in foreign trade and foreign investment. Table 8.23 reviews the foreign trade of India. Imports exceed exports so that the country has an external trade deficit of about 3 per cent of the GDP. Nevertheless, India has been able to accumulate sizeable foreign exchange reserves in view of incoming FDI, foreign loans, and portfolio investment.58

The Developing World: Country Profiles Table 8.21

315

India: Shares of the value added of industry and services in the GDP, per cent

Share of agricultural value added in GDP Share of industrial value added in GDP Share of services value added in GDP Composition of industrial value added, % Manufacturing Non-manufacturing Composition of services value added, % Modern services, of which: Communications Finance Business services Education and medical Traditional services, of which: Trade Transport and others

1960

1970

1980

1990

2000

2005

46.4 19.4 34.2

46.0 20.7 33.3

38.9 24.5 36.6

31.3 27.6 41.1

23.3 26.2 50.5

18.3 27.3 54.4

14 86

14 86

16 84

17 83

16 84

16 84

19 2 6 1 10 81 40 41

20 (a) 2 6 1 11 80 (a) 39 41

22 3 7 1 11 78 37 41

31 (b) 3 14 2 12 69 (b) 34 35

35 6 14 4 12 65 33 32

40 11 12 5 11 60 33 27

Source, note: Rows 1 to 5 from World Bank at http://devdata.worldbank.org/query/. Other rows are from NEBR Working Paper 12901 by Bosworth, Collins, and Virmani (2007). pp. table 8.5. Totals are lower than sum of components due to unspecified components; (a)  extrapolated; (b)  1993.

Table 8.22 Comparative sources of GDP growth in industry and services, China and India Country

Annual Annual growth of growth of DP employment

Annual Contributions of annual growth of growth of Capital Labour Factor labour stock education productivity productivity

Industry China

11.0

1.2

9.8

3.2

0.2

6.2

India

6.7

3.6

3.1

1.7

0.3

1.1

China

9.8

4.7

5.1

3.9

0.2

0.9

India

9.1

3.7

5.4

1.1

0.4

3.9

Services

Source: Adapted from NEBR Working Paper 12943 by Bosworth and Collins (2007).

As in China so also in India the incoming FDI tended to be invested in lines that associate with the lines of exports. But there is a significant difference between the two countries. In China, the lines of FDI and exports are primarily concentrated in the production of merchandise goods with little in services. Table 8.24 shows for 2004 the composition of exports to be 90 per cent in goods and only 10 per cent in services. The composition of Indian exports as shown in Table 8.24 is more balanced, with about two-thirds in goods and one-third in services. It can be assumed that FDI and other foreign capital inflow to India are more or less distributed along these proportions. In some sense, the package of comparative advantages of China is less diversified than that of India.

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Economic Systems Analysis and Policies

Tables 8.23 and 8.24 thus suggest that there is much potential with comparative advantages that can be realized in India in the future once several barriers are removed. The barriers relate to inferior physical infrastructures and transport, wage and labour market regulations, and entry restrictions on large-scale mass production of final goods. (4) Fiscal budget. There are the central government budget and the all union budget that include state budgets as well. Taking first the central government, Table 8.23 India: Foreign trade and its composition, per cent

Exports of goods and services/GDP Exports of goods/GDP Exports of services/GDP

1960

1970

1980

1990

4.6

3.6 – –

6.3 4.7 1.6

7.1 5.7 1.5

–

2000 2005 13.2 9.2 4.0

20.3 12.3 8.0

Composition of exports of goods, per cent Merchandise Non-merchandise

–

52 48

59 41

70 30

77 23

70 30

– – – 4.5 0.9

30 16 54 9.5 3.2

45 21 34 8.6 1.4

66 12 22 14.2 0.9

– – – 23.3 3.0

Composition of exports of services, per cent Computer, communications & others (a) – Transport services – Travel services – Imports of goods and services/GDP, per cent (a) 7.3 External trade balance/GDP 2.7

Source, note: World Bank at http://devdata.worldbank.org/query/ (a) The share of computer, communication, and others in exports of services, i.e. 30%, 45%, and 66%, can be compared with the share of these items in the imports of services, amounting to 29%, 30% and 29%, in 1980, 1990, and 2000, respectively. The IT-imported content of IT-exports is thus shown to fall down from 97% to 64% to 44% in 2000, reflecting an increasingly self-supportive IT-industry.

Table 8.24

Comparative export growth in merchandise and services, China and India Annual growth rate of exports, per cent 1995–2000

Share in total exports, per cent

2000–2004

2000

2004

13.7

23.8

100.0

100.0

14.2

24.2

89.1

90.5

9.7

19.7

10.9

9.5

9.5

16.6

100.0

100.0

6.7

14.5

72.2

67.1

19.8

21.6

27.8

32.9

China Total exports Goods Services India Total exports Goods Services

Source: World Bank at http://devdata.worldbank.org/query/. Since 2004 there is an accelerated increase in merchandise exports.

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317

Table 8.25, left-hand side, India is shown to have a stable share of central government expenditure in GDP to figures around 16 per cent. This is in line with levels in many developing countries. But the share of revenue in the GDP is lower by about 1 to 4 per cent, implying chronic budget deficits and high interest payments on debt, 28 per cent of public expenditure in 2000, and thus limiting the spending functions of the state on public goods, i.e. economic infrastructure and social provisions for collective goods and services. Furthermore, the already noted high spending in defence, about 16 per cent, is realized at the cost of less developed physical infrastructures and other public goods. It was stated earlier that a limiting factor to industrial growth in India is the less developed physical infrastructure. Table 8.25, right-hand side, gives the union budget outlays and revenues. This union budget is about twice the size of the central budget, as can be gathered from the ratios of state to central government revenues and expenditures in the last two rows of the table. The share of all public outlays in the GDP is doubled. The share of all revenue in GDP does not double, since all union total expenditure increases more than all union revenues. There are much more expenditures spent than revenues collected at the states level. The result is that the union budget gap is higher than the central government gap and amounts in 2000 to 11.8 per cent as compared to the central government gap of 4.6 per cent. By comparison, earlier

Table 8.25 India: Fiscal features of public revenue and expenditure. Central government and all union Central government

1990–1, 2000–1, All union governments: per cent per cent Central, state and territories

1990–1, 2000–1, per cent per cent

Expenditure/GDP

16.3

16.6

Outlays/GDP

34.3

34.3

Revenue/GDP

15.3

12.0

Revenue/GDP

22.9

22.5

1.0

4.6

Gap/GDP

11.4

11.8

Expenditure distribution 100.0

100.0

100.0

100.0

Development

61.2

51.4

Administration

10.2

20.1

Gap/GDP

Economic

21.4

14.0

Social

10.2

9.0

Other expenditure

23.9

26.7

6.5

6.6

Administration

Outlay distribution

Defence

16.6

15.5

Defence

12.4

9.1

Interest

21.6

28.3

Interest

16.1

19.3

State/central gov. exp

80.1

88.8

State/central gov. tax rev

51.2

59.6

Source: All items on central government left-hand side are from UN Public Administration Programme at http://unpan1.un.org/intradoc/groups/public/documents/un/unpan014053.pdf. All union figures on right-hand side are from Union Budget, Government of India at http://Indiabudget.nic.in.

318 Economic Systems Analysis and Policies

Table 8.13 shows China to be abler in restraining deficits at both central and local levels than India. Besides, from both tables it is clear that there is a relatively greater role for local governments contra central government in financing economic development in China than in India. 8.3.2.3 System performance (1) Economic growth. While economic growth in India exceeded that of SA, differences are not as high as in the case of China compared with EAP. Growth accounting for India, Table 8.26, shows increasing contributions of capital, education, and factor productivity, the latter being the highest. This is similar to the growth accounting results for China. Growth accounting can be displayed in terms of sectoral contributions to aggregate growth. There are comparable decompositions for India and China. For India in the period 1993–2004, the contributions of agriculture, industry, and services amounted to 11, 19, and 45 per cent, respectively. Services are thus the highest contributor in India in contrast to China where industry is the highest contributor. The remaining 25 per cent is due to reallocations between the sectors, mainly from agriculture to industry and services.59 The relative contribution of the reallocation component is slightly higher in India than in China, suggesting that in that period the economic restructuring in India was higher than in China. Table 8.26

India: Decomposition of sources of economic growth Annual growth rate of GDP

Contribution of annual growth of Capital stock Employment

Education

Factor productivity

1960–1980

3.4

0.8

2.2

0.2

0.2

1980–2004

5.8

1.4

1.9

0.4

2.0

Source, note: Adapted from NEBR Working Paper 12901 by Bosworth, Collins, and Virmani (2007). Capital stock includes land.

Table 8.27 Country

India: Economic growth and Gini index Gini index

Average annual growth GDP per capita % in constant prices

Change in Gini index/growth of GDP per capita

Col. 1 Col. 2 Col. 3 Col. 4 Col. 5 Col. 6 Col. 7 Col. 8 1981–90 1991–2000 2001–05 1981–90 1991–2000 2001–05 1981–2000 1991–05 SA (a)

3.4

3.2

4.6

30.0

33.7

37.6

1.12

1.00

India

3.6

3.8

5.3

32.1

35.0

36.8

0.78

0.40

India/SA

–

–

–

–

–

0.70

0.40

–

Source: Col.1 to 6 same as Table 8.19. Col. 7  (Col. 5  Col. 4)/(Col. 1  Col. 2)/2. Col 8  (Col. 6  Col. 5)/ (Col. 2  Col. 3)/2.

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319

(2) Income inequality. The other dimension of socio-economic performance we consider is income equality. Table 8.27 shows India to do better than the average within its region of South Asia. In spite of the higher growth in India, the Gini index is slightly lower in the period 2001–05. According to the reported data India has been more able to combine growth with least negative redistribution than the other SA countries as shown in the inequality-growth propensities that are calculated in columns 7 and 8 of Table 8.27. In 1981–2000, a per cent growth is coupled to a 0.78 increase in the Gini index, and this falls down in 1991–2000 to 0.4. The propensity for the SA region is higher at 1.12 and 1.00. A comparison between China and India with respect to inequality-growth propensities would support the above statement on India’s pattern of growth with least negative redistribution. The calculated propensities for China for the two periods are very high: 1.77 and 0.77; Table 8.16. The Gini index tends to hide sporadic inequalities. In the context of India there are small numbers of the population working and living in organized segments with high productivity and high shares of income, while the over majority of the population is in the unorganized segments, or what is elsewhere described as the informal sector, with much lower productivity and income shares. The unorganized sector refers to unregistered establishments, which are mainly selfemployed and tiny enterprises with minimal hired labour. Table 8.28 displays in the first three columns the percentage distribution of GDP on the organized and unorganized segments for the three sectors of agriculture, industry, services, and total India. In the next set three columns, the percentage distribution of labour employment on these categories is displayed. The last set of columns divides the GDP percentage that a category earns by the labour percentage in that category. For all India the outcome is 1.0, in the bottom corner. The most well off are those in organized industry followed by organized services: 16.7 and 10.3, respectively. The least well off are in the unorganized agriculture and unorganized industry: 0.4 and 0.8, respectively. Table 8.28 per cent

India: Distribution of GDP and labour on various population segments, 2000,

Sector

Organ- Unorgan- (Total) ized ized India GDP GDP GDP

Agriculture

Organ- Unorganized ized labour labour

(Total) India labour

Organized GDP/ Organized labour

Unorgan- (Total) ized India GDP/ GDP/ Unorgan- India ized labour labour

0.8

24.5

25.3

0.6

66.4

67.0

1.3

0.4

0.4

15.9

9.5

25.4

0.9

12.1

13.0

17.7

0.8

2.0

Services

25.2

24.0

49.2

2.5

17.5

20.0

10.1

1.4

2.5

Total India

42.0

58.0

100.0

4.0

96.0

100.0

10.5

0.6

1.0

Industry

Source: Central Statistical Office: New Series on National Accounts Statistics, base year 1999–2000, Government of India, New Delhi, 2006. Col. 7  Col. 1/Col. 4. Col. 8  Col. 2/Col. 5. Col. 9  Col. 3/Col. 6.

320 Economic Systems Analysis and Policies

18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 Agriculture Organized GDP%/labour%

Industry

Services

Unorganized GDP%/labour%

Total India Total India GDP%/labour%

Figure 8.3 India: Index of GDP/labour for various segments of the population, 2000 (Value of index for Total India  1.0) Source: Table 8.28.

The last set of columns in Table 8.28 is reproduced in Figure 8.3. The income differences between the segments are striking. While for the organized segments the indicator of (GDP %)/(labour %) is basically a labour productivity indicator, for the unorganized segment the indicator represents average earnings as well.60 As can be expected the incidence of absolute poverty is concentrated in the cells of unorganized agriculture in the rural areas and unorganized industry in urban areas, and related dependents to these segments. World Bank sources report for the year 2000 a poverty headcount share, PHS, at rural poverty line at 30 percent of the rural population, and a corresponding figure of 25 per cent for the urban population. Other measures of poverty based on an expenditure of $1 a day (ppp) give for the year 2004 a national PHS of 34 per cent of the population. By either measure, there is a large but as yet unorganized, one –quarter to one-third of the population that experience poverty conditions. The PHS is significantly high and is about four times as big as in China. The previously discussed risks of voice and exit to the stability and development of social system are thus highly relevant in the context of India, and may overshadow the relatively positive and progressive character of economic growth with least income inequality that has characterized the Indian economic system so far. Assessment of the future economic outlook of India for the long term should distinguish between the domestic front and the foreign front. At the domestic front, the prospects are moderated by impediments that lie in problems of strong state regulations that impede free labour and investment markets, fiscal deficits at the national and state levels, persistent poverty and isolated clusters of better offs in India, related problems of a hierarchical distribution of education and

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321

human resource development, and ethnic and religious minority problems that can lead to civil disorder. However, the trickledown effects of a higher growth of the GDP, and an increasing greater political participation in an institutionalized parliamentary democracy, are bound to mitigate these domestic problems. At the foreign front the prospects are optimistic in view of the recent accelerations in the growth of both modern industry and modern services, and their outward orientation, the advancement made in the Indian financial markets, and the ability of Indian multinationals to coin alliances with counterparts in economically advanced countries. The prospects draw at the same time attention to the high dependence of India on imported energy resources that may backfire under an inelastic supply. How does the above account on impediments for India compare with China? This is a very difficult question. China is more prepared on many counts, while India can be signalled on other counts. Roughly speaking, and considering our assessment of the Chinese economy in the previous section, China seems to be better equipped than India with regard to prospects and problems at the domestic front. This is also generally the case for prospects and problems at the foreign front, though there may be greater opportunities lying ahead in the foreign front for India than China.61 We shall touch again on the comparative performance and prospects of the two economies in Chapter 10.62 8.3.2.4 System coordination: Concluding remarks An exemplary setting in which the politics and economics of human behaviour are subjugated to the socio-cultural dimension is that of India. Through India’s long history of politics and economics, such factors as religion, caste, kinship relations, and the village environment were the carriers and preservers of culture. The importance of hereditary priesthood, often vested in Brahmans, facilitated their rise as the intellectual elites. Closely related is the caste system that classifies and separates people from birth within thousands of different groups labelled by ritual status, social conduct, language, occupation, and village. Strictly maintained kinship relations drive the caste system. And it is in the villages that India’s most basic activity – household agriculture – takes place. Scattered throughout the country are more than half a million villages, constituting about 75 per cent of India’s total population of about 1.03 billion, in 2001. Each village is connected through a variety of horizontal linkages with other villages and with urban areas. Most villages are characterized by a multiplicity of religious, caste, kinship, and occupational groups linked vertically within each settlement. The catching socio-economic story of India is the emergence of the middle class from the 1980s. The speeded emergence of the middle class in India is a matter of the past two to three decades, very much in similarity with China. This group includes members of prosperous farming families, as well as such urban residents as professionals; administrative, business and white-collar jobs that benefited from the growth of firms and the state. The middle class may make up about 20 per cent of the population, approximately about 200 millions, but they may capture about 40 per cent of the national income. Economically, they are a

322 Economic Systems Analysis and Policies

forceful consuming group that influences the distribution of public expenditure to their benefits, and their share of fiscal revenue. Politically, the middle class is a vocal group and is able to influence the executive and legislative branches via a sharing of media content, living patterns, and cultural norms with the political elites. Daily life and activity coordination in rural areas and urban areas are totally different. The traditional attitudes of agents in village, and kinship settings on the one side, and the modern attitudes of agents in metropolitan cities on the other side, limit inter-agent interactions, and result in making the intra-agent interactions within the separated groups to be more dominant than inter-agent interactions. The outcome is a lesser degree of communication and integration between major groups in the national context. This raises the need for supporting coordination between the top leaders of the major groups to facilitate some basic coordination and integration. This need is fulfilled via what is called persuasion in politics. We described the bigger and highly dualistic countries of China and India as multipolar and emphasized the important role of persuasion settings in the coordination of their social systems. Persuasion settings are capable of integrating the divergent interests of labour, firms, and state, over-crossing conflicts of belief and interest between ethnic groups, and raising hopes for a speedy rise in the economic welfare of less privileged groups. Leading agents in these persuasion settings have experiences, affiliation, networks, and respected authority in household, firm, and state as well as religious settings, and are able to transform contrasting interests towards a consensus. Parliaments can be seen as one form of persuasion setting where leaders of major groups try to reach consensus. State sponsored councils of knowledgeable experts to resolve specific issues are another form of persuasion settings. While India can make use of both types of persuasion China relies on the latter type. An obvious conclusion is that India has a greater diversity of persuasion settings than China. It is much more difficult to assess where would the need for persuasion settings be higher: in India or China? In general, there is a greater need for persuasion when system performance does not respond equally to the different settings in which agents live and work.

8.4 Middle East and North Africa (MENA) 8.4.1 Background There is no one valid delineation, for all purposes, of the Middle East and North African region (MENA). In the context of international politics analysts sometimes tend to include in MENA outlaying countries to the Middle East such as Pakistan and Afghanistan, and outlaying countries to North Africa such as Mauritania and Sudan. In studies of economic systems and economic development these countries are usually considered as belonging to South Asia and Sub Saharan Africa, respectively. This is followed accordingly in the economic

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323

development databank of the World Bank, with which we conform. Furthermore, for obvious reasons the economic systems of the six oil-rich countries of the Arab Gulf, the GCC, are different from the other MENA countries, and we have throughout considered them separately. In this section, we shall focus on the MENA region comprising the countries in Table 8.29, while the next section will treat the GCC region. The economic system of the MENA countries has some common structural features pertaining to the physical environment, the agents and settings in which they interact, the ruling institutions in these settings, and their information flows. In terms of natural resources, with the exception of three countries in the region, i.e. Iran, Algeria, and Libya, which possess significant oil and gas resources, the other countries are generally less endowed in natural resources. The large diversity in richness is most apparent in the difference in the GDP per capita between Libya (at about 4.2 times the average) and Yemen (at one-third of the average). All settings in which agents interact are characterized by a strong influence of Arab culture and Muslim traditions. Some Christian influence is mainly present in Lebanon and Egypt. Although there is a growing presence of modern practices, acquired traditions have been more influential in determining an authoritarian orientation of ruling institutions in household, firm, and state settings, and subdued information flows among and between agents in these settings. There are no dominant players in the region as can be gathered from Table 8.29. Table 8.29 shows the total population of the 13 countries of MENA in 2000 at 276 millions, with the top four countries commanding 70 per cent of the region’s population and 67 per cent of the region’s GDP. While the EAP and SA regions Table 8.29 Population and GDP of MENA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Country

MENA Egypt Iran Algeria Morocco Iraq Yemen Syria Tunisia Jordan Libya Lebanon Palestine Djibouti

Population

GDP US$

Million

%

Million

%

275.9 67.3 63.7 30.5 27.8 25.4 17.9 16.8 9.6 4.9 5.3 3.4 3.0 0.7

100.0 24.4 23.1 11.1 10.1 9.2 6.5 6.1 3.5 1.8 1.9 1.2 1.0 0.3

423,827 99,839 101,287 54,790 33,334 25,857 9,441 18,427 19,443 8,460 34,495 16,822 1,081 551

100.0 23.6 23.9 12.9 7.9 6.1 2.2 4.3 4.6 2.0 8.1 4.0 0.3 0.1

Source: World Bank at http: //devdata.worldbank.org/query

Country’s GDP per index I I  capita average US$ col. 2, 4 100.0 24.0 23.5 12.0 9.0 7.7 4.4 5.2 4.0 1.9 5.0 2.6 0.7 0.2

1536 1483 1590 1796 1199 1018 527 1097 2025 1727 6508 4948 365 787

GDP per capita ppp$ 4764 3526 5804 5327 3578 – 822 3161 6276 4109 – 4336 – 1910

324

Economic Systems Analysis and Policies

are dominated by China and India respectively, with shares of the population and GDP of around 70 per cent, the case is very different in MENA. The largest two countries in MENA, i.e. Egypt and Iran, master less than quarter each of the region’s population and GDP. Diversifying factors such as absence of dominant players in the region, together with the wide geographical space and the lagging inter-country transport, are likely to be more significant than the unifying factors such as common religious, language, and cultural traits, in explaining the weak interdependence and the relatively lagging economic integration among the MENA countries as compared to other developing regions. 8.4.2 System development Focusing on the largest four countries, as representatives of the region, it is seen from Table 8.30 that the region is about half inclined to household-agricultural and rural-traditional modes of production and living, and the other half in firmindustry and urban-modern modes. Egypt and Morocco have slightly more of the household and rural, while Iran and Algeria more of the firm and urban. Most of the other countries in the region have also more of the firm and urban as can be gathered from the averages that are based on total MENA. However, the table tends to exaggerate the degree of commercialization associated with firms, since the over majority of agents employed in the industrial sector and in private services in urban areas are working in small-scale and self-employed units that operate in household-like settings, while the rest of urban workers are employed by the public sector, i.e. column 7 shows 41 per cent. These are likely to manifest behaviours that associate more with state setting than firm setting. Table 8.30 Economic structure and conduct in MENA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Country

Indicators relating to relative significance of household versus firm settings Labour GDP Sector ratio ratio index agri: agri: of I I  industry industry average % % cols. 1, 2

Total MENA (a)

55:45

21:79

38:62

Egypt

58:42

34:66

46:54

Iran

43:57

27:73

35:65

–

13:87

–

71:29

30:70

50:50

Algeria Morocco

Rural: urban ratio, %

56:44

Indicators of state influence

Indicators of global links

Public Of which Public Foreign budget/ defence sector/ merGDP, spendurban chandise % ing/ employ- trade/ GDP, % ment, % GDP, % 40.8

50.2

FDI/ GDP, %

25.1

4.3

1.3

57:43

21.3

2.7

70.3

18.7

1.2

36:64

23.4

5.4

36.6

42.1

0.0

40:60

38.3

3.4

39.0

56.9

0.8

45:55

–

4.1

17.1

56.9

0.7

Source, note: World Bank at http://devdata.worldbank.org/query. Col. 5: Public budget is average of public revenue and public spending. Col. 7 on public sector employees/urban employment is reported upon in Gardner (2003). (a)  average of all MENA countries for referred years with available data.

The Developing World: Country Profiles

325

A common feature for the MENA is the relatively high shares of public revenue and public spending in the GDP, when compared to other developing regions. For all MENA countries the public spending share exceeded 40 per cent in the 1970s and was above the public revenue share by deficit shares that varied between 2 and 10 per cent. Since the 1980s all three shares have been falling.63 For all MENA public revenue and public spending were in balance in 2000, but the average share of public sector in the GDP remained high at 25 per cent, which is greater than in most developing regions. This is partly due to the relatively high involvement in defence spending, with a share of defence spending in the GDP of 4.3 per cent. The relatively high public share in MENA is associated also with widely recognized obligations by governments to employ job seekers in the public sector. The table shows that public employment absorbs on the average 41 per cent of urban employment, with Egypt having one of the highest public employment shares in the world at among developing countries at 70 per cent. Greater public shares tend to strengthen sentiments of state paternalism and state authority, with the likely result of less aptitude towards inter-regional economic interdependence and integration. Another common feature of MENA is the achieved little-achieved global integration compared with other developing regions, as shown by the last two indicators in Table 8.30. Foreign merchandise trade/GDP is at 50 per cent and FDI/GDP is at 1.3 per cent for the whole region, and the four major countries of the region score generally below the average. Some analysts reason that the low degrees of global integration reflect attitudes and choices that protect embedded traditions from foreign influences. Another aspect of the global links is the relatively greater role of foreign official development assistance than foreign private financial flows in MENA. The average figure of ODA/GDP for MENA is 1.0 per cent. Egypt obtains more than the average, with a ratio at 1.3 per cent. This gives additional influence to the state, than already present, in the disposal of ODA revenue. 8.4.3 System performance Economic growth performance of MENA is generally observed to have been less than the average when compared to other developing regions. This is explainable partly in terms of a generally lagging industrial entrepreneurship as the active population is more inclined towards households and household-like firm settings, and state settings, and partly in terms of anti-growth influences of other features of the economic structure such as the large public share and state paternalism, and the preferred closed economy and financial orientation to ROW. Acquired traditions explain agent behaviour and attitudes towards resisting family control and such matters as individualist’s choice voice and exit. The attitudes tend to undervalue entrepreneurial material success, and overrate the role of state’s responsibility and welfare expectations from state actions. Behavioural attitudes in MENA, compared to other developing regions, are behind the higher population growth in MENA than the average for the developing world; as well as a lower degree of industrialization, greater state paternalism, and less open economies. Many of these shortcomings are reinforced by a low degree of development and utilization of human resources. The average rate of unemployment in

326 Economic Systems Analysis and Policies Table 8.31

Comparative performance of the economies of MENA, 1981–2005

Country

Total MENA (a)

Average annual growth GDP % 1981– 1990

1991– 2000

2001– 2005

3.0

4.3

3.9

Average annual growth GDP per capita % 1981– 1990 0.0

1991– 2000 2.0

Gini index

2001– 2005

1981– 1990

1991– 2000

2001– 2005

1.9

40.5

38.7

38.1

Egypt

5.5

4.3

3.9

3.0

2.4

1.9

32.3

34.4

Iran

2.4

4.6

5.7

0.9

2.9

4.2

45.5

–

43.2

43.0

Algeria

2.8

1.6

4.3

0.2

0.4

2.8

40.1

40.1

35.3

Morocco

3.9

2.6

4.0

1.7

1.0

2.4

39.2

39.2

39.5

Source, note: World Bank at http://devdata.worldbank.org/query/ (a)  average of all MENA countries for referred years with available data.

MENA countries, about 15 per cent in 2000, is higher than in other developing regions.64 The rate of underemployment is likely to be also higher in view of the over absorption of labour in the public sector. Furthermore, preferences of agents for white-collar public employment cause mismatches between offered qualifications as such and demanded qualifications that are more industrially oriented. The mismatches cause more unemployment and foregone economic growth. System performance in terms of income equality shows a different picture. What is lost in terms of economic growth and income per capita is gained in terms of income equality. Table 8.31 shows the Gini index to decline slightly between 1980 and 2005, while most developing countries showed increases in the Gini index over the same period. It can be consistently reasoned that the same institutional rules that tend to moderate economic growth are also active in promoting greater income inequality. In general, a more equitable income distribution shows up in relatively smaller differences between formal and informal sectors in MENA as compared to other developing regions. The MENA economies are less dualistic than other developing regions.

8.5 Arab Gulf (GCC) 8.5.1

Background

The Gulf Cooperation Council, consisting of six oil-rich Arab countries, was created on 25 May 1981. The stated objectives are to increase cooperation between the six countries. Since then, more steps were taken towards forming an economic union, and the establishment of a common currency, the Khaleeji, is planned for 2010. Political events and security threats from 2002 onwards have hastened the pace of economic integration. Table 8.32 shows that Saudi Arabia is the dominant country in the region with about 70 per cent of the region’s population and 55 per cent of the region’s GDP, giving an average interactive influence of 62 per cent. But UAE is a strong contender even though it has an interactive influence of 16 per cent. UAE, with a very

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327

Table 8.32 Population and GDP of GCC: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Country

Population

GDP US$

Million

%

Million

Total GCC

29.8

100.0

342400

Saudi Arabia

%

Country’s GDP per index I I  capita average US$ cols. 2, 4

100.0

100.0

GDP per capita ppp$

11490

12989

20.7

69.5

188400

55.0

62.2

9101

11390

UAE

3.2

10.7

70600

20.6

15.7

22063

19410

Oman

2.4

8.1

19900

5.8

6.9

8292

–

Kuwait

2.2

7.4

37700

11.0

9.2

17136

18690

Bahrain

0.7

2.3

8000

2.3

2.3

11429

–

Qatar

0.6

2.0

17800

5.2

3.6

29667

–

Source: World Bank at http://devdata.worldbank.org/query/

small national population, relies most on foreign labour, which has predominantly shaped its economic system.65 The features of the UAE are largely shared in the other small countries of GCC. There is less variation in country GDP per capita in GCC compared to MENA, but variation in income per capita within the individual countries of GCC is much higher than within the individual countries of MENA, due to differences in income entitlements of foreign workers and national citizens in GCC. 8.5.2 System development In general, the economic structure applying to MENA would have applied to GCC if not for the discovery and exploitation of oil resources in GCC, which have changed the economic landscape of GCC irreversibly. Because the size of the national labour force is very small, the GCC had to rely on foreign labour from neighbouring countries. The background settings characterizing the national and foreign labour are basically different and thus leading to a highly structured economic system. The development of the economic system is characterized by several features. (a) The rising oil revenues fed the modern economy, resulting into higher consumption, higher investment in construction and diversification, and an outward growth in invisible service. The expansion required import of foreign high productivity skilled manpower at world market clearance rates. This drove consumption and investment demand of the modern economy further. (b) The expansion required also import of foreign unskilled labour from neighbouring SA and EAP countries. A liberal policy has led to a significant surge in foreign unskilled labour. These workers, having a lower opportunity cost in SA and EAP, are generally remunerated at rates below their marginal productivity. As these workers fall back on an informal economy for their consumption needs given

328

Economic Systems Analysis and Policies

their low levels of remuneration and high remittances, they further create a multiplier demand effect for more foreign unskilled labour in the informal economy to satisfy their increased consumption demands. (c) The results are a heightened expansion of both the modern and informal economies and an expanding foreign labour inflow in diversified firm settings with significant wage discrepancies that reflect biased remuneration of high and low productivity labour skills. (d) At the same time, convention and legislation play significant roles in enabling the national population to conserve national characteristic profiles, enacted entitlements, institutional rules and information flows; and adapt to modern changes in gradual and managed ways. The dualistic structures of the economic system featured above are more prominent in UAE than in Saudi Arabia in view of the relatively greater labour shortage and the greater openness of the UAE to foreign labour inflow than in Saudi Arabia.66 As many agricultural products are imported, there is little labour and GDP activity in agriculture, see Table 8.33. Next to some rising activities in industry, the bulk of economic activities take place in construction and various service sectors where the largely foreign-based labour force work and reside in urban cities. The total population at large is also urban based. Rates of urbanization in GCC countries vary from 72 to 98 per cent. The abundant presence of foreign labour in commercialized firms and in urban areas associate with behavioural patterns typical of firm settings, even though significant pockets of household settings among the national population in the larger GCC continue to be highly influential. How important are state settings and state influence in GCC? There is generally less bureaucracy in GCC than in MENA. State agencies are less numerous and agent participation in state agencies is less pronounced in GCC than in MENA. The evolution of behavioural patterns associated with state settings is less prominent in GCC than in MENA. This does not exclude that the state in GCC remains influential via indirect channels of influence, such as public spending, defence spending, and state regulations and jurisdiction. The average ratio of public spending to GDP in GCC, at 31 per cent, is highest among the six world developing regions. The same applies to the ratio of public spending in the GDP, which is at the high figure of 7 per cent. Because oil revenue is the major source of financing public expenditure there is only little influence of the state on agents regarding public revenue collection. In most GCC countries public revenues exceed public spending, see Table 8.33. On the global front, the indicator of foreign trade merchandise/GDP in GCC is about twice that of MENA, which indicates more outward orientation and global linkage. Within the region, UAE and Bahrain are more outward oriented and Saudi Arabia and Kuwait are less so. The UAE is also more active than Saudi Arabia with respect to other signals of outward orientation. While in their use of the foreign exchange reserves accumulated from oil revenue, the UAE puts relatively more in investment and financing of private equity in the world at large, Saudi Arabia invests more in the purchase of US government bonds.

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329

Table 8.33 Economic structure and conduct in GCC: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Country

Indicators relating to relative significance of household versus firm settings Labour GDP Sector ratio ratio index agri: agri: of I I  industry industry average % % cols. 1, 2

Total GCC (a)

26:76

Saudi Arabia UAE

Rural: urban ratio %

Indicators of state influence

Indicators of global links

Public Public Of which: Foreign revenues/ Spend- defence merGDP, ing/GDP, spend- chandise % % ing/GDP, trade/ % GDP, %

5:95

15:85

19:81

36.6

30.9

7.1

91.7

23:77

8:92

15:85

20:80

22.2

26.2

10.6

57.2

19:81

6:94

13:87

23:77

42.0

31.6

3.4

120.2

Oman

36:64

3:97

20:80

28:72

30.0

34.8

10.6

82.8

Kuwait

–

–

–

2:98

51.3

35.7

7.1

70.5

Bahrain

–

–

–

5:95

35.6

25.9

4.0

135.9

Qatar

–

–

–

5:95

38.6

31.3

–

83.6

Source, note: World Bank at http://devdata.worldbank.org/query/, except columns 5 and 6 on public revenue and spending, which are from http://www.sesrtcic.org/stat_country.php. (a)  average of all GCC countries for referred years with available data.

Furthermore, an analysis of a large number of output indicators relating to outward communication and cooperation in business and science 67 shows also that the UAE is more active than Saudi Arabia. This occurs with relatively less resources used towards these ends in UAE than Saudi Arabia, suggesting a higher efficiency in achieving outward orientation in UAE compared to Saudi Arabia. 8.5.3 System performance Table 8.34 shows past growth rates of the GDP and GDP per capita for GCC, and the two main players of Saudi Arabia and UAE. Given the economic system of the region, while the GDP trends depend on the world energy market, GDP per capita trends depend on the absorption of overseas labour. GDP growth increased progressively over the three reported periods as demand and prices of crude oil surged. In contrast, depending on the pace of foreign labour inflow GDP per capita fell in 1980–90, stabilized in 1990–2000, and showed some rise in 2001–05. The notion of GDP per capita in the context of distinct entitlements for foreign workers and national households, as in GCC, does not tell much. Similarly, measurement of the Gini index is less meaningful in the GCC context, having many one-person worker households next to full family households of nationals, and differentiated systems of entitlements in money and kind. Figures on the Gini index in GCC are not constructed.

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Economic Systems Analysis and Policies

Table 8.34

Comparative performance of the economies of GCC, 1981–2005

Country

Average annual growth GDP % 1981– 1990

Average annual growth GDP per capita %

Gini index

1991– 2000

2001– 2005

1981– 1990

1991– 2000

2001– 2005

1981– 1990

1991– 2000

2001– 2005

0.1

3.1

5.5

4.9

0.4

1.6

–

–

–

Saudi Arabia

0.8

2.6

4.0

5.8

0.3

1.7

–

–

–

UAE

0.2

4.3

8.1

5.4

1.9

1.1

–

–

–

Total GCC (a)

Source, note: World Bank at http://devdata.worldbank.org/query/ (a) average of all GCC countries for referred years with available data.

8.6 Sub Saharan Africa (SSA) 8.6.1 Background In Chapter 1, we have positioned the SSA region closest to household settings. The characteristic feature of African society, and thus the economic system, is the allegiance of agents to kin groups, which aligns with household behavioural features. Prior to colonial rule kinship settings dominated life in SSA. Firm and state settings are relatively new. Environments that prosper kinship settings and kin groups are characterized by high levels of uncertainty and risk, and limited resources, specialization and exchange; and this is typical of the SSA region. The kin group is able to enforce collective action, mutual help, and reciprocal favours among its members under the threat of exclusion of non-abiding members. The ruling institutions and sanctions in kin groups and kinship settings, which apply equally to household settings in an impoverished economy, succeed in reducing enforcement costs for securing insurance against calamities, provision of public goods, management of common resources, and intra- and inter-generational transfers. While the dominance of household settings, and in particular kin groups, is also found in other least prosperous developing countries, African kin groups are distinctive both by their ubiquity and the strength of their claims upon members.68 When the newly introduced commercial firms and state agencies started functioning in the SSA environment it was imperative that their structure, conduct, and performance would manifest the allegiance of agents to kin groups. Kin groups will attempt to favour their own members in the assignment of jobs in firms or government, and the allocation of other benefits and costs. While kinship settings have efficiency advantages in minimizing transaction costs among its members, the same kinship settings have efficiency costs when favouritism leads to misallocation of physical and human resources. When ethnic favouritism spreads to state settings, the probability is high that civil discontent, disorder, and violence accelerate. The positive

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331

associations between ethnic fractionalization, political instability, and economic underperformance are highest for the SSA region, when compared with other developing regions.69 The functioning of firm and state settings in SSA are thus embedded within a behavioural system that prioritize the value of kin relations and loyalty. Table 8.35 displays basic data for countries of SSA. The region contains a very large number of countries: 42 countries, next to some more small country territories. To obtain a grip on the diversity of countries, it is helpful to subdivide the region roughly into a central belt consisting of 22 countries and a southern belt consisting of 20 countries. The details of the borderline between the two belts are a matter of balanced judgement and common sense, and need not be exhaustive. While the two subgroups of countries share common similarities on the kinship dimension with similar consequences for their social, political, and economic systems, there are some subtle background differences between the central and southern belts that differentiate their structures, conduct, and performance. The central belt is more arid and is subjected to more desertification when compared to the more temperate and water rich southern belt. Although both belts are rich in natural resources, these are less exploited in the central than the southern belt. While the central belt is more Islamic, the southern belt is more Christian. The central belt had less in-migration of labour and capital from other countries and colonial settlements than the southern belt. France was the main colonial power in the central belt, Britain in the southern belt. French is more spread in the central belt, English in the southern belt. The decolonizing of the central belt and achievement of national independence in these countries occurred quite peacefully in the central belt, compared to various wars of independence in most countries of the southern belt. All these circumstances taken together have resulted in a central belt that is economically less developed and poorer than the southern belt. Average GDP per capita, in US$ or in ppp$, in the central belt is about half that in the southern belt, but there is much more variance in economic welfare in the southern than the central belt, Table 8.35. The central belt counts more population but less income than the southern belt. The central belt Index of Interactive Influence, index of I I, which consists of averaging the shares of population and income, amounts to 45 and 55 for the central and southern belts respectively, indicating a lower influence of the central compared to the southern belt. Within the central belt Nigeria has the highest country index of interactive influence, this is at 15 out of 45, which is about 35 per cent of the central belt. Within the Southern belt South Africa has the highest country index of I I at 22 out of 55, which is again about 35 per cent of this subregion. In their respective blocs, both Nigeria and South Africa have equal weights. But South Africa is higher than Nigeria for the whole SSA. However, both countries are much less significant players in SSA, when compared to India or China in the SA and EAP contexts.

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Economic Systems Analysis and Policies

Table 8.35 Population and GDP of SSA: Ingredients of a Country Index of Interactive Influence (Country Index II), 2000 Population Million

%

GDP US$ Million

%

Country’s index I I  average cols. 2, 4

Total SSA

662.9

100.0

341600

100.0

100.0

Central belt

367.8

55.5

116347

34.1

Nigeria

117.6

17.7

46000

13.5

Ethiopia

64.3

9.7

7800

Sudan

32.9

5.0

12400

GDP per GDP per capita capita US$ ppp$ 515

1600

44.4

316

1101

15.6

391

854

2.3

6.0

121

814

3.6

4.3

377

1506

Ghana

19.9

3.0

5000

1.5

2.2

251

1920

Ivory Coast

16.7

2.5

10400

3.0

2.8

623

1582

Cameroon

14.9

2.2

10100

3.0

2.6

678

1877

Niger

11.8

1.8

1800

0.5

1.2

153

678

Mali

11.6

1.7

2400

0.7

1.2

207

785

Burkina Faso

11.3

1.7

2600

0.8

1.2

230

986

Senegal

10.3

1.6

4400

1.3

1.4

427

1427

Guinea

8.4

1.3

3100

0.9

1.1

369

1974

Chad

8.2

1.2

1400

0.4

0.8

171

801

Benin

7.2

1.1

2300

0.7

0.9

319

974

Somalia

7

1.1

847

0.2

0.7

121

–

Togo

5.4

0.8

1300

0.4

0.6

241

1358

Sierra Leone

4.5

0.7

634

0.2

0.4

141

463

Central Af. Rep.

3.8

0.6

953

0.3

0.4

251

1209

Eritrea

3.6

0.5

634

0.2

0.4

176

1022

Liberia

3.1

0.5

561

0.2

0.3

181

–

Mauritania

2.6

0.4

1,081

0.3

0.4

416

1910

Guinea-Bisau

1.4

0.2

216

0.1

0.1

154

863

Gambia

1.3

0.2

421

0.1

0.2

324

1631 Continued

8.6.2 System development Focusing on Nigeria and South Africa, being the largest two countries in the two belts, it is clear from Table 8.36 that rural households settings and agricultural sector transformations are more important in Nigeria than in South Africa; this is also borne out in a lower urbanization ratio: 44 and 57 per cent, respectively. In contrast, firm settings appear thus to be weak in Nigeria and stronger in

The Developing World: Country Profiles

Table 8.35

333

Continued Population Million

GDP US$

%

Million

%

Country’s index I I  average cols. 2, 4

GDP per GDP per capita capita US$ ppp$

Southern belt

293.5

44.3

220968

64.7

54.5

753

2244

South Africa

44.0

6.6

132900

38.9

22.8

3020

8764

Congo D.R.

50.1

7.6

4300

1.3

4.4

86

601

Tanzania

34.8

5.2

9100

2.7

4.0

261

524

Kenya

30.7

4.6

12700

414

1033

Uganda

24.3

3.7

5900

1.7

2.7

243

1167

Mozambique

17.9

2.7

3800

1.1

1.9

212

799

3.7

4.2

Madagascar

16.2

2.4

3900

1.1

1.8

241

843

Angola

13.8

2.1

9100

2.7

2.4

659

1462

Zimbabwe

12.6

1.9

7400

2.2

2.0

587

2498

Malawi

11.5

1.7

1700

0.5

1.1

148

583

Zambia

10.7

1.6

3200

0.9

1.3

299

785

Rwanda

8.0

1.2

1800

0.5

0.9

225

951

Burundi

6.5

1.0

709

0.2

0.6

109

650

Congo R.

3.4

0.5

3200

0.9

0.7

941

1055

Namibia

1.9

0.3

3400

1.0

0.6

1789

5838

Botswana

1.8

0.3

6200

1.8

1.0

3444

8349

Lesotho

1.8

0.3

859

0.3

0.3

477

2592

Gabon

1.3

0.2

4900

1.4

0.8

3769

6175

Mauritius

1.2

0.2

4500

1.3

0.7

3750

9673

Swaziland

1

0.2

1400

0.4

0.3

1400

4167

Source, note: World Bank at http://devdata.worldbank.org/query/ Total SSA is slightly higher than the sum of countries due to unspecified small countries, islands, and territories with very small populations.

South Africa. This would also generally apply for the central and southern belts, respectively. As an indication of the strength of state settings we resort to the budget share in the GDP and defence spending/GDP. Both indicators are lower in Nigeria than in South Africa. This is to be in view of a more extended role for state institutions at a higher level of economic development. Furthermore, special circumstances in South Africa relating to transfer of political power and state

334

Economic Systems Analysis and Policies

Table 8.36 Economic structure and conduct in SSA: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Country

Indicators relating to relative significance of household versus firm settings

Indicators of state influence

Indicators of global links

Labour GDP Sector Rural: Public Of which Foreign FDI/ ratio ratio index urban budget/ defence merGDP, % agri: agri: of II  ratio, % GDP, % spend- chandise industry, industry, average, ing/GDP, trade/ % % cols. 1, 2 % GDP, % Total SSA (a)

85:15

37:63

61:39

67:33

19.8

1.9

51.9

2.0

Nigeria

87:13

33:67

60:40

56:44

14.1

0.8

64.6

3.2

S. Africa

38:62

9:81

23:77

43:57

26.3

1.4

44.9

1.2

Source, note: World Bank at http://devdata.worldbank.org/query/. Col. 5: Public budget is average of public revenue and public spending. (a)  average of all SSA countries and referred years with available data.

obligations to bolster this transfer have contributed to the relatively high public share. As regards global integration, SSA maintained the status of the least globally integrated among the developing regions, which is mainly due to the institution by the states of extensive quotas, tariffs and export taxes, foreign exchange controls, marketing boards and investment regulations. One indicator of global links is that of the share of foreign merchandise in the GDP. The average for SSA amounted to 52 per cent in 2000; which is as low as was found for the MENA region, and is lowest among the developing regions. Table 8.36 gives some surprising comparisons between Nigeria and South Africa on this dimension. Nigeria shows a figure of 65 per cent compared to South Africa at 45 per cent. Given its higher level of economic development South Africa could be expected to be more globally linked than Nigeria, and thus would show a higher share of merchandise export in GDP. This is not the case, however. In the past two decades, South Africa has been moving rapidly through a deindustrialization phase to the benefit of the services sectors, and relatively away from tradable to non-tradable goods and services. The recent tendency in South Africa towards an inward rather than an outward industrial development can be explained in terms of increased regulation by the state and a bigger state sector, a widening of the income gap associated with greater spending on services, and a backlog in the vocationally trained manpower and industrial infrastructure.70 For the year 2000, Nigeria appears to be more globally linked than South Africa with respect to the degree of inflow of foreign direct investment. In Nigeria, foreign investment in energy exploitation pushed FDI/GDP to 3.2 per cent, while South Africa lagged behind at 1.2 per cent.

The Developing World: Country Profiles

335

Another source of foreign finance, official development assistance, ODA, is more significant for the other countries of SSA than for either Nigeria or South Africa. In 2000, ODA/GDP amounted to 4.1 per cent for the SSA as a whole, but only to 0.43 per cent and 0.38 per cent for Nigeria and South Africa, respectively. 8.6.3 System performance It is generally acknowledged that the economic growth performance of the Sub Saharan African region up to the year 2000 was among the least in the developing world, as was apparent from Chapter 7. Because of the high population growth, average annual growth of the GDP per capita was negative in the years before 2000, as can be seen from Table 8.37. However, there is a turn towards higher growth in the GDP and positive growth in the GDP per capita in the period 2001–2005, which has been helped by the rise in world demand and prices for primary commodities, but tempered by persisting high growth of the population. The association between frequent political instabilities and slow economic growth in SSA has been noted, tested empirically, and found significant in various studies.71 In many SSA countries, similarities regarding regionalization of politics and ethnic bias in policy-making are striking, and this probably applies to both the central and southern belt equally. There is tension between insiders (those identified with the political establishment) and various groups of outsiders. The distinction between insiders and outsiders is often based on kin groups, ethnic origin, regional and religious affiliation. As violence erupts, economic infrastructure is hit most. Besides, in an unstable political environment, the allocation of economic resources is distorted. The government, and its running heads, usually play leading roles in the diversion of resources to non-developmental ends, either actively or passively. Under these circumstances, the investment climate is weak and openness to foreign direct finance and trade is discouraged.

Table 8.37 Country

Comparative performances of the economies of SSA, 1981–2005 Average annual growth GDP, % 1981– 1990

1991– 2000

2001– 2005

Average annual growth GDP pc, % 1981– 1990

1991– 2000

2001– 2005

Gini index, %

1981– 1990

1991– 2000

2001– 2005

Total SSA (a)

1.9

2.3

4.4

1.0

0.3

2.0

43.5

47.0

43.3

Nigeria

1.3

3.1

5.3

1.5

0.4

3.0

38.7

48.5

43.7

S. Africa

1.5

1.4

3.6

0.9

0.8

2.0

58.0

57.8

Source, note: World Bank at http://devdata.worldbank.org/query/ (a)  average of all SSA countries and referred years with available data.

–

336 Economic Systems Analysis and Policies

The performance regarding income inequality is mixed. For all SSA combined, the Gini index rose and fell several percentage points in 1980–2005, and settled around 43 per cent in 2005. Nigeria followed these trends closely. But the other major country in the region, South Africa, displays income inequalities that are as high as in Brazil, both have a Gini index of around 58 per cent; see next section. There is a positive correspondence between low economic growth and the high concentration of income in South Africa. This will also be noted to be the case for Brazil.

8.7 8.7.1

Latin America and Caribbean (LAC) Background

The distinguishing features of the socio-economic system in the LAC region are best highlighted when the destiny of the LAC region is compared with the destiny of its northern neighbours. North America and South America, two continents discovered and populated by Europeans at around the same time in 1500, fall now some 500 years later, in the economically advanced and rich US and Canada, and a poor region of LAC consisting of 33 developing countries. US and Canada, are identifiable as leaders of the firm intensive economic system, while LAC forms a conglomeration of household, firm, or state settings with a low degree of interaction between them. One way of explaining the economic failure of LAC compared to US is to go back to the initial situation and early years, and signal differences. For instance, arguments have been advanced such as US is geographically closer than LAC to Europe, and more people and capital moved there first giving LAC a disadvantage. Another argument is that Protestant colonists settled in US, while Catholic colonists settled in LAC. There is also the argument that US fought for and gained its independence some 40 to 50 years earlier than LAC. And US became a union of states with a federal constitution. In contrast, some LAC countries tried to unite after independence but attempts failed. There was also a lesser urge to uphold to the passed constitutions in the individual countries. All these arguments from the past are valid explanations of the current differences between US and LAC. The huge gap in economic development between LAC and US can be also seen in other terms. Although favourable economic conditions allowed firm settings to flourish in US and expand their scope through intensive interaction to many aspects of life, resulting thus in a firm intensive economic system, FIM, various socio-economic barriers and divisions in LAC stood in the face of intensive communication between agents who belong to different socio-economic strata, ways of living and levels of living. When established socio-economic divisions separate agents (groups) from interacting with each other, the country nation is reduced to a loosely related economic system that ignores the benefits of positive externalities and ends up in a deadweight loss.

The Developing World: Country Profiles

337

The socio-economic barriers and divisions in LAC are highlighted by huge income differences. It is remarkable that the most skewed income distribution in the world is in LAC countries. In the years between 1980 and 2005, the average Gini index for LAC countries varied between 50 and 53, with Mexico reaching 50 and Brazil reaching 60, compared to the other developing regions where the range was between 30 and 44.72 To complete the picture, for Russia and US the most recent figures of the Gini index are 40 and 41, respectively.73 The extent of income disparities in LAC prohibits intensive interaction between population groups with significantly differing household incomes. Differing origins by birth,74 which associate with material endowments, strengthen furthermore the social differentiation and separation in the population, and minimize intensive interaction between stratified population groups even though agents may meet each other in the same settings. Although Table 8.39 shows the over majority of agents to work in non-agricultural firm-like settings, a disaggregation of these categories would show that most agents work in the informal sector that is behaviourally household-oriented, with small portions in the private, formal sector that is behaviourally firm-oriented and a public, formal sector that is behaviourally state-oriented. There is relatively little interaction between these different settings. And although more than three-quarters of the population in LAC is urbanized, there are wide differentiations and barriers between rich and impoverished neighbourhoods that impede agent interaction and evolvement towards a unified system of common behaviour. There are differences among LAC countries as to the degree in which they manifest the above-mentioned systemic features. In general, the more skew the income distribution and the greater the differentiation of household origin by birth, the greater the barriers that impede agent interaction and system integration. Related differences between Mexico and Brazil are a case in point. Income inequality is less in Mexico than in Brazil suggesting that Mexico is a more agent interactive and integrated socio-economic system than Brazil. Since Mexico and Brazil are the two major leaders in the LAC region we shall focus on these two countries in illuminating other structural features of LAC. The LAC region is vast and consists of 33 countries and some territories. Table 8.38 subdivides the 33 countries into a Central or Caribbean belt consisting of 11 countries that are centred around Mexico and a southern belt consisting of 12 countries more or less bordering Brazil. An Index of Interactive Influence based on shares of population and GDP gives the values of 34 and 66 for the central and southern belts respectively, suggesting that the central belt is half as influential as the southern belt. Within central belt Mexico has the highest country index of II at 24, which is 72 per cent of the subregion. Within the Southern belt Brazil has the highest country index of II at 32, which is only about 48 per cent of this subregion. In their respective blocs, Mexico has a stronger weight than Brazil. But for the LAC as a whole, Brazil supersedes Mexico in expectable influence.

338

Economic Systems Analysis and Policies

Table 8.38 Population and GDP of LAC: Ingredients of a Country Index of Interactive Influence (Country Index I I), 2000 Country

Population

GDP US$

millions

%

millions

%

Country’s index I I  average col. 2, 4

GDP per capita US$

GDP per capita ppp$

Total LAC

514.9

100.0

1,983,527

100.0

100.0

3,852

7,102

Central belt

163.5

31.8

699,262

35.3

33.5

4,275

7,454

Mexico

98

19.0

581,426

29.3

24.2

5,933

9,197

Guatemala

11.2

2.2

19,291

1.0

1.6

1,722

4,048

Cuba

11.1

2.2

16,382

0.8

1.5

1,367

–

Dominican R.

8.3

1.6

19,772

1.0

1.3

2,382

6,649

Haiti

7.9

1.5

3,771

0.2

0.9

477

1,619

Honduras

6.4

1.2

5,956

0.3

0.8

931

2,872

El Salvador

6.3

1.2

13,134

0.7

0.9

2,085

4,597

Nicaragua

4.9

1.0

3,936

0.2

0.6

803

3,110

Costa Rica

3.9

0.8

15,946

0.8

0.8

4,089

8,170

Panama

2.9

0.6

11,621

0.6

0.6

4,007

6,046

Jamaica

2.6

0.5

8,027

0.4

0.5

3,087

3,596

Southern belt

349.5

67.9

1,276,494

64.4

66.1

3,652

6,877

Brazil

173.9

33.8

601,732

30.3

32.1

3,460

6,978

Colombia

42.1

8.2

83,779

4.2

6.2

1,990

5,783

Argentina

36.9

7.2

284,204

14.3

10.7

7,702

11,769

Peru

26

5.0

53,290

2.7

3.9

2,050

4,592

Venezuela

24.3

4.7

117,148

5.9

5.3

4,821

5,693

Chile

15.4

3.0

75,213

3.8

3.4

4,884

8,787

Ecuador

12.3

2.4

15,942

0.8

1.6

1,296

2,941 2,325

Bolivia

8.3

1.6

8,398

0.4

1.0

1,012

Uruguay

3.3

0.6

20,671

1.0

0.8

6,264

8,759

Paraguay

5.3

1.0

7,071

0.4

0.7

1,334

4,126

Trinidad

1.3

0.3

8,154

0.4

0.3

6,272

8,282

Suriname

0.4

0.1

892

0.0

0.1

2,230

6,000

Source, note: World Bank at http://devdata.worldbank.org/query/ Total LAC is slightly higher than the sum of countries due to unspecified small countries, islands and territories with very small populations.

8.7.2 System development Table 8.39 shows the economic system of Brazil compared to Mexico to be more oriented towards agriculture and household settings, and less towards industry and firm settings. Nevertheless, the degree of urbanization is higher in Brazil than Mexico.

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339

Table 8.39 Economic structure and conduct in LAC: Indicators of the relative significance of households, firms, government, and global links, 2000, per cent Country

Indicators relating to relative significance of household versus firm settings

Indicators of state influence

Indicators of global links

Labour GDP Sector Rural: Public Of which Foreign FDI/ ratio ratio index of urban budget/ defence merchan- GDP, % agri: agri: I I ratio, % GDP, spend- dise trade/ industry, industry, average % ing/GDP GDP, % % % cols. 1, 2 Total LAC (a)

48:52

19:81

33:67

25:75

20.7

1.4

37.4

4.0

Mexico

46:54

13:87

29:71

25:75

14.7

0.5

60.0

3.1

Brazil

53:47

21:79

37:63

19:81

24.2

1.7

19.0

5.4

Source: World Bank at http://devdata.worldbank.org/query/. Col. 5: Public budget is average of public revenue and public spending. (a)  average of all LAC countries and referred years with available data. (b)  1998.

Indicators of state influence show that the role of the state is more pronounced in the southern than the central belt. The public budget share stood in Brazil at 24.2 per cent in 2000, while Mexico stood at 14.7 per cent which is almost 10 per cent less. The share of defence spending in the GDP is also higher in Brazil than in Mexico by about 1 per cent. As regards indicators of global links, and with reference to foreign merchandise trade/GDP, Mexico is shown as more outward oriented in trade than Brazil, with a share of 60 per cent compared with 19 per cent. But with reference to FDI/GDP there is relatively more foreign capital inflow in Brazil than Mexico, with a share of 5.4 per cent compared to 3.1 per cent. The higher share reflects the greater future economic prospects that are being held by foreign investors for the Brazilian economy and the Brazilian market. For LAC as a whole, when compared with other major developing regions, LAC is less outward oriented in terms of trade but is more globally linked in terns of foreign capital inflow. Linkages between foreign trade and foreign investment are thus less exploited in LAC when compared to other major developing countries. Official development assistance plays a minor role in LAC with a ratio of ODA/GDP in 2000 of 0.24 per cent. 8.7.3 System performance The economic performance of LAC between 1950 and 2000 was disappointing compared to Asian countries, as can be gathered from Chapter 7, and Table 8.40. Inequalities, stratification, immobility, and shallow interaction between population groups must have contributed to the weak performance, as was already mentioned. Table 8.40 shows that the income inequalities as represented by the Gini index are also the highest in the world.

340 Economic Systems Analysis and Policies Table 8.40

Comparative performance of the economies of LAC, 1981–2005

Country

Average annual growth GDP %

Average annual growth GDP per capita %

Gini index

1981– 1990

1991– 2000

2001– 2005

1981– 1990

1991– 2000

2001– 2005

1981– 1990

1991– 2000

2001– 2005

Total LAC (a)

1.9

3.0

2.3

0.9

1.3

0.9

49.6

50.1

52.8

Mexico

1.9

3.4

2.6

0.4

1.7

1.4

46.3

50.1

47.9

Brazil

1.6

1.8

2.6

0.2

0.3

1.2

58.9

59.7

58.1

Source, note: World Bank at http://devdata.worldbank.org/query/ (a)  average of all LAC countries and referred years with available data.

From 2000 onwards, favourable trade and macroeconomic conditions have contributed to positive signs of economic progress for LAC. World Development Indicators show that the region as a whole ran a trade surplus since 2002 reaching $45 billion in 2005, and thus substantially reducing the region’s external financing needs. The public debt profiles of many countries improved as total debt service fell to 22 per cent of exports in 2005, some16 percentage points lower than 2000. The debt service ratio to GNP has fallen from 11.4 per cent in 2000 to 8.8 per cent in 2005. Inflation was brought down to single digit levels in most countries where double digit rates were common in the 1990s. Between 1995 and 2005, LAC had the highest investment in infrastructure projects with private participation in the developing world, with three LAC countries, i.e. Brazil, Mexico, and Argentina in the top five. The effects of these positive developments do not show up in GDP growth and GDP per capita as yet for the LAC as a whole as evident from Table 8.40 where the performance in 2001–2005 is lower than in 1991–2000. In terms of individual countries, the positive developments show up in Brazil where there is an acceleration of economic growth but not yet in Mexico. On the other hand, there is a greater improvement in income equality in Mexico as compared to Brazil. The above suggests that the phenomenon of a trade-off between growth and distribution, noted earlier in other contexts, is of general validity; and should be an essential part of assessments and evaluations of system performance.

8.8 Summary and conclusions This chapter examined main features of the economic systems of the six developing regions, namely: EAP, SA, MENA, GCC, SSA, and LAC. This was done first via a brief review of the historical background of each region and its composition in countries of different sizes and influence. Second, we examined the current development of the economic systems of the regions relying on indicators that show the changing influence of settings relating to households, firms, the state, and the rest of the world. Among the indicators examined were those of the distribution of the labour force and the GDP between agriculture and industry,

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341

distribution of the population between rural and urban areas, as reflecting on issues of the changing influence of household settings versus firm settings. We examined also the extent of the public budget and defence spending in relation to the GDP, as reflecting on the impact of the state on the economic system. We examined the global linkage and outward orientation of the economic systems by looking at indicators of the shares of foreign merchandise trade in the GDP and foreign direct investment in the GDP. Third, we did a brief assessment of the system performance for each region in terms of economic growth and income equality over the periods 1980–90, 1991–2000, and 2001–05 and attempted to relate these performances to aspects considered in the background and the development of the economic system. Given the leading positions that China and India occupy in EAP and SA respectively, and the expected influence of each in determining systemic changes and tendencies of neighbouring countries within their respective regions we went at length in examining for these two countries relevant features relating to background, developments, and performance of their economic systems. The country Index of Interactive Influence, based on shares of the population and GDP in the region, gives values of around 70 per cent for China and India. Other countries in other regions do not pair these levels. We, nevertheless, single a few countries in the other regions that show higher values of the index, and reflect on their economic systems. These included Nigeria and South Africa in Sub Saharan Africa, Brazil, and Mexico in LAC, and Saudi Arabia and United Arab Emirates in GCC. There is less dominance of the individual countries in MENA, when compared to other developing regions.

9 Comparative Performance of Countries Relating to Different Economic Systems: A Social Accounting Approach

9.1

Introduction

This chapter is devoted to developing and applying a quantitative framework for evaluating the performance of economic systems. We shall begin with introducing basic elements of an evaluation framework, then review alternative analytical frameworks and end up with choosing the Social Accounting Matrix model, SAM, as a comprehensive and an easily workable model for evaluating comparable economies. We shall then apply the SAM to evaluate the performance of countries allied with the major economic systems treated in this book. Section 9.3 deals with the comparative performance of the economies of Western Europe and Eastern Europe. Section 9.4 offers a comparative analysis of the performances of the Russian and Chinese economies in the midst of their economic transitions. Section 9.5 comments on the limitations of the SAM model, and Section 9.6 contains a summary and conclusions. The choice to apply the quantitative framework of the SAM to a comparative assessment of the properties and performances of the economies of Eastern Europe and Western Europe, and along similar lines to extend the analysis to Russia and China, is logical and relevant. The economies of the Baltic, Central, and Eastern Europe (BCEE), under communist rule for more than four decades, have developed specific traits that are in variance with structural patterns of economic development. Communist priorities are known to have favoured investment in heavy industries over final consumption, the so-called productive sectors over services, large-scale firms over small ones, state owned over private firms, etc. Besides, the height and distribution of remuneration as well as the size and pattern of consumption were superficially maintained at levels imposed by state authorities without due consideration of agent responses. Now that these economies are turning back to normal market conditions, and have joined West European countries (WE) as part of the European Union, questions rise about the extent and nature of the economic ‘imbalance’ in BCEE countries when compared to the more ‘balanced’ economies 342

Comparative Performance: A Social Accounting Approach

343

of WE. This chapter deals with these questions and examines the gap between the imposed and normal structural patterns. Two other major countries that have followed different paths in their shift from state intensive settings to firm intensive settings are Russia and China. This chapter will also examine the underlying properties of these two economies and how these differing properties result in different economic performances in Russia and China.

9.2

Frameworks for analysing economic system performance

Comparative assessments of economic systems distinguish between several concepts that are often brought together as is done in Figure 9.1. They are 1. 2. 3. 4. 5.

Economic system (internal structures); Outside forces (environment, state); Outcome of economic activity; Criteria of judging performance of economic systems; Analysis of performance as being the result of an outcome and a criteria.

There is no one commonly accepted view on what comprises an economic system. Most economists though adopt the conventional view that the economic system is comprised of four complementary internal structures. The four internal components, as was displayed in our first chapter, are ● ●

●

●

The agent structure comprising the profile of the agents and their preferences. The institutional structure that includes rules guiding the behaviour of agents. The information structure serving to inform agents about the environment in general and the actions chosen or contemplated by other agents making interrelated decisions. The technological structure defining transformation boundaries within which agents transform value added.

There are the outside forces impacting the economic system. These are often taken to be the environment and the state. External influences exerted by other countries, and random factors such as the weather and natural disasters, are part of the environment. The environment is relatively more non-controllable than the state. State policies obviously affect economic activity. They are not independent of the economic system, but are not fully endogenous either. The four internal components and the external forces work together to determine the outcomes of economic activity, which are commonly considered to be the production of goods and services, their distribution among economic agents and their subsequent consumption by these agents. The outcomes are not static, since they are supposed to include as well provisions for future production, distribution, and consumption.

344

Economic Systems Analysis and Policies

External forces

Environment

Economic system

State

State policies

Economic activities Production Income Consumption

Economic outcomes

Performance criteria

Economic performance Figure 9.1

The analytical framework for comparing performances

To make an assessment of the performance of an economic system, performance criteria need to be specified. A distinction can be made between prevailing norms and comparer’s norms. The prevailing norm represents the norm or preference function of those decision-makers who actually resolve the economic decisions. The comparer’s norm represents the norm adopted by a given student of economic systems for purposes of comparison. Thus, he could focus only on production efficiency or the growth rate in GNP in a comparative study of different economies. The point is that no discussion of a system or an economy’s performance can proceed in an orderly manner unless the norm used to evaluate performance is made explicit. Performance criteria from the viewpoint of the comparer can be based upon conceptual notions of static efficiency of production, consumption, and distribution (mainly based on Pareto optimality conditions), and dynamic efficiency (including inter-temporal allocation between consumption and investment, as well as intertemporal distribution). Performance criteria can also take the form of operational indicators such as economic growth, factor productivity, income equality, poverty reduction, consumer satisfaction, stability, freedom etc. While conceptual notions are essential as a tool of analysis and for theoretical understanding, they are not easily convertible into quantifiable indicators that can be applied for individual countries that represent specific economic systems. Operational indicators

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345

are easier to apply. This chapter develops a framework for appraisal on the basis of operational indicators, and in particular, growth, and equity. The diagram in Figure 9.1 can be formalized in an equation form as is done in equation (1). Economic order discussions are often formulated in terms of the following equation.1 Outcome  f (system, external environment, government policies)

(1)

This equation is valid for the medium to the long run. In the longer perspective, there will be more interactions among the four sets of variables. For example, the outcome over many periods can influence the form of the state and its policies in the future. Environment has also cumulative effects on the state and its policies. Also the system is not independent of the outcome in the very long run. The quantitative analysis of the economic performance of a specific economic system has to be always approximated in terms of real economies that are aligned to that specific economic system. The set of national economies can be denoted by J and the particular national economy observed is j, and there are many national economies j, ... , j’. The economic system type can be denoted by M, and there are several of them, m, ... , m’. The economic outcomes are expressed in indicators forming an outcome set Q, consisting of elements q, ... , q’. In the present context, two Q variables are of special interest; these are economic growth and social equality. Variables of the external environment are denoted by E, and they include e, ... , e’. Variables of government policies are denoted by C, and they include c, ... , c’. The economic outcome of a specific country, Q j, is thus explained in terms of three factors: the identifiable economic system to which the country belongs Mj, the external environment variables circumventing the country Ej, and government policies that the country features, Cj. Figure 9.1 and equation 1 can now be expressed more concretely as in equation 2 that specifies that outcome for observed countries is dependent on the systems to which they belong, and variables of the external environment and government policies. Q j  function of (Mj, Ej, Cj)

(2)

Economists have applied the analytical framework of Figure 9.1, the general equation (1), and the quantifiable equation 2, to different themes and at different levels of aggregation when comparing countries. There is the alternative between conducting a general analysis and a partial analysis of economic systems.2 Among the latter, there are partial studies dealing with organizational issues relating to structure, conduct, and performance at the micro and meso levels. There are also partial studies that deal with macro features. Both the general and partial methods of analysis are, in their ways, useful as well as awkward. The difficulty with the general approach is that in lack of a uniform and focused systemic analysis the comparative assessment between countries belonging to different systems is greatly weakened. The danger with the

346

Economic Systems Analysis and Policies

partial approach is that the image of the organic unity of individual systems may become excessively fragmented. By jumping from one system to another, with only one trait in mind at a time, the student never gets a chance to see any of them as a whole. Many economists tend to believe that it is more fruitful to apply the partial system analysis than the general systems analysis, which is reflected in the large empirical literature of trait-by-trait for various countries, and the little attention given to a general systems analysis of economic orders. We choose to pursue the elaboration of a general systems approach that is reasonably standardized and focused to allow drawing fruitful comparative assessments. In the way of elaborating our general systems approach, we propose to modify equations (1) and (2) towards equations (3) and (4), respectively. The refinement introduced is in consistency with the reduced form solution of a system of equations. Outcome  (system multipliers) (environment, policies)

(3)

Q j  (system multipliers of Mj) (Ej, Cj)

(4)

What we have in equation 4 is a more specific multiplicative relationship between the inverse of the system of equations – the system multipliers – and the exogenous variables that stand for the external environment and government policies. One may extend the analogy with the modelling jargon and denote the environmental variables as uncontrollable and the policy variables as controllable. The solution of the economy model, read the economy outcome, is the result of a multiplication of the reduced form multipliers of the economy in question by exogenous vectors facing that economy. Practically speaking, almost all comparative studies of economic systems are guided in their application by equation (2). The empirical literature is very scanty as regards guidance by equation (4). There is little comparative multiplier analysis done between economies in the context of economic systems. It will be demonstrated that it is more useful and easily accessible to work with equation (4) instead of equation (2). For applying a comparative multiplier approach a number of issues have to be resolved. Choosing for a general system approach requires specifying a concrete model for a concrete economy. Recall equation 4 above, giving the reduced form solution of an economic system, which can simply be written as Q j  Mj (Ej, Cj)

(5)

where Q j denotes outcome, Mj is for system multipliers, E is for the non-controllable exogenous vector of the environment variables, and C for the controllable exogenous vector of policy variables, all relating to a country j that can be identified with a specific economic system Mj. The question now is along which line of specification should the economic system be modelled in the first place.

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347

Broadly speaking, there are three prototypes of models which can connect Q, M, E, and C to each other: (1) models that emphasize the supply side, production functions, and production capacity (2) models that emphasize the demand side, purchasing power, and expenditure patterns, and (3) general equilibrium models that equally emphasize demand and supply forces in the clearance of factor and product markets. General equilibrium models are more comprehensive than supply side or demand side models, and it can be usefully employed for a comparative analysis of economic systems that share competitive rules of market clearance, but they lose applicability in case of economic systems where market clearance is restricted or highly structured. Among the remaining two alternatives of a supply model and a demand model, there are more advantages for working with demand rather than supply models. Demand models give outcomes for both performance criteria: growth and equity. Supply models treat growth only. Demand models can be easily supplemented by supply constraints, while it is more difficult to satisfy the contrary situation. Measurement, testing, and predictions in demand models are more robust than in the case of production functions. Given the above considerations we choose for the demand-oriented model as an analytical framework. Since national accounts supplemented by industry, household, and government statistics can be conveniently integrated in the form of a social accounting matrix, SAM, and because the form of the SAM is that of a general economic system, it is therefore very well suited as an analytical framework. After appropriate manipulations, to be addressed in the next sections, the inverse of the matrix would give the economic system multipliers M in equation (5), that would show in which ways the outcome variables denoted by Q (consisting of growth and equity, among many other endogenous variables), vary following simulated changes in the exogenous vectors of the external environment E (usually consisting of the rest of the world), and governmental policies C (usually consisting of public expenditures and transfers).

9.3 SAM applications to countries of Western and Eastern Europe 9.3.1

Introduction

Studies of structural patterns have been the subject of intensive empirical analysis by Colin Clark in the 1940s, Simon Kuznets in the 1950s and 1960s, and Hollis Chenery and associates in the 1970s and 1980s. 3 They attempted to specify normal structural patterns of the economy for varying levels of economic development, country size, and other specific characteristics. These approaches have been criticized for their dominant assumptions of universal tendencies and for lacking an analytical framework that reflects on mechanisms behind observed differences in structural patterns among countries observed. The issue of structural patterns can be approached differently through modelling economies along the structure of the social accounting matrix, SAM. Using a comparative analytical framework, the SAM can be helpful in deriving normalized patterns and indicating prospective patterns for economies in transition. The

348

Economic Systems Analysis and Policies

SAM multiplier analysis can give insight as to which economic mechanisms need to be strengthened to push a specific economy closer to its prospective patterns.4 The purpose of the next sections is to compare and assess the future courses of economies in BCEE, i.e. using as examples Poland and Hungary, in relation to representative economies in Western Europe , Germany, Italy, Netherlands, and Spain, on the basis of standardized SAMs for a particular year. We shall review in Section 9.3.2 the comparative form of the SAMs for these six countries. We will then employ in Section 9.3.3 the SAM as a model of the economy. Sections 9.3.4 and 9.3.5 discuss the size and distribution of different multipliers. 9.3.2 The construction of comparative SAMs The SAM itself is nothing more or less than the transformation of the circular flow in the national economy of Figure 9.2 into a matrix of transactions between the various agents as in Table 9.1 descriptively, and Table 9.2 emprically, which will be shortly reviewed. In the lower bound of Figure 9.2, households supply labour and capital to firms who are organizers of production activities; households are paid back in return for the use of their labour and capital factors. In the upper bound, households spend their incomes on products that are delivered by the firms/activities. In the centre there is the government, which is involved in transfers to and from households and firms/ activities. Furthermore, there are the economic relations between the country and the rest of the world. A SAM contains the following list of accounts. ● ● ●

●

Wants accounts; indexed as 1. Factors of production accounts; indexed as 2. Institutions accounts; indexed as 3. A distinction is made between current and capital transactions. Current transactions are disaggregated by whether they belong to households, firms, and government. Capital transactions are aggregated for all institutions in one national capital account, called accumulation. Activities accounts, and Rest of the world accounts, indexed as 4.

Products delivered Products purchased

Households

Government

Factors delivered Factor payments

Figure 9.2

Circular flow

Firms/ activities

Rest of World

Comparative Performance: A Social Accounting Approach Table 9.1

Entries in the aggregate SAM (3) Institutions

House(1) Wants (2) Factors holds Firms (1) Wants

Government

(4) Activities ProducAccumula- tion tion sectors

hshlds factor income

gvrnmnt transfers to hhs

Firms

firms factor income

gvrnmnt debt servicing

Government

public hshlds enterprises direct profits taxes

Accumulation

firms direct taxes

hshlds firms gvrnmnt savings savings savings

private consumption

foreign factors factor income payments

transfers rest world

hshlds income firms income

indirect taxes

transfers gvrnmnt rest world income

depreciation

deficit gross balance of capital payment formation

public investment intermedi- exports to gross consump- goods ate goods rest sectoral tion deliveries deliveries world production

Rest of the world

transfer to rest world wants receipts

Totals wants expenditures

domestic value added

(3) Institutions Households

(4) Activities Production sectors

Rest world

hshlds spend on wants

(2) Factors Labour Capital

Totals

349

factors income

transfer to rest world

hshlds firms Gvrnmnt gross cptl formation income income income

imports rest world

gross production

outgoings rest world incomgrand ings total rest world

The SAM is the transformation of the circular flow of products and factors between production and household activities into a matrix of transactions between the various actors as represented by their accounts. A particular row gives receipts of the account while the corresponding column gives the expenditure of the account. The content of the SAM can be introduced further by means of Table 9.1. The first set of accounts represents the wants account. It is not obligatory to include these accounts in the SAM, but by incorporating the wants accounts,

350

Economic Systems Analysis and Policies

focus is increased on a whole range of goods and services indicative of levels of well- being. These will usually include expenditure on food, housing, clothing, health, education, transport, and other goods and services. It is informative to know, for instance, how much each specific household group spends on food, and how this expenditure flows to agriculture and the non-agricultural sectors. The factors of production accounts are meant to show how the value added generated in the various production activities are allocated over the production factors, and subsequently how these factor incomes are distributed to the current institutions. The SAMs constructed here make a distinction between the two major factors of production, namely labour and capital; either may be disaggregated further. The institutions current accounts are split up into accounts for households, firms, and government. For any institution, the total incomings of that institution are found by adding the different sources of incomes in the rows. In the columns is shown how the institutions pay out some of their incomings as direct taxes and transfer payments, spend on consumer goods, and transfer their savings to the combined national capital account. The capital transfers between the separate institutions are netted and can therefore be left out from the SAM. It follows that domestic and foreign savings should be spent on capital goods. As a result, the accumulation account shows total savings equal total investment. The activities accounts show on the row the money receipts of the producing sectors from the sale of private and public consumption goods, investment goods, intermediate goods, and exports. Column-wise, the sales revenue of the producing sectors go in part as value added to factors of production, indirect taxes, depreciation costs, and purchase of intermediate goods and imports. The sales revenue of each production activity is taken up in part by purchases of raw materials that may be either domestically produced or imported, these besides indirect taxes and subsidies and depreciation costs. Part of the production costs takes the form of value added paid out to the factors of production labour (wages) and capital (profits). Finally, in the rest of the world account, imports and exports are matched with incoming and outgoing foreign transfers, intermediate goods, consumer goods, investment goods, and exports. The row gives the distribution of imports on consumption goods, investment goods, intermediate goods, and transit imports for re-exports. The column gives the expenditure of the external world in the form of net factor incomes from abroad, net household and government transfers, net capital inflow, and export and transit balances of goods and services. The aggregate SAMs of Germany and Poland are shown here as examples in Tables 9.2 and 9.3. These SAMs are no more than presentations of available national accounts statistics in a matrix form, noting that for Hungary and Poland several adjustments had to be made in converting their accounts from the Material Product System to the United Nations System of National Accounts. Once an aggregate SAM is constructed, each account can be disaggregated further on the basis of additional data from surveys of the labour force, household

Comparative Performance: A Social Accounting Approach

351

Table 9.2 SAM for Germany 1 1 Wants 2 Labour 3 Capital 4 Households 5 Firms 6 Government 7 Accumulation 8 Activities 9 ROW Total

2

3

4

5

6

7

8

1003570

9

Total

489790 37840 90470 47320

19700 79760 23800 221980 350230 310642 1508506 30888 315414

1003570 3510 954000 10550 403930 12110 1583830 480 85160 17170 676970 22340 361230 476852 3469530 60558 499370

1003570 954000 403930 1583830 85160

676970 361230 3469530

499370 9037590

950490 393380 954000 342960 81680 87760 20710

298980 3960

823300 92510

Source: Cohen (2002b). The SAM for Germany relates to 1984, and is in million marks.

Table 9.3 SAM for Poland 1 1 Wants 2 Labour 3 Capital 4 Households 5 Firms 6 Government 7 Accumulation 8 Activities 9 ROW

8371 365

Total

8736

2

3

4

5

6

7

8

9

8736

4425 458

72 1130 19373 2286

57 8 3516 109

8736 8332 7431 9526 5932 5481 4884 38623 4049

4883

38623

4049

92994

8332 7431 6740 1592

8332

851 5616 964

7431

1561 316 180 610

9526

2616 3316

5932

164 2937 831 5481

Total

375

Source: Cohen (2002b). The SAM for Poland relates to1987, and is in billion zlotys.

income and expenditure, input–output deliveries, finance, government, trade, and other statistics to give the disaggregated SAM, which is really what we are after.5 The disaggregated SAM tables and details on their construction for the six countries are found in Cohen (2002b). With the comparative analytical purposes in mind, as set out in the introduction above, the disaggregated SAMs have been standardized to give the following details. 1. The wants account is subdivided into six groups of products: foodstuffs, housing, clothing and footwear, medical care and hygiene, recreation and culture and transport, and other goods and services with few exceptions regarding Italy. 2. The factors account distinguishes between labour and capital. 3. The households are classified by income deciles, with the exception of Spain for which directly available data are more aggregate. The accounts of government and accumulation remain as they are. 4. The classification of activities covers five sectors: agriculture, industry, trade, transport, and services. The account of rest of world, ROW, remains as it is.

352 Economic Systems Analysis and Policies

All SAMs were calculated and stored in spreadsheet format, which has the advantage that row and column totals can be checked simultaneously while changing any cell in the matrix. Additional matrix operations can also be easily performed in a spreadsheet. 9.3.3 Structural differences in the six SAMs A comparison of structural parameters of the SAMs for countries belonging to different economic systems can be useful in reviewing basic structural differences behind the systems. The purpose of this section is to use the SAMs for gaining insight into the structural differences between market- and planning oriented economic systems, while reserving the more analytical tasks to subsequent chapters. One way of presenting the underlying structure of the SAM is to express each entry as a percentage of the grand total of matrix. Examples are presented in Tables 9.4 and 9.5 for Germany and Poland, taking as l00 per cent the matrix total found at the bottom of last column and last row. Expressing the entries in terms of the grand total of the matrix has the advantage of providing a comparable basis for evaluating the relative importance of individual flows in the various countries. Alternative presentations are when the total of individual columns or individual rows is taken as 100 per cent. Table 9.4

SAM structure for Germany 1

1 Wants 2 Labour 3 Capital 4 Households 5 Firms 6 Government 7 Accumulation 8 Activities 9 Rest of World Total

2

3

4

5

6

7

8

9

Total

0.1 0.1 0.0 0.2 0.2 5.3 0.7

11.1 10.6 4.5 17.5 0.9 7.5 4.0 38.4 5.5

11.1 10.5 4.4 10.6 1.0

3.8 0.9 0.2

3.3 5.4 1.0

0.4 0.5

9.1 1.0 11.1

10.6

4.5

17.5

0.9

0.2 3.4 0.3

0.9 2.5 16.7 3.5

7.5

4.0

38.4

6

7

8

0.3 3.9

5.5 100.0

Table 9.5 SAM structure for Poland 1 1 Wants 2 Labour 3 Capital 4 Households 5 Firms 6 Government 7 Accumulation 8 Activities 9 Rest of World

9.0 0.4

Total

9.4

2

3

4

5

9

9.4 9.0 8.0 7.2 1.7

9.0

0.9 6.0 1.0

8.0

1.7 0.3 0.2 0.7

10.2

2.8 3.6

6.4

0.4

0.2 3.2 0.9

4.8 0.5

0.1 1.2 20.8 2.5

5.9

5.3

41.5

0.1 0.0 3.8 0.1

Total 9.4 9.0 8.0 10.2 6.4 5.9 5.3 41.5 4.4

4.4 100.0

Comparative Performance: A Social Accounting Approach

353

Already on the basis of the aggregated SAM and such calculated percentages as mentioned above, one can observe important structural differences between the six countries falling in two identifiable economic systems, the firm intensive allied economies of Western Europe, for short F-system, and the state intensive allied economies of Eastern Europe, for short S-system. Table 9.6 presents for selected variables of national accounts percentage values that are derived directly and/or indirectly from the six SAMs. Rows 1 to 4 give gross output, intermediate deliveries, labour income, and capital income as percentages of the matrix total. To be noted is the higher share of intermediate deliveries in the S-system, 19.4 per cent, than the F-system, 15.0 per cent, implying that there is less value added, i.e. GDP, created per unit of output. The shares of the remuneration of primary inputs, that is the GDP, in total output are thus lower in the S-system, 45 per cent, as compared to the F-system with an average of 51 per cent.6 This confirms the general observation that more resources are used to create a specific level of GDP in the S- than in the F-system. It is also noted that the share of the gross output is highest in Poland and lowest in the Netherlands. Poland is higher due to a relatively large share of intermediate deliveries, which is typical of the S-system. As regards the Netherlands, the low figure is due to the large income transfers for maintaining welfare that occur via the government and social security system. The grand total is pushed up, leading Table 9.6 total

East and West Europe: Selected variables expressed as percentages of the matrix Average Average Poland Hungary S-system Spain Italy Netherlands Germany F-system

Gross output

37.8

32.6

35.2

33.6

31.7

25.2

31.8

30.6

Intermediate deliveries

20.8

17.9

19.4

17.5

15.8

9.9

16.7

15.0

Labour returns

9.0

11.5

10.3

7.6

11.0

10.3

10.6

9.9

Capital returns

8.0

3.2

5.6

8.5

4.9

5.0

4.5

5.7

Households income

10.2

12.9

11.6

15.8

18.0

17.1

17.5

17.1

Government income

5.9

8.3

7.1

5.3

6.7

8.1

7.5

6.9

Firms income

6.4

2.4

4.4

2.9

2.8

1.4

0.9

2.0

Rest of World

4.4

5.5

5.0

3.8

4.4

9.5

5.5

5.8

Consumption

13.4

12.6

13.0

15.1

14.8

13.9

14.0

14.5

5.3

4.7

5.0

4.4

3.3

3.7

4.0

3.9

Investment

354

Economic Systems Analysis and Policies

to a reduced share of most items in the SAM, and hence the gross output. Income transfers for welfare maintenance are generally higher in the F-system. The third and fourth rows give the distribution of value added on labour returns and capital returns. In relative terms the ratio of labour returns/capital returns is higher in S-system countries than F-system countries. The comparison here is complicated by different statistical ways in which factor returns are assigned to labour and capital in Poland and Hungary. There are non-harmonized differences in the distribution of operating profits of corporate and state enterprises, the share of premiums for social security in the compensation of employees, and the registration of incomes from small unincorporated enterprises. In the second part of the table, the share of households’ transactions in the matrix total is shown to be smaller in the S-system, 11.6 per cent, than in the F-system countries, 17.1 per cent. The share of government transactions is about the same in both systems, around 7 per cent. The share of firms’ transactions is higher in the S-system, with Poland on top with a figure that is more than twice as much as the other countries. As the firms’ account still consists mainly of state enterprises, the high share for Poland should be evaluated in the light of the relatively low share of the government. Then, together, firms and government make up for a larger share in the economy in the S-system than in the F-system. Next, the Rest of World account has a lower share in the S-system, 5.0 per cent, as compared to the F-system, 5.8 per cent, which is equivalent to a difference of 16 per cent. But there are wide differences among countries of the F-system. A small open economy as the Netherlands has a ratio about twice that of Italy, Germany, or Spain. Finally, in the last part of the table and as can be expected, the policy orientations of the S-system lead to a lower consumption share and a higher investment share as compared to the F-system. Table 9.7 displays the components of the GDP from the expenditure side as consisting of consumption plus investment plus exports less imports. The GDP is not directly apparent in the SAM but is indirectly derived from the SAM. With the ownership of firms entrusted collectively to the state, households in the S-system get very little capital returns in the form of profits and/or dividends. Table 9.8 shows that capital returns that are earned by households as percentage of the matrix total is only 0.5 per cent in the S-system as compared to 4.1 per cent in the F-system. The labour returns that go to households as percentage of the matrix total is also lower in the S-system than in the F-system, 8.0 per cent Table 9.7 East and West Europe: Components of the GDP from the expenditure side Average Average Poland Hungary S-system Spain Italy Netherlands Germany F-system GDP

100

100

100

100

100

100

100

100

Consumption

74

71

73

81

83

78

77

80

Investment

29

25

27

24

19

19

21

21

Net exports

3

4

0

5

2

3

2

1

Comparative Performance: A Social Accounting Approach

355

compared to 9.3 per cent. As a result, households in the S-system obtain only 8.5 per cent of the matrix total to spend, as compared to 13.45 in the F-system. Table 9.8 shows Hungary to be closer than Poland to the F-system. There are typical differences in the field of financing the government expenditures between the two groups of countries, as is shown in Table 9.8. The share of the government is high in more advanced countries with an F-system such as Germany or the Netherlands. Especially the size of the social security system is often larger than in a S-system. Correspondingly, the household contribution to the government budget in the form of social security premiums and direct taxes is more important in the F- than in the S-systems. The only exception to the above is the case of Spain when compared with Hungary, which may be attributed to the lower level of economic development of Spain in 1980 than at present. In Table 9.9, it is shown that the value added tax, VAT, in Hungary is already an important source of revenue, and its share is equivalent to that in the Western European countries. However, in most countries with a S-system, as is shown for Poland, no VAT system and no personal income tax system were introduced. As a result, operating profit and turnover tax of firms are taxed heavily in a S-system. Table 9.8 East and West Europe: Returns to labour and capital that go to households as a percentage of matrix total Average Average Poland Hungary S-system Spain Italy Netherlands Germany F-system Labour income

7.3

8.6

8.0

7.6

11.0

8.0

10.6

9.3

Capital income

0.9

0.2

0.5

5.4

3.0

4.0

3.8

4.1

Total

8.2

8.8

8.5

13.0

14.0

12.0

14.4

13.4

Table 9.9 East and West Europe: Government incomings, total and by source, expressed as percentage of matrix total

Poland Total

Average Average Hungary S-system Spain Italy Netherlands Germany F-system

5.9

8.3

7.1

5.3

6.7

8.1

7.5

– factors

2.7

2.6

2.7

– households

0.2

2.0

1.1

– firms

2.8

1.6

– indirect tax

0.1

1.6

– vat

0.0

P.M.

1.7

6.9

0.1

0.1

2.0

0.2

0.6

1.7

4.7

3.7

5.4

3.9

2.2

0.6

0.5

0.7

0.4

0.6

0.8

2.7

1.4

0.8

1.1

1.5

1.3

0.7

0.2

0.0

1.0

1.0

0.6

3.2

2.5

2.6

4.0

5.3

3.3

3.8

Of which

Note: P.M. social security transfers to households expressed as percentage of matrix total.

356

Economic Systems Analysis and Policies

The same table shows low shares of transfers from the government to households in Poland among the S-system countries and Spain among the F-system countries, indicating that these two countries have the least developed social security systems. With the disaggregated SAMs for the six countries it becomes possible to compare incomes and expenditures per income deciles, consumption expenditures by products (wants), and the relative importance of different sectors of activities. Tables 9.10 and 9.11 present the percentage distribution. Examining expenditure by wants in Table 9.10, it is observed that the share of expenditures for food in the S-system of Poland and Hungary is remarkably high (50.4 and 37.1 per cent). The F-system spends no more than 25 per cent on food, with the remaining 75 per cent on other product groups. The different expenditure patterns in F- and S-systems are not fully explainable in terms of differences in levels of economic well-being and economic development; limited supply in contrast to abundant supply of non-food items in the two systems is an additional explanation. Considering the income distribution among household groups, Table 9.10 shows the income distributions in the S- and F-system remarkably similar, with a slightly more equal distribution for Poland and Hungary. The highest 40 per cent has on average about 24 per cent of income in the S-system as opposed to 20 per cent in the F-system. The highest 20 per cent receives around 35 per cent in the S-systems and slightly be1ow 40 per cent in the F-systems. Table 9.10 East and West Europe: Distribution of expenditure by want category and income by decile group, per cent Poland Hungary Average 1987 1990 S-system Expenditures by wants category Food Non-food Income by decile group 1st group 2nd group 3rd group 4th group 5th group 6th group 7th group 8th group 9th group 10th group

50.4 49.6

37.1 62.9

43.8 56.25

Spain 1980

23.5 76.5

Italy Netherlands Germany Average 1984 1987 1984 F-system

24.5 75.5

16.7 83.3

23.8 76.2

22.1 77.9

3.5 5.1 6.4 7.1 8.1 8.9 10.1 11.9 14.5 24.4

3 4.5 5.7 6.9 8.2 9.7 10.8 12.7 15.2 23.3

2.3 3.6 5.3 6.7 8.4 10.2 11.9 13.7 17.5 20.4

2.9 4.4 5.8 6.9 8.2 9.6 10.9 12.8 15.7 22.7

na 3.8 5.3 6.4 7.4 8.6 9.6 10.9 12.4 14.7 20.9

Note: Na  not available.

4.7 6.2 7 7.7 8.5 9.3 10.4 11.7 13.7 20.8

4.3 5.8 6.7 7.6 8.6 9.5 10.7 12.1 14.2 20.9

Comparative Performance: A Social Accounting Approach

357

Table 9.11 East and West Europe: Sectoral shares in the total output and total value added, per cent Poland Hungary Average Spain Italy Netherlands Germany Average 1987 1990 S-system 1980 1984 1987 1984 F-system Output share Agriculture Industry Trade Transport Services Value added share Agriculture Industry Trade Transport Services Output/value added Agriculture Industry Trade Transport Services

10.2 66.0 7.5 6.1 10.3

15.8 52.2 9.1 5.8 17.1

13.0 59.1 8.3 6.0 13.7

7.4 54.4 13.4 4.8 20.0

5.3 55.1 8.5 4.1 27.1

4.6 47.5 13.7 5.9 28.3

2.2 51.8 8.0 4.5 33.5

4.9 52.2 10.9 4.8 27.2

10.6 57.9 10.5 6.9 14.0

14.6 42.1 12.9 8.1 22.3

13.0 59.1 8.3 6.0 13.7

8.4 37.2 19.6 6.8 28.0

5.6 32.8 12.2 6.5 43.0

4.2 32.2 16.1 7.2 40.4

1.8 41.4 12.8 5.9 38.0

5.0 35.9 15.2 6.6 37.4

104 88 141 114 136

92 81 142 140 130

98.0 84.5 141.5 127.0 133.0

114 68 146 141 140

106 60 143 160 159

91 68 118 122 143

81 80 160 131 114

98.0 69.0 141.8 138.5 139.0

Next is Table 9.11 that gives the distribution of output by activity. This shows the generally observed feature of an underdeveloped status of the service sector (including trade) in Poland and Hungary, which cannot be attributed only to differences in the level of economic development. System-specific factors manifest themselves in central planning, a limited role for financial markets, and a dogmatic attitude towards services as a non-productive activity, all together attaching low priority to the development of services. The higher shares of the agriculture sector in Poland and Hungary are more related to the level of economic development. Additional insight is gained when total output is divided by value added, specified by sector. These ratios are shown in the bottom part of Table 9.11. The lower the ratio for a sector the more efficient is that sector in running its operations. The results in Table 9.11 are mixed. Countries with the F-system show lower ratios for industry. But the S-system shows lower ratios for transport. 9.3.4 The comparative analysis of multiplier properties The use of SAM as a model that generates multipliers can be demonstrated from a very simple example. Take the simplest Keynesian model, which contains an equation relating consumption to income via a propensity to consume, and an equation defining income as consumption plus an exogenous investment. This is thus a model of two equations in two endogenous variables of consumption and income. The model can be written as a square matrix that is then inverted to give a Keynesian multiplier showing the impact of a change in investment on

358 Economic Systems Analysis and Policies

income. Similarly, in an input–output analysis, an endogenous vector of sectoral production, q, can be predicted from a matrix of input–output coefficients, L, and a vector of exogenous final demand, f. That is q  Lq  f  (I – L)  1 f  ML f

(6)

where ML is the Leontief multiplier matrix. Now, the interesting case arises when the SAM is also a square matrix, and, as such, represents a model of the economy. By appropriate manipulations of this square matrix, it is also possible to derive SAM multipliers that are more comprehensive than those of Keynes and Leontief together. The SAM multipliers are more comprehensive because the underlying matrix contains the whole circular flow of the economy. To transform the social accounting matrix into an economy-wide model requires performing two steps. First, assuming proportional relationships for the cells in terms of their column totals, a SAM coefficient matrix that relates variables to each other is obtained. Second, the variables and coefficients can be rearranged to give a model of the economy. In these equations the endogenous variables and related coefficients are placed on the left-hand side, and the exogenous variables and related coefficients are placed on the right-hand side. The endogenous variables in this model include production, income, consumption, and investment, among others. In the context of the European countries it is logical to consider as exogenous variables the layouts of government and Rest of World. As a result of the above manipulations an economy-wide model in the form of Table 9.12 is obtained. The row totals of the endogenous accounts represent the endogenous variables; the y vector denotes these. The x vector denotes the exogenous variables. Note that the A matrix, which relates the y and x vectors to each other, appears in a partitioned form to facilitate a decomposition of multiplier effects. The vector of endogenous variables y can now be solved from equation (7) y  Ay  x (I – A)  1 x  Ma x

(7)

where Ma is the aggregate multiplier matrix. For reasons of space we shall select only a few parts of this matrix for comment. For instance, a distinction can be made between two types of exogenous impulses: demand injections into the activities account x4, and transfer injections to the institutions account x3. The impact of either impulse can be traced on the four types of endogenous accounts y: (1) expenditure by product, (2) earnings by factor, (3) income by household group, denoted by h, and (4) output by sectoral activity, denoted by s. We are interested in the latter two endogenous accounts. We shall limit the analysis to the impact of sectoral demands and institutional transfers on output by activity and income by household. The effects on expenditure by product and earnings by factor are of less interest here given the focus of the chapter on growth and distribution. This means that the four parts of the multiplier matrix indicated in Table 9.13 will be further analysed.

Comparative Performance: A Social Accounting Approach Table 9.12

359

SAM in the form of Ay  x  y Exogenous account x

Endogenous accounts y

Government, and rest of 1 Wants 2 Factors 3 Institutions 4 Activities the world Totals Endogenous 1 Wants 2 Factors 3 Institutions 4 Activities Government, and rest of the world Totals Table 9.13

x1 x2 x3 x4

A13 A24 A32

A33

A41

A44

y1 y2 y3 y4

(Residualbalances) y1

y2

y3

y4

–

Selected multipliers for further analysis Types of exogenous impulses x

endogenous Accounts y

1 products

2 factors

3 transfers to household h

4 injections to sector s

1 products 2 factors 3 income of household h

Ma,hh

Ma,hs

4 output of sector s

Ma,sh

Ma,ss

Summarizing, analysis can be restricted to four types of multipliers. These are the output and income multipliers by two types of injection: expenditure and transfers, as is shown below. By output multipliers we mean Mss’ and Msh’. By income multipliers we mean Mhs’ and Mhh’. There are several uses of these multipliers. For years directly before and after the year of computation, the SAM multipliers can be employed to show economic effects of exogenous additional demand for sectoral activities emanating from either government allocations or foreign trade. Two economic effects are prominent: first, the growth of output and its distribution on sectors s, and, second, the generation and distribution of income by household groups h. These two effects will be called, respectively, the output and income effects. In a similar way, one can assess the effect of institutional transfers (by government) on the generation and distribution of both output and income. For assessment purposes, the income multiplier is a more relevant concept than the output multiplier. There are two reasons for this. Earned income is closer to the efficiency notion of value added than is gross output. Besides, earned income by household groups is a better indicator of social welfare than is gross output. Although this is generally true, there may be minor exceptions.

360 Economic Systems Analysis and Policies

9.3.5 Size and distribution of multipliers of sectoral injections This section will examine in Table 9.14 selected results from cross-country comparisons of SAM models applied to the six countries. We shall examine size aspects and distribution aspects. Size aspects. In general, the size of the multipliers of an inverted matrix is relatively high if the leakage is relatively low. The leakage may take two forms: external outflow of effects and internal outflow of effects. The first form of leakage is that of an outflow of effects beyond the system, as when the endogenously inverted share of the SAM is low because of a high exogenous share. For instance, this outside leakage is higher for Hungary (endogenous share is 87.3 per cent, exogenous is 13.8 per cent), than for Poland (endogenous Table 9.14 East and West Europe: Income and output multipliers resulting from injections in alternative activities, exogenous shares, and other indicators Average Poland Hungary Spain Italy Netherlands Germany Western 1987 1990 1980 1984 1987 1984 Europe Income multipliers of injections in: Agriculture 1.06 Industry 0.82 Trade 0.76 Transport 0.93 Services 1.06 Average 0.92 High/Low 1.39 Output multipliers of injections in: Agriculture 5.16 Industry 4.58 Trade 3.98 Transport 4.72 Services 4.81 Average 4.65 High/Low 1.30 Income/output 0.20 multiplier (a) Exogenous shares 10.2 (per cent) of which Government 5.9 ROW 4.3 Other indicators (b) Population (millions) 37.7 Income per capita (US$) 1930

0.81 0.64 0.78 0.77 0.86 0.77 1.34

1.44 1.28 1.62 1.70 1.61 1.53 1.33

1.34 1.12 1.57 1.86 1.63 1.50 1.66

0.85 0.67 0.88 0.89 0.97 0.85 1.45

1.24 1.16 1.48 1.38 1.35 1.32 1.28

1.22 1.06 1.39 1.46 1.39 1.30 1.43

3.27 2.95 2.93 2.89 3.03 3.01 1.13 0.26

4.54 4.41 4.74 4.91 4.54 4.63 1.11 0.33

3.64 3.55 3.82 4.57 3.89 3.89 1.29 0.39

2.54 2.24 2.22 2.23 2.22 2.29 1.14 0.37

3.63 3.36 3.37 3.39 3.50 3.45 1.08 0.38

3.59 3.39 3.54 3.78 3.54 3.57 1.16 0.37

13.8

9.1

11.0

17.6

13.0

12.7

8.3 5.5

5.3 3.8

6.7 4.3

8.1 9.5

7.5 5.5

6.9 5.8

14.7 11860

61.2 11130

10.6 2590

37.4 57 5400 6420

Note: (a)  row 6/row 13 (b)  Population and Income per capita with reference to the SAM year applicable for the selected countries.

Comparative Performance: A Social Accounting Approach

361

share is 89.2 per cent, exogenous is 10.2 per cent). As a result, the SAM multipliers are lower in Hungary than Poland, 3.01 vs 4.65 for output multipliers and 0.77 vs 0.92 for income multipliers, respectively. Similarly, the Netherlands has higher exogenous shares than do Germany, Italy, or Spain, resulting in lower multipliers for the first than for the latter. Taken as a whole, the EE and WE countries show equal endogenously inverted share of the SAM, so that the external leakage should be on average about the same. The exogenous share in the SAM consisting of government and rest of the world will generally depend on the population size of the country, its location, politicoeconomic system, and the level of its economic development. Small population countries like The Netherlands or Hungary tend to have higher shares of transactions with rest of the world, other things remaining the same; this may in turn lead to a greater role of the government in maintaining specific infrastructures for the preservation of foreign trade. The politico-economic regime in planning oriented economies, that is, the S-system, imply a dominant share of the state in the economy. But the share of the public sector in market-oriented economies, i.e., F-system, can be as high or higher due to large income redistributions that take place through social security. Furthermore, the politico-economic system has an important influence on the openness of the economy and the share of exports in the economy; this share is lower in EE than in WE. Finally, the level of economic development contributes positively to the openness of the economy to foreign trade. Economic theory predicts at higher levels of economic development higher shares of government and exports. There is, therefore, a general tendency for the exogenous share to be lower, and for the output multiplier to be higher, in a country with a lower economic development level. The exogenous shares in Hungary and Poland are 10.2 per cent and 13.8 per cent, respectively. These fall in the range of the average exogenous share for WE, which amounts to 12.7 per cent. So, on average the external leakage is about the same, though it differs appreciably by individual country. This and the previous paragraph suggest that the exogenous in the EE context is influenced more by system-specific factors that enhance the exogenous share than by a lower level of economic development that downplays the exogenous share. The second form of leakage, the internal leakage, is very much influenced by system-specific factors. Taking the SAM multiplier performance of the WE countries as the norm the following can be stated. The average income multiplier for the F-system countries was found to be 1.30 that was achieved with an average endogenous share of 87.3. This implies a multiplier of 0.015 for each endogenous percentage point. Applying this norm to Hungary, which has an 86.2 per cent endogenous share, would result in an income multiplier of 1.28 as compared to the observed income multiplier of 0.77. This is a significant gap. A similar calculation for Poland would give a normalized income multiplier of 1.33 as compared to the observed income multiplier of 0.92. The lower performance of EE countries reflects a lower effectiveness of the (internal) circular flow and should be fully accounted for by the specific politico-economic regime.

362 Economic Systems Analysis and Policies

The lower effectiveness occurs in contexts of low forward and backward linkages between economic activities and restricted rolling of the circular flow over more agents that are more typical of the S-system as compared to the F-system. The endogenous inverted share of the SAM in a typical S-system will be less extensively and intensively filled than in an F-system. Due to the lack of a capitalistic drive and the absence of market competition the introduction of new innovative activities with higher multipliers is limited in the S-system, so that the circular flow in the S-system does not undergo major structural changes. Such an economy tends to show stationary tendencies as can be manifested in multiplier effects that vary within a narrow range. In contrast, an F-system which experiences frequent exits and entries of new activities would show more variation in multiplier effects, whereby the new activities with higher multipliers would pull old activities with lower multipliers, and contribute to a higher overall multiplier effects. These tendencies can be gathered from Table 9.15. The highest/ lowest ratio for income multipliers is lower in both Poland and Hungary (1.39 and 1.34, respectively) when compared with the average of 1.43 for the F-system studied here. The range for the output multipliers shows Poland to be high (1.30), Hungary low (1.13), and the average for WE countries in-between (1.16). There are other mechanisms in the S-system that result in relatively lower multiplier performances when compared to F-system. Consider the size of the multipliers from injections in alternative sectors. The results for the F-system countries Table 9.15 East and West Europe: RDM analysis for activities resulting from an overall injection in activities

Percentage distribution of multipliers Agriculture Industry Trade Transport Services Percentage distribution of actual shares Agriculture Industry Trade Transport Services RDM (a) Agriculture Industry Trade Transport Services

Poland 1987

Hungary 1990

Spain 1980

Italy 1984

12.9 69.2 8.5 6.5 2.9

19.9 50.2 9.7 6.9 13.3

8.7 57.8 14.1 5.0 14.5

7.1 58.7 9.5 4.7 20.0

4.5 47.9 16.6 7.0 24.0

3.3 53.2 9.4 5.4 28.6

10.2 66.0 7.5 6.1 10.3

15.8 52.2 9.1 5.8 17.1

7.4 54.4 13.4 4.8 20.0

5.3 55.1 8.5 4.1 27.1

4.6 47.5 13.7 5.9 28.3

2.2 51.8 8.0 4.5 33.5

1.27 1.05 1.14 1.07 0.28

1.26 0.96 1.06 1.19 0.78

1.18 1.06 1.05 1.03 0.73

1.36 1.06 1.12 1.15 0.74

Note: (a) For example, RDM for Polish agriculture is 12.9/10.2  1.27.

Netherlands Germany 1987 1984

0.96 1.01 1.22 1.19 0.85

1.51 1.03 1.18 1.20 0.85

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show services, transport, and trade to have the highest income multipliers, and, often, the highest output multipliers. For the S-system, agriculture is still more prominent. To guarantee a shift of emphasis in Poland and Hungary towards the tertiary sectors and away from the primary sectors will thus require introduction of differently oriented investments in infrastructure and technology. Furthermore, the ratio of income to output multipliers is 0.20 and 0.26 in Poland and Hungary, respectively. These are far below the average of 0.37 in the F-system countries. The contention of a very low efficiency in factor use in S- as compared to F-system countries is thus supported. Distribution aspects. Besides comparing the levels of the multipliers, it is also important to study the distribution of the multiplier effects on the respective sectors and households and assess the underlying structural bias in the two countries. For instance, one should ask how the output multipliers of an injection in sector s’ distribute themselves on the individual sectors s. Equation (8) develops such a Relative Distributive Measure of sector on sector effects ss’, denoted by RDMss’,

RDM ss' 

M  d / Output  ¦ M  1 ¦ Output a , ss'

s

ss'

a , ss'

s ,0

s

(8)

s ,0

where the individual multiplier effect of s’ on s, Ma,ss’, is divided by the column sum of multipliers of s after deducting the initial injection. Here we use dhh’ for the Kronecker symbol that equals 1 if h  h’ and o in other cases. The result is divided by the actual output share of sector s in year 0, as found in the SAM for the base year. For values of RDMss’ >1, <1, and  1, there are positive, negative, and neutral redistributive effects. For instance, values of RDMss’  1 mean that sectoral injections would reproduce exactly the sectoral distribution pattern of the base year. RDMs have been calculated for the six countries under study in Table 9.15. Given are the relative distributions of the output multipliers across sectors as well as those for the income multipliers on household groups. A few comments are now given regarding the results. Taking first the distributionary pattern of the output multipliers, most RDMs show little difference between the S- and F-system countries. Thus, note a large positive bias towards agriculture, trade, and transport, a small positive bias towards industry, and a strong negative bias towards services, especially in Poland. A display of more or less the same bias for F- and S-system countries would be acceptable for Poland and Hungary if the economic structures of both countries were indeed consistent with prospective patterns that go with higher levels of economic development. To take Hungary first, it is noted that the actual share of agriculture, which was 15.8 per cent in 1990, should be expected to fall in the longer run to levels comparable to the F-system countries, say about 5 per cent. Contrary to this, the endogenous mechanisms of the SAM multipliers show a distribution share going to agriculture of 19.9 per cent. This is a bias towards more agriculture, which is

364 Economic Systems Analysis and Policies

contrary to the norm track. Similarly, in Poland, there is a share of agriculture of 10.2 per cent that should fall in the longer run. However, the SAM multipliers, with a 12.9 per cent share going to agriculture, obstruct achievement of the prospective patterns. This is even more apparent in the case of services. (Poland has an actual share of services of 10.3 per cent, which should grow to 30 per cent by Western standards. However, the SAM multipliers produce a share of only 2.9 per cent.) In bringing both Poland and Hungary on the right track with respect to prospective patterns, it will be necessarily to either (1) mobilize the exogenous forces through government expenditure and exports in such a way as to curb the prospects of agriculture and industry to the advantage of services and/or (2) reshape the mechanisms of SAM multipliers through appropriate investments in the transition phase to favour services vs agriculture and industry. The first alternative seems unattractive for both economies because there are many healthy prospects for export of agricultural and industrial goods. The second scenario thus looks to be the more effective. The question to be raised is where and which actions must the countries take to modify the distribution bias of the SAM multipliers. A decomposition of these multipliers in the so-called transfer, open- and closed-loop effects, and other types of decompositions, will give insight into the more significant mechanisms. Similarly, a relative distributive measure for the multiplier effects of sectoral injections s’ on income of household group h, that is RDMhs’, can be calculated as in equation (9), see results in Table 9.16. RDM hs c

M a ,hs c

/

Incomeh ,0

¦ h M a ,hs c ¦ s Incomeh ,0

(9)

Values of RDMhs’  1 mean that sectoral injections would reproduce exactly the initial distribution pattern of the base year. A positive value for a household group h would mean an increase in its income share relative to the base year; a negative value would mean a deterioration. In reviewing the distribution pattern of the income multipliers, i.e. the percentage distributions of the multiplier benefits on each household group, the results in Table 9.16 show that, for all countries, that RDMs are higher for richer household groups. This is an indication of regressive redistributions of primary income. It is generally due to the exogenous influences of government transfers; that is, some incomes of higher deciles are redistributed to lower deciles to reproduce the more equal distributions that are actually observed in these countries. The degrees to which these tendencies occur in the S- and F-system countries are clearly different. Poland and Hungary are much less regressive in primary income distribution than the F-system countries. The role of the government budget is, therefore, less of a redistribution instrument in the S- than F-system countries. This role may have to change if they approach the F-system patterns. The prospects may be that of reduced government intervention in the factor market and in the formation of primary incomes and their distribution. However, there may be a more significant role for the state as a re-distributor of secondary

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Table 9.16 East and West Europe: RDM analysis-s for households resulting from an overall injection in activities Poland 1987 Percentage distribution of multipliers 1st decile 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile 10th decile Percentage distribution of actual shares 1st decile 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile 10th decile RDM (a) 1st decile 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile 10th decile

Hungary 1990

Spain 1980

Italy 1984

Netherlands 1987

Germany 1984

1.6 3.9 5.3 6.4 7.7 8.7 10.2 12.7 16.0 27.7

0.6 1.7 3.3 5.6 7.7 10.1 11.2 14.3 17.0 28.5

0.9 2.0 3.7 5.2 7.1 9.2 11.3 14.0 20.3 26.1

3.5 5.1 6.4 7.1 8.1 8.9 10.1 11.9 14.5 24.5

3.0 4.5 5.7 6.9 8.2 9.7 10.8 12.7 15.2 23.3

2.4 3.7 5.3 6.7 8.4 10.1 11.7 13.6 17.5 20.5

na 3.5 4.9 5.8 6.8 8.0 9.4 10.6 12.5 15.7 22.8

3.4 5.0 6.0 6.8 7.7 9.0 10.4 12.3 14.8 24.5 na

3.8 5.3 6.4 7.4 8.6 9.6 10.9 12.4 14.7 20.9

4.7 6.2 7.0 7.7 8.5 9.4 10.4 11.7 13.7 20.8 na

0.91 0.93 0.91 0.91 0.93 0.97 0.97 1.01 1.06 1.09

0.73 0.81 0.87 0.89 0.91 0.96 1.00 1.04 1.08 1.18

0.45 0.77 0.82 0.90 0.95 0.98 1.01 1.06 1.10 1.13

0.10 0.38 0.57 0.81 0.93 1.05 1.03 1.13 1.12 1.22

0.37 0.55 0.70 0.78 0.85 0.91 0.96 1.03 1.16 1.28

Note: na  not available. (a) For example, RDM for Poland 1st decile is 3.5/3.8  0.91

income transfers; and in this way to correct for the regressive mechanisms of primary income formation. The results show that the burden of such a shift in emphasis is likely to be higher in Poland than in Hungary. The disaggregation of household groups for Spain is not done in terms of deciles. 9.3.6 Size and distribution of multipliers of household transfers Size aspects. We may now treat the multiplier effects of household transfers. Table 9.17 gives income and output multipliers of transfers to different household groups classified by income deciles. Taking up first the income multipliers, the

366 Economic Systems Analysis and Policies Table 9.17 East and West Europe: Income and output multipliers resulting from transfers to different household groups Poland 1987 Income multipliers of transfers to 1st decile 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile 10th decile Average Output multipliers of tranfers to 1st decile 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile 10th decile Average

Hungary 1990

Spain 1980

Italy 1984

Netherlands Germany 1987 1984

na 1.78 1.78 1.78 1.79 1.79 1.79 1.79 1.78 1.78 1.78 1.78

1.53 1.53 1.53 1.52 1.52 1.51 1.50 1.50 1.49 1.48 1.51

4.22 4.23 4.23 4.24 4.24 4.24 4.24 4.24 4.24 4.23 4.23

2.20 2.17 2.16 2.15 2.13 2.10 2.08 2.04 2.02 1.98 2.10

2.30 na

4.02

2.22 2.09 2.06 2.03 2.00 2.00 2.01 2.00 1.99 1.90 2.03

1.60 1.57 1.54 1.53 1.51 1.49 1.49 1.48 1.46 1.43 1.51

2.00 1.93 1.82 1.78 1.75 1.73 1.71 1.70 1.70 1.69 1.78

3.30 2.97 2.89 2.81 2.76 2.75 2.79 2.74 2.72 2.53 2.83

1.53 1.47 1.40 1.38 1.33 1.29 1.30 1.26 1.23 1.14 1.33

2.62 2.45 2.17 2.07 1.99 1.92 1.88 1.86 1.85 1.84 2.06

Note: Na  not available.

results show that the average level in Poland and Hungary is quite similar to that in Germany and the Netherlands. The average multiplier is 1.78 in both Poland and Germany, and approximately 1.50 for Hungary and the Netherlands. However, the differences in multipliers between the deciles are much smaller in S-system countries than in the F-system countries. The differences are small in Poland and Hungary because the multiplier by deciles is dependent on how much is leaking away from the system in the form of direct taxes and social premiums, and these leaks are uniform for all groups. On the other hand, in Germany, the Netherlands, and Italy, transfers to lower income groups are found to generate more income than transfers to higher income groups, because of the higher propensity to spend among the lower income groups that works positively on the circular flow. Higher income groups in the F-system countries must pay a relatively higher share of taxes and premiums, leading to lower multipliers. This progressive taxation system is less developed in Hungary and almost absent in Poland. Similar observations hold for the output multipliers of household injections.

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367

Distribution aspects. Along similar lines as was done for the distribution effects of activity injections, two types of distribution effects of transfer injections can be formulated, thus there are in equations 10 and 11 the indicators RDMsh’ and RDMhh’. RDM hh c

M a ,hhc  dhh ' Incomeh ,0 / ¦ h M a ,hh c  1 ¦ h Incomeh ,0

(10)

RDM shc

M a ,sh c Output s ,0 / ¦ s M a ,shc ¦ s Output s ,0

(11)

Respective results from an overall transfer to households are displayed in Table 9.18. Here we find the relative distributions of (1) the income multipliers on household groups, and (2) the output multipliers on the sectors. A few comments will be made on the results obtained. Taking first the distribution pattern of the output multipliers, positive biases exist for agriculture and trade, rather low and mixed biases for transport and industry, and a strong negative bias for services. The Netherlands is the country deviating most from this pattern with negative biases for agriculture and industry and a positive bias for services. Other results are similar to those already discussed for injections to activities. In general, RDMs indicate little difference between the S- and F-system countries. As regards the distribution pattern of the income multipliers, the results show that for all countries, that RDMs are again higher for richer household groups, which is an indication of regressive redistributions of primary income. Table 9.18 East and West Europe: RDM analysis of households and activities resulting from an overall transfer to households

Households 1st decile 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile 10th decile Activities Agriculture Industry Trade Transport Services

Poland 1987

Hungary 1990

0.91 0.92 0.91 0.91 0.93 0.98 0.98 1.01 1.07 1.09

0.73 0.81 0.87 0.89 0.91 0.96 1.00 1.04 1.08 1.18

1.15 1.04 1.45 0.98 0.27

1.14 0.96 1.28 1.08 0.82

Spain 1980

1.04 1.01 1.30 0.94 0.79

Italy 1984

Netherlands 1987

Germany 1984

0.45 0.77 0.82 0.90 0.95 0.98 1.02 1.07 1.10 1.13

0.20 0.38 0.57 0.81 0.93 1.05 1.03 1.13 1.12 1.22

0.36 0.54 0.70 0.78 0.85 0.92 0.97 1.04 1.16 1.26

1.14 1.04 1.34 0.94 0.79

0.68 0.81 1.50 0.96 1.14

1.07 0.96 1.44 1.03 0.95

368 Economic Systems Analysis and Policies

In conclusion, it was shown that there are growth biases in the transition economies towards primary sectors. The size and share of multipliers of the services sectors were thus found to be relatively low. In bringing both Poland and Hungary on the right track with respect to prospective patterns, the results suggest that it will be necessary to do one or more of the following. First, mobilize the exogenous forces through government expenditure and exports in such a way as to curb the prospects of agriculture and industry to the advantage of services. Second, reshape the mechanisms of SAM multipliers through appropriate investments in the next few years to favour services vs agriculture and industry. The first solution is unattractive for both economies because there are many healthy prospects for export of agricultural and industrial goods. The second solution is the more effective one. As far as distribution bias is concerned, Poland and Hungary are much less regressive in primary income distribution than are the selected Western European countries. The role of the government budget is, therefore, less of a redistribution instrument in planning than it is in market-oriented systems. By WE standards, this role is bound to change in the transition phase and thereafter. The future prospects are those of reduced government intervention in the factor market and in the formation of primary incomes and their distribution, and a more significant role for the state as a re-distributor of secondary income transfers to correct for the regressive mechanisms of primary income formation. Our results showed that the burden of such a shift in emphasis would be higher in Poland than in Hungary. More analysis is required to determine where and which actions to take in modifying distribution bias of the SAM multipliers. Decomposition of SAM multipliers can assist in such analyses.

9.4 9.4.1

SAM applications to Russia and China Differences

Even though the comparative analysis for Russia and China done here is based on the SAM benchmark for one year only, around 1990, the obtained results will show consistency and durability that are supported by contrasting trends in the two countries over some earlier decades and during transition and after. Before dealing with the SAM analysis some comparative data on the fall of Russia and rise of China are displayed. Russia’s GDP, measured in constant prices of 2000 in US$, grew between 1979 and 1989 by 43.2 per cent and then decreased between 1989 and 1997 by about 46 per cent, see Chapter 6, then gradually recovered to reach a level in 2006 that is roughly twice the level of 1979, as shown in the fourth row, Table 9.19. In contrast, since the start of economic reforms in China, dating back from 1979, China’s GDP has increased constantly and became 2.5 times as much in 1989. The growth continued at annual rates around 9 and 10 per cent raising the GDP level to about 12 times the level of 1979, third row. In 1979, China’s GDP was about 60 per cent that of Russia. Ten years later in 1989 they had about equal sizes. The relative sizes of the two economies have

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Table 9.19 China and Russia: GDP and Indices of GDP

China Russia China Russia China/Russia

Constant prices 2000 US$ billion Constant prices 2000 US$ billion (GDP for 1979  100) (GDP for 1979  100) GDP China/GDP Russia

1979

1989

2000

2006

170 278 100.0 100.0 0.6

428 398 251.8 143.2 1.1

1,198 382 704.7 137.4 3.1

2,092 544 1230.6 195.7 3.8

Source: World Bank at http://devdata.worldbank.org/query/

Table 9.20 Output of major goods in China and Russia China

Russia

Item

1990

1995

% change

1990

1995

% change

Electric Energy (bn kwh) Steel (mn tons) Synthetic fibres (mn tons) Mineral fertilizers (mn tons) Tractors (000) Television sets (mn) Washing machines (mn) Textile fabrics (bn m) Grain (mn tons) Meat (mn tons) Non-weighted average

620 63.5 1.6 18.7 39 26.8 6.6 18.8 355.0 25.1 –

1000 94.0 2.9 24.5 63 34.7 9.4 21.0 417.0 42.0 –

61 48 81 31 62 29 42 12 17 67 45

1082 89.6 0.6 16.0 214 4.7 5.4 8.4 107.8 9.8 –

862 51.3 0.2 7.5 21 0.98 1.3 1.7 63.5 3.4 –

20 43 66 53 90 79 76 80 41 65 61

Sources: Russian Statistical Yearbook, several years; Economics of Transition, Vol. 4, No. 1, 1996, p. 289; China Statistical Yearbook, several years; World Economic and Social Survey 1994, United Nations, p. 259.

since then reversed position in historically unmatched terms in less than two decades. In 2000, the GDP ratio of China to Russia was 3.1 times, and in 2006 the gap widened to 3.8, fifth row. Most of the increase in the gap between Russia and China occurred during the period of the short transition in Russia. The contrast between the recession downfalls in Russia and the growth drive in China and the extent of the respectively positive and negative performances can be comprehended from a comparison of output of some ten major goods in physical terms; as is shown in Table 9.20. Nonweighted average gives an increase of 45 per cent over five years for China and a decrease of 61 per cent for the same years for Russia. Turning from economic growth to income distribution this has shown regressive tendencies for Russia after 1990. The trend in China has been more equitable than in Russia. The contrast in the economic trends and performance between these two major countries has been persistent for a long time and shows constancy even in the periods of reform suggesting that the differences in the structures and mechanisms behind these trends are endurable and can be subjected fruitfully to

370 Economic Systems Analysis and Policies

comparative systemic analysis. The SAM framework for comparative analysis has been tested and is found suited for this context. The following sections introduce the SAMs of Russia and China, derive SAM multipliers, analyse the growth effects of injections in final demand and income transfers, and do the same for distribution effects. 9.4.2 The SAMs of Russia and China The aggregate SAM for Russia is exclusively constructed from the definite and published estimates of the national accounts for 1991. These accounts have been disaggregated further into four products, five factors, five household groups classified by income ranges, firms, government, aggregate capital account, three production activities and rest of world, together resulting in a SAM of 21 rows by 21 columns, as found in the appendix. The required data for disaggregating the SAM include (a) the household budget survey for breaking up the household account into the first income groups, specifying their incomes by source, and expenditures by type of product, (b) the input–output table for disaggregating the production activities, and (c) an initial converter table for transforming a products classification into a sectoral classification. The household budget survey provides distributional structures of receipts and expenditures by household groups. These are multiplied by the number of households and applied to the aggregate household account to give the disaggregate details. Regarding the data in the input–output table these are aggregated to suit the classification into three sectors. The absolute values thus obtained fit directly within the disaggregated SAM. Regarding the converter matrix between products and sectors, this was constructed in a preliminary way from the codes of the household budget survey and the input–output and later subjected to several adjustments to assure consistency of the grand totals of its rows and columns, which is solved by applying the RAS method. For China, we have constructed a comparable aggregate SAM and a disaggregated SAM for 1989, both are displayed in the appendix. The disaggregate SAM of China is a 19 x 19 matrix. It consists of about the same accounts as for Russia except that there is less disaggregation in the factor and household accounts. 9.4.3 Deriving SAM multipliers for Russia and China To transform the social accounting matrix into an economy-wide model and compute SAM multipliers along the lines of this chapter requires performing the two previously stated steps: first, inserting proportional relationships for the cells in terms of their column totals, a SAM coefficient matrix that relates variables to each other is obtained and second, the accounts of the SAM need to be subdivided into exogenous and endogenous and regrouped in such a way that the expenditure and receipts of the exogenous accounts would fall respectively to the right and bottom of the endogenous accounts. The choice regarding subdivision into exogenous and endogenous accounts can lead to lengthy discussions on alternative closure rules. Instead, we follow here an established convention for basically

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371

centrally planned economic systems that assumes the expenditure accounts of capital, government, and rest of world as exogenous.7 Applied to the Russian SAM this would mean that columns 16, 17, and 21 will be shifted further to the right. The corresponding receipts of these exogenous accounts, rows 16, 17, and 21 are shifted to the bottom of the matrix. As a result, the remaining accounts which are endogenous accounts, would for the Russian SAM count the following categories: ● ● ● ●

Products, rows and columns 1 to 4; Factors, rows and columns 5 to 9; Households 10 to 14, and firms row and column 15; Production activities, rows and columns 18 to 20;

These endogenous accounts form a 18 x 18 submatrix within the regrouped SAM, containing all the flows from endogenous to endogenous accounts. The same procedure applied to the Chinese SAM results in the three exogenous expenditure accounts of capital, government and ROW, and a 16 x 16 submatrix of endogenous to endogenous accounts.

9.4.4

Growth multipliers in Russia and China

To start with, Table 9.21 gives the growth multiplier effects of final demand injections on variables of income Ma,hs and output Ma,ss. The results are obtained from the inversion of the SAM as explained in equation (18). The results show for Russia that, on average, a demand injection in the sectors, of say one billion rubles (br) has a multiplier effect or output of 2.81 br, and a multiplier effects on income of 0.62 br. An income transfer of 1.0 leads to a combination of an output multiplier of 2.09 with an income multiplier of 1.40. The corresponding results for China in Table 9.22 show demand injections lead to output and income multipliers of 3.26 and 1.26, while transfer injections lead to output and income multipliers of 2.84 and 1.66. China’s performance is higher than Russia’s in all four respects. This section will further examine selected results from cross-country comparisons of SAM models applied to the two countries. The section will design an interpretation of multipliers of demand injection by sector of activity and review the results on the sizes of the multipliers. Later on we consider transfer injections. In general, the size of the multipliers of an inverted matrix is relatively high if the inverted SAM coefficient matrix, i.e. the endogenous part, represents a large share of the economy, and correspondingly the exogenous part represents a small share. Multipliers are relatively low if the endogenous share is small and the exogenous share is large, as this exogenous share is not ploughed back in the economy. The exogenous share in the SAM, consisting of investment, government, and rest of the world, will generally depend on the economic system, the development level, and the size of the country. The share of investment and government is expected to be greater in planning oriented

372 Economic Systems Analysis and Policies Table 9.21 SAM multipliers for Russia 1991 Multipliers of demand injections into sectors

Multipliers of transfer injections to household groups

Income effects

Output effects

Income Output effects effects

Agriculture

0.76

2.95

Hh. < 250 Rbl. per month

1.47

2.44

Industry

0.52

3.05

Hh. 250–300 Rbl. per month

1.43

2.26

Services

0.59

2.44

Hh. 300–350 Rbl. per month

1.41

2.15

Hh. 350–400 Rbl. per month

1.39

2.08

Hh. > 400 Rbl. per month

1.29

1.52

Average

0.62

2.81

Average

1.40

2.09

Highest/Lowest

1.46

1.25

Highest/Lowest

1.14

1.61

Table 9.22 SAM multipliers for China 1989 Multipliers of demand injections into sectors

Multipliers of transfer injections to household groups

Income effects

Output effects

Income effects

Output effects

Agriculture

1.66

3.70

Rural farm

1.77

3.30

Industry

0.89

3.07

Rural non-farm

1.72

3.08

Services

1.06

3.00

Urban employed

1.73

3.12

Urban self-employed

1.43

1.85

Average

1.20

3.26

Average

1.66

2.84

Highest/Lowest

1.87

1.23

Highest/lowest

1.24

1.78

economies especially among those with a larger defence budget. Economic theory predicts also a greater share of investment, government, and ROW at more advanced levels of economic development. Countries with a larger population tend to have lower shares of transactions with rest of the world, other things remaining the same. Given the above it is not surprising that the exogenous share as defined here is higher in Russia than in China. This is also evident from the SAMs that show a higher exogenous share for Russia than China, with respectively 19.6 and 14.7 per cent of the economy considered exogenous. The correspondingly endogenous shares are 80.4 and 85.3 per cent for Russia and China, respectively, implying a lesser circular flow in Russia than China. As a result, the SAM multiplier should be expected to be lower in Russia than China, which is the case as Tables 9.22 and 9.23 indicate. However, there is the additional question of which of the two countries is more successful in generating more output, and more income, per one percentage point

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373

Table 9.23 RDM analysis for Russia 1991 Demand injections into sectors: Agriculture

Industry

Services

0.74 0.93 0.99 1.01 1.05

0.73 0.92 0.99 1.01 1.05

1.31 1.10 0.74

1.06 1.17 0.69

RDM hs’ Impact on income of five household groups Hh. < 250 Rubles p.m. Hh. 250–300 Rubles p.m. Hh. 300–350 Rubles p.m. Hh. 350–400 Rubles p.m. Hh. > 400 Rubles p.m.

0.67 0.91 0.97 1.01 1.06

RDMss’ Impact on output of three sectors: Agriculture Mining and Industry Services

1.89 0.99 0.74

Transfer injections to households group categories Hh. < 250 Hh. 250–300 Hh. 300–350 Hh. 350–400 Hh. > 400 RDM hh’ Impact on income of five household groups Hh. < 250 Rubles p.m. Hh. 250–300 Rubles p.m. Hh. 300–350 Rubles p.m. Hh. 350–400 Rubles p.m. Hh. > 400 Rubles p.m.

0.72 0.92 0.98 1.01 1.05

0.72 0.92 0.98 1.01 1.05

0.72 0.92 0.98 1.01 1.05

0.72 0.92 0.98 1.01 1.05

0.72 0.92 0.98 1.01 1.05

1.41 1.16 0.61

1.37 1.16 0.62

1.35 1.16 0.62

1.31 1.15 0.66

RDMsh’ Impact on output of three sectors: Agriculture Mining and industry Services

1.50 1.15 0.60

of the endogenous share. It can be calculated, on average that in the case of Russia a demand injection gives an output multiplier of 2.81 for an endogenous share of 80.4 per cent, implying an output multiplier of 0.035 for each endogenous percentage point. China’s performance is higher in this respect (i.e. 3.26/85.3  0.038), as it is able to achieve from an equivalent demand injection an output multiplier of 0.038 for each endogenous per cent. The difference amounts to a positive edge of about 10 per cent (i.e. 0.038/0.035). This edge can be interpreted as a more efficient use of the circular flow of the economy. Why China surpasses Russia in the efficient use of the circular flow? Three related reasons can be given. First, a better-knitted economy, in the sense of having more extensive and intensive transactions between its agents is characterized by more transactions and a more filled SAM. The more that the SAM cells are filled the greater the multiplier effect. The extreme situation of an autonomous sector that produces and supplies exclusively for its own employed labour households, and who buy exclusively from this sector, will show very low multipliers. Centrally planned economies tend to save on transactions and emphasize autonomy. This in contrast to free market economies which

374 Economic Systems Analysis and Policies

propagate more transactions and a higher turnover of circulating funds. While both Russia and China share features of a command economy there is general agreement in the empirical literature that the Russian system has been less forthcoming than the Chinese system in creating multi-channels for the flow of goods and services and creating a more flexible framework for resolving imbalances. Second, while there may be specific flows with higher multiplier effects than others yet in the longer run an economy which manifests little structural change will tend to show less variation in multiplier effects of alternative injections. In contrast, a rapidly moving economy undergoes frequent structural changes and the variation in multipliers is bound to be greater. The introduction of a new activity or flow extends the circular flow by that activity and links with other activities, resulting in a widening of the variation between multipliers as well as higher overall multipliers. Russia has been less successful than China in modernizing its economy and extending the circular flow, this is associated with lower range of multiplier values in Russia as compared to China. We tried to demonstrate these tendencies for Russia and China in Tables 9.21 and 9.22. The highest/ lowest ratio of output multipliers shows about the same value for Russia (1.25) and China (1.23). However, the disparity in the income multipliers for Russia is lower (1.46) than for China (1.87), suggesting more replication of the status quo in Russia as compared to China. A related remark is with respect to the size of the multipliers from injections in alternative sectors. Comparative SAM multiplier results for the economically advanced countries of Western Europe in the previous section showed the sectors of services and agriculture to have the highest output and income multipliers, while industry lags behind in its multiplier effects. This is also true for multiplier analysis of developing countries. These results are due to the high expenditure on food and services and greater earnings flows in services as compared to industry. While the results for China are in general agreement with the findings for other countries, those for Russia differ as they show a predominance of the output multiplier for demand injections in industry. These results are due to a restricted circular flow in Russia that tends to downgrade the role played by the sectors of agriculture and services and foregoes, as a result, potentially higher multiplier effects. For assessment purposes, the income multiplier is a more relevant concept than the output multiplier for two reasons: (1) earned income is closer to the efficiency notion of value added than gross output and (2) earned income by household groups is a better indicator of social welfare than gross output. Assessment of the income multipliers of Russia and China leads to two remarks. First, the average income multiplier from demand injection for Russia is found to be 0.62 that is achieved at an endogenous share of 80.4 per cent, implying a multiplier of 0.0077 for each endogenous percentage point. Applying this norm to China should result in an income multiplier of 0.66 as compared to the SAM income multiplier of 1.20, which is a significant edge. A similar calculation for Russia on the basis of China would give a normalized income multiplier for Russia of 1.3 as compared to

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375

the SAM income multiplier of only 0.62. The conclusion is that China fairs better than Russia in aggregate income multiplier effects as well. Furthermore, the ratio of income to output multipliers is 0.22 and 0.37 in Russia and China, respectively; supporting the hypothesis of greater leakages of value added and/or a lower efficiency in factor use in Russia as compared to China. Attention can now be directed to the multiplier effects of transfer injections. These are generally consistent with the preceding results for demand injections showing output and income multipliers of transfer injections to household groups to be lower in Russia, 2.09 and 1.40 respectively, than in China where they reach 2.84 and 1.66 respectively, even though the performance edge tends to be narrowed to the extent that the income/output ratio of transfer injections is reversed in favour of Russia, reaching 0.67, as compared to China 0.58. In the light of the preceding results this outcome can be interpreted to mean that transfer payments to household groups in Russia occur in an economy with a relatively less intensive and extensive circular flow and with more emphasis on the direct rather than indirect effects, and hence converting transfer payments directly into higher income rather than higher output effects. The Chinese economy, in contrast, allows the transfer payment, to be turned over more intensively and extensively permitting more output and more income. 9.4.5 Distribution impacts in Russia and China Besides comparing the levels of the multipliers, it is also important to study the distribution of the multiplier effects on the respective sectors and households and assess the underlying structural bias in the two countries. For these we have developed the relative distribution impact of output multipliers of an injection in sector s’ on the individual sectors s, denoted by RDMss’ and a relative distributive measure for the multiplier effects of sectoral injections s’ on income of household group h, that is RDM hs’. In correspondence with the above, we have also formulated two types of RDM for transfer injections, giving RDMsh’ and RDMhh’.8 It is remembered that values of RDM  1 mean that injections would reproduce exactly the initial distribution pattern of the base year. A positive value would mean an increase in the recipient share relative to the base year; a negative value would mean deterioration. Table 9.23 shows all four measures for Russia. Results show that the effect of sectoral demand injections on the sectoral distribution of output is positively biased towards the agricultural sector, the value of RDM being between 1.06 and 1.89. In contrast, the results show a negative growth bias for the services sectors, RDM between 0.69 and 0.74 and a uniform replication of the share of industry with RDM being about 1.0. Considering the effects of sectoral injections on income distribution the results show injections in the various sectors to have the same effect of high repressiveness. The poorest household group comes badly off with RDM around 0.7. Most benefits go to the richest groups, which are calculated to enjoy RDM of 1.05 or more.

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Next we may consider the RDM of transfer injections. The pattern is the same as found for demand injections. Among the sectors the share of agriculture ends better off, services worse off and industry is unaffected. Among the household groups the poorest are disfavoured, RDM  0.7, while the richest are favoured with RDM  1.05. That, nevertheless, the actual income distribution in Russia shows more equality than what the SAM multipliers demonstrate, is due to the positive effect of annually repeated initial injections to the poorest household groups. The results for China can be now reviewed from Table 9.24. On the average, demand injections in China favour both industry and agriculture, but industry more so than agriculture, this in contrast with Russia which does the opposite. Both countries do not favour services. Income redistribution effects are uniform for alternative demand injections. The effects favour rural households RDM > 1.0, and disfavour urban households RDM < 1.0, and to the extent that the poorest population lives in rural areas the multiplier effects can be interpreted to promote more equality. It was observed before that the results for Russia show the opposite RDM effects as regards income distribution. These results reveal sector earning and household expenditure patterns and mechanisms, which redistribute income towards the richer groups in Russia as opposed to a redistribution towards poorer groups in China. Table 9.24 RDM analysis for China 1989 Demand injections into sectors Agriculture

Industry

Services

RDM hs’ Impact on income of four household groups categories Rural farm Rural non-farm Urban employee Urban self-employed

1.37 1.37 0.46 0.47

0.91 0.91 1.13 1.15

0.76 0.76 1.35 1.38

1.30 1.03 0.71

0.91 1.17 0.70

0.97 1.15 0.70

RDMss’ Impact on three sectors Agriculture Industry Services

Transfer injections to household group categories: Rural Farm

Rural Non-Farm

Urban Employer

Urban Self-employed

RDM hh’ Impact on income of four household groups categories Rural farm Rural non-farm Urban employee Urban self-employed

1.17 1.17 0.76 0.77

1.18 1.18 0.74 0.75

1.17 1.17 0.75 0.76

1.17 1.17 0.75 0.76

1.45 0.93 0.82

1.46 0.95 0.76

1.45 0.95 0.78

1.44 0.96 0.76

RDMsh’ Impact on three sectors Agriculture Industry Services

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9.5

377

Refuted limitations

While some limitations of the SAM multipliers for policy-making are valid, there are counterpart arguments to these limitations in defence of the approach followed here for the comparative study of economic performance. Six issues are discussed below. (1) The evaluation of the multipliers of the SAM model cannot be done in isolation from the closure rules applied. The size of the multipliers depends on the choice of the exogenous and endogenous variables, which in turn depends on the problem studied. In the context of the comparative analysis of economic systems there is an established rationale due to Koopmans and Montias (1971) for considering government policy and rest of the world conditions as exogenous and taking the rest of the economy as endogenous. This is also what is postulated in the SAM model. (2) The SAM model describes an endogenous economy with fixed relative prices and complementarities-based production and consumption functions. Producers and consumers are assumed to face fixed prices, and in their pursuit of profit and utility maximization, respectively, adjustment takes the form of changes in quantities supplied and demanded. As regards the assumption of producers and consumers facing given relative prices this is common practise in short run models. Moreover, even in the longer run, having in mind the broad categories of sectors and products in the SAM we can draw on empirical evidence over long periods which supports indefinite shifts in relative prices between such broad categories, cf. Bleaney and Greenaway (1993). (3) Cell entries of the SAM are amounts, i.e. products of prices × quantities. However, quantities and prices are not explicitly disentangled. In the fixed price multiplier model, supplied amounts are supposed to adjust to demanded amounts. They will, but if there is restricted capacity the result is inflation. This may require a revision downward in the real sizes of multipliers. Of course, if the size of the injection is relatively small, which is usually the case, the fixed price multiplier results can still be seen to represent realizable quantity effects. It is also feasible to check in a single way within the SAM framework whether the capacity limits will be violated or not. The supply side can simply be modelled as a relationship between the investment rate and economic growth via an incremental capital output ratio k, as in K/Y  k(ΔY/Y). From the SAM, we obtain multiplier effects for K and Y. If division of the multiplier effects of K by those of Y gives values equal to or above K/Y for the base period, this implies that the SAM solves for sufficient investment to meet the projected capacity increase. It is noted that multiplier results show that this condition is fulfilled for the six Western and Eastern European countries studied, as well as Russia and China. (4) The coefficient matrix in the SAM model, A, is a matrix of fixed average proportions. Linear relationships are assumed throughout: constant shares of factor remunerations in total output, of household incomes in the various factor payments, of commodities in household expenditure, and of sectors in commodity production. Compared to averages, observed marginal coefficients are better since they incorporate income and scale effects, but they can be disputable as their estimated values may carry other than income effects, which is inconsistent with the SAM

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framework. While consumption propensities can be calculated sensibly as marginal instead of average values, the problem is severe for input – output coefficients, factor earnings coefficients, and other coefficients in the model, which do not usually depict stable marginal propensities. Taking a portion of the coefficients as marginal and the other as average propensities introduces an estimation bias. Moreover, the uniform fixed coefficient assumption in cross-country comparisons is an advantage in contrast to incomparable specifications for individual countries. (5) The size of the multiplier depends to some degree on the level of aggregation. This argument is not relevant in the context of a uniform aggregation for the compared countries. Moreover, the differences in multipliers due to alternative aggregations tested do not go beyond 8 per cent for the individual countries studied here. (6) It is commonly perceived that a SAM-inverted model that belongs to the prototype of demand-oriented models. However, under general equilibrium conditions the SAM can be seen as a representation of both the demand and the supply side as well, which is why the SAM is directly convertible to the CGE model. The shortcoming that the SAM is a static model and its reflections are valid for the year for which it is observed is a relative one, since it was shown for the countries studied here of Western versus Eastern Europe, and especially in the cases of Russia versus China, that the growth and distributionary effects observed in one year tended to be sustained in years before and after.

9.6 Summary and conclusions The use of the SAM as a framework for the comparative analysis of systemic differences in economic performance serves as an important tool in outlining and checking the differences and gives valuable insight in the patterns and mechanisms that cause the differences in performance. The SAM was applied to analyse the size and the structure of multiplier effects of demand injections into sectors and of income transfers to households. We focused on multiplier effects relating to economic growth and income equality. The case studies related to four West European countries (Germany, Italy, Netherlands, and Spain), and two East European countries in the transition phase Hungary and Poland). The differences in growth and equity performance are explained partly by differences in the levels of economic development and partly by differences in the economic systems. When these two effects are isolated it appears that the FIM related economies appear to be more efficient in their use of inputs, and are able to generate higher growth multipliers than the SIM related economies. In terms of equity effects, the SAM multiplier analysis shows more regressive income distribution mechanisms in the West European than in the East European countries. A similar comparative SAM analysis was applied to Russia and China. The growth and equity multipliers and their decomposition point out to a better performance of China than Russia with respect to both growth and equity. These findings increase understandings for the widening gap in economic performance between the two countries during the past two decades.

10 Long-Range Convergence and Displacements in Economic Development and Interactions between Economic Systems

10.1

Introduction

This chapter reflects on the relationship between long-range changes in economic systems and changes in levels of economic development across countries worldwide. Among the questions considered are the following. Is there a convergence between rich/developed countries and poor/developing countries? How to separate the effects of different economic systems from the effects of levels of economic development? Is there a place for displacements after convergence, whereby poorer contemporaries displace current leading rich/developed nations from leadership in the not too distant future? What are the implications of the displacements for the relative dominance of competing economic system? To start with, the basics for the chapter are laid down in an opening sentence from Haavelmo (1964): In the world economic picture that we can piece together from current international statistics, perhaps the most striking feature is that of economic dissimilarities. ... The ultimate question to be expected from the thinking citizen is as plain as it is scientifically formidable. It is the question why certain areas or peoples are economically ‘backward’ while others are ‘advanced’. (Haavelmo (1964), pp. 1–2) It took a quarter of a century after Haavelmo’s plea for understanding long-range economic development before the study of income convergence patterns between rich and poor countries could take off. The take off has been greatly facilitated by the well known data set of real GDP for 130 countries over 35 years, compiled by Summers and Heston (1988). Works using the data set include those of: Baumol (1986), followed by Dowrick and Gemmell (1988), Barro (1991), Mankiw, Romer and Weil (1992), Sprout and Weaver (1992), and Theil and Seale (1994), among others. Taking all the rich versus all poor countries together, the statistical 379

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material shows that there is a slight catching-up tendency. Further disaggregration has highlighted a convergence of income levels within the richer countries but divergence within the poorer countries with some of the latter even falling behind the rest and becoming relatively poorer.1 Economic theorizing on these tendencies and empirical testing emphasized supply factors. Little attention has been given to demand factors that could lie behind convergence tendencies, and the interaction between demand and supply factors. The chapter will attempt to complement this gap in the understanding of convergence tendencies. After a brief review of the supply side theory and evidence in Section 10.2, the chapter will lay out the demand side approach in Section 10.3, the evidence in Section 10.4, the simulations in Section 10.5, and elaborations thereupon in Section 10.6. The question of the displacement of current leading economies by current lagging countries some time in the near future is discussed in Section 10.7. This is done at the hand of projections of the populations and the size of economic transformation (GDP) for the US, EU, Japan, Russia, next to China and India from the developing world. Implications of an eventual displacement of leader economies have consequences for the relative dominance of alternative economic systems that associate with leader economies. The chapter ends with summary and concluding remarks in Section 10.8.

10.2 The convergence hypothesis: Supply side theory and evidence Two economic models have been invoked to explain the mixed convergence tendencies between poor and rich countries referred to above: Solow’s growth model, which predicts convergence, Solow (1956) and Krugman’s divergence model Krugman (1981). The mechanism behind Solow’s growth model is diminishing returns to reproducible capital. A poor country characterized by a low capital/ labour ratio has a higher marginal productivity of capital and thereby tends to grow at a higher rate than a rich country with a higher intensity and lower marginal productivity of capital. Furthermore, there is a tendency for capital to move from rich to poor and thereby accelerating the convergence process. The contrary model of Krugman stresses increasing returns to capital, technological edges, and learning in assuring higher levels of more competitive capital and industrial exports in the rich country. Endogenous growth is seen to work to the advantage of the rich country that grows at a higher rate than the poor country. Capital flow tends to reverse from poor to rich, aggravating income gap between rich and poor, furthermore. Lucas (1993), Barro (1991), and others have elaborated Krugman’s model along endogenous growth theory to show basically the same. An increasing income gap between, on the one hand, countries that invest in human resources and are able to capture the public goods character of those investments, and on the other, countries that do not (are unable or unwilling) to invest sufficiently in human resources, learning, and innovation. A synthesis is found in Mankiw, Romer and Weil (1992) who developed a model that combines the mechanical growth theory as represented by Solow and

Long-Range Convergence and Displacements 381

endogenous growth theory as represented by Krugman, Lucas, and others. They test their model to the data set of Summers and Heston and find that countries with similar technologies and rates of accumulation and population growth should converge in income per capita. Yet this convergence occurs more slowly than the Solow model suggests. In general, the results indicate that the Solow model is consistent with the international evidence if one takes account of (dis)advantages of individual countries with respect to human and physical capital endowments. Another empirical paper, which contributes to a synthesis, is by Barro and Lee (1993). They explain the growth performance of 116 economies from 1965 to 1985. They find a conditional convergence effect, whereby a country grows faster if it begins with lower real GDP per capita in relation to its initial level of human capital; next to other stimulating factors such as high ratio of investment to GDP, small government, and political stability.

10.3 The convergence hypothesis: Demand side theory and evidence It is noted that the models mentioned above emphasize supply factors in determination of economic growth. The debate has so far been unbalanced as it excluded models of economic growth that emphasize demand factors. In this paper we highlight the insights to be gained from employing a demand-determined growth model. For the purpose in mind, the fittest framework within the wide range of demand-oriented models is the circular flow model based on the Social Accounting Matrix, SAM. We shall lay down the analytical framework, and elements of demand theory supporting the approach. The SAM is a general database that is well suited for the flexible modelling of the economy. The SAM is nothing more or less than the transformation of the circular flow into a matrix of transactions between the various agents. In the rows of such a matrix there are the products, the factors, the current accounts of institutions consisting of households, firms, and government as well as their capital accumulation account, the activities and the rest of the world. The columns are ordered similarly. Transactions between these actors take place at the filled cells and in correspondence with the circular flow. A particular row gives receipts of the account while column-wise we read the expenditure of the actor. Assuming proportional relationships for the cells in terms of their column totals a SAM coefficient matrix A. The SAM can be written as a model of the economy where the A matrix links a vector of endogenous variables y, to a vector of exogenous variables, x. The endogenous variables include production, income, consumption, and investment, among others. The exogenous variables in such a model are those of government and rest of world. We shall discuss this use in a moment. The system can be described in matrix form by y – Ay = x, solving gives y = (I–A) –1x = Mx where M stands for the matrix of system multipliers.

(1)

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We focus on the national income multiplier of rich and poor countries and examine their growth tendencies to shed light on the convergence hypotheses. Hence, our concern goes to one endogenous variable from the vector y, i.e. national income, call it Y; and one exogenous variable from the vector x, i.e. government expenditure and exports combined, call it X. The multiplier elements from the multiplier matrix that interest us here are those giving the sum total effects of equal sectoral demand injections via X on Y, which we shall call m. We shall thus restrict our interest to the total multiplier effect of the non-weighted exogenous injections in government expenditures and exports, X, on the national income, Y, as in equation (2.1) where m consists of the summed relevant elements2 from the multiplier matrix M. Y = mX

(2.1)

To simplify matters we shall ignore for the moment the multiplier impact of the exogenous variable of transfer payments, T. We shall comment on the impact of its incorporation in a later section, which will be shown to reinforce our conclusions. Equation (2.1) can be rewritten as in equation (2.2)

X Y = m ⎜⎛ ⎟⎞ Y ⎝Y ⎠

(2.2)

and re-expressed in growth rates using index g as in equation (2.3)

X g Y g = m g + ⎜⎛ ⎟⎞ + Y g ⎝Y ⎠

(2.3)

Note here that we treat the three growth rates on the right-hand side as hypothetical values in the sense that these growth rates are either assumed or forecasted and are consistently estimated in relation to each other. The combined effect of the three growth rates result in the realizable growth rate of the national income on the left-hand side which can differ from the hypothesized growth rate. If a hypothesized growth rate is denoted by h and a realizable growth rate by o, equation (2.3) can be rephrased as in equation (3).

Y go

> <

X gh m gh + ⎛⎜ ⎟⎞ + Y gh ⎝Y ⎠

(3)

We are in a position to formulate the question of how much economic growth the poor economy and a rich economy will realize in the longer run based on the hypothesized components derived from the SAM model. Equation (3) reads more specifically for poor countries, p, and rich countries, r, as follows:

Ypgo

> <

X gh m pgh + ⎛⎜ ⎞⎟ + Ypgh ⎝ Y ⎠p

Yrgo

> <

X gh mrgh + ⎛⎜ ⎞⎟ + Yrgh ⎝ Y ⎠r

Long-Range Convergence and Displacements 383

The hypothetical and realizable values of the growth rate of income, Ygh and Ygo, respectively, are generally different due to the independent determinacy of mgh and (X/Y)gh. If it can be shown for the groups of the poor and rich countries for which we have SAMs that starting from the same hypothetical growth rates Ypgh = Yrgh the following holds

X gh X gh m pgh + ⎛⎜ ⎞⎟ > mrgh + ⎛⎜ ⎞⎟ , ⎝ Y ⎠p ⎝ Y ⎠r then it follows that realizable growth rates will show Ypgo > Yrgo, which is an indication of catching-up. We treat first the growth of the exogenous share (X/Y)gh, and show that this can be expected to be higher for poor than rich countries, and take up later the prospects for mgh. We start first with (X/Y)gh. An interesting feature of the accounting system is that the row element of government expenditure and exports X can be divided by the row of total national income Y to give the exogenous share, X/Y. We have defined X to consist of government expenditure and exports. Our hypothesis is that the share of these items in the national income tends to grow rapidly during early stages of economic development but ebbs down and stops growing at higher stages of economic development. This hypothesis is put down in Figure 10.1 that shows the relationship between X/Y and income per capita, Y/N, this being the conventional expression for the stage of economic development. The quasi-logistic curve in Figure 10.1 can be formulated as equation (4). This is also the form in which the hypothesis will be empirically tested.

X E (Y / N ) = Y (Y / N ) + D

(4)

X/Y

Wagner’s law predicts that at higher levels of economic development, that is, as income per capita grows, the relative share of the public sector in national income will grow. Although the basis of the statement of Wagner’s law was the empirics

Y/N Figure 10.1 Relationship between the exogenous share in national income X/Y and income per capita Y/N

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of the nineteenth century, the theoretical foundations behind the phenomenon were developed later by Peacock and Wiseman, Musgrave, Baumol, and others, using various public choice arguments. More recent experiences in the balancing of budgetary deficits in rich countries directed attention to fiscal, monetary, and incentive limits to the further growth of the government share in total expenditure. So the share of the public sector grows as income per capita grows, up to a certain limit. This share has a tendency to stabilize at the higher levels of income per capita. A similar tendency applies to the share of exports in income which is very much dependent on economic development, location, and population. As per capita income grows, there is a tendency for the economy to become more open and attain a higher share of exports up to a point where the share levels off as more open economy countries get their portions of world exports. It is also established that the larger the country is in terms of population and economy the lesser the share of exports in income. Among the four rich countries treated in this chapter, Germany, Italy, and Spain will be seen to fall in this class. On the other hand, small population countries, also centrally located like the Netherlands, tend to have higher shares of foreign transactions with the rest of the world. The conclusion is that as far as the exogenous share is concerned, and this applies to both constituents of government expenditure and exports, the growth of this share for poor countries is higher than for rich countries: gh gh ⎛X⎞ >⎛X⎞ . ⎜ ⎟ ⎜ ⎟ ⎝ Y ⎠p ⎝ Y ⎠r

We go now to mgh. Recalling equation (2.1) we have 1/m = X/Y. Seen as a definition a rise in X/Y should lead to a proportional fall in m. The relationship between m and X/Y can be put down more generally as equation (5), which will be empirically tested in the next section.

X −G m = J ⎜⎛ ⎟⎞ ⎝Y ⎠

(5)

In Figure 10.2, curve I is obtained for values g 5 d 5 1, while curve II corresponds with our empirical estimation, which results in g having a slightly lower value than 1, and d < 1 indicating that the fall in m is somewhat moderated. The underlying relationship behind empirical curve II is that m is higher at low shares of exogenous demand that correspond with an early stage of economic development, that m declines rapidly with higher X/Y as economic development takes off, but that m tends to stabilize with values of X/Y of around 0.6 or higher. The circular flow effects fall with a rise in the exogenous share, this decline is rapid in the beginning but takes a lower rate than the rise in the exogenous share at higher values of the exogenous share. The reasoning is as follows. When the size of the exogenous part is relatively small, as it happens in the early stages of development, then the size of the

Long-Range Convergence and Displacements 385

12.0 10.0 m1 m2

m

8.0 6.0 4.0 2.0 0.0 0

0.2

0.4

0.6 X/Y

0.8

1

1.2

Figure 10.2 Relationship between multipliers m and exogenous share in national income X/Y

inverted endogenous part will be relatively large, resulting in high multipliers. As the exogenous share of final demand increases there is relatively a lesser endogenous part to invert and the multipliers are bound to fall. But the proportionate fall in the multipliers is less than the proportionate increase in the exogenous part. The income-expenditure-production linkages in the economy, that have been accumulated throughout the past, result in significant increases in the density of the input–output relationships beyond which further increases are only marginal. Once the endogenous linkages are built over time, their multiplier effects will not be proportionally written off with an increased exogenous share of the circular flow of the economy. There is an economic growth advantage here for the rich versus the poor country. The above means that the relative decline in multiplier m with an increasing exogenous share of the circular flow can be expected to be higher for the poor than for the rich country, mpgh < mrgh. This contributes to a widening of the gap between rich and poor. With the above contrary implications of the tendencies in X/Y and m for convergence and divergence in economic growth, it is then up to empirical testing to verify which effect is greater. As will be empirically shown in the following sections, the widening tendency in economic growth due to m is not strong enough to countervail the catching-up tendency due to, so that in the longer run convergence in economic growth will occur, nevertheless. It is important to emphasize that the well known empirical findings and theoretical elaborations by Kuznets, Clark, Fischer, Chenery, Syrquin, and others, form the backbone of the demand side explanation to catching-up tendencies. They highlighted the fact that as higher economic development is achieved there is a strong shift in final demand and value added from primary goods to manufacturing and services, and that at still higher income levels the share of manufacturing declines and of services increase.

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The findings are consistent with (a) earlier works of Clark (1940) and Fisher (1939) that gave a demand side explanation based on relatively higher income elasticities of demand for services as compared to non-services, and that predicted the emergence of the service economy at the cost of a de-industrialization process at the higher end of economic development. In the SAM analysis, the changes in final demand are driven by higher levels of exports and government spending that favour at a later stage services more than non-services. The result is a rapid growth in X/Y at low-income levels that strengthens convergence. The findings are also consistent with (b) the work of Chenery and Watanabe (1958) who found that during the process of development, the total use of intermediate inputs relative to gross output increases and its composition shifts as the importance of primary products declines and of heavy industrial products and services increase. Multiplier effects tend to diminish with development due to increases in the density of the input–output matrices as the economy evolves from relatively simple handicrafts production to more complex systems of fabrication and delivery. In the SAM analysis presented in this chapter, the CheneryWatanabe explanations support high levels of m in low-income countries but falling as the exogenous share of final demand rises with economic development, and stabilizing at a higher and stable exogenous share of final demand as is typical for rich countries.

10.4 Empirical results This section will report on selected results from cross-country comparisons of SAM models applied to ten developing countries (India, Pakistan, Sri Lanka, Indonesia, Iran, Kenya, Colombia, Egypt, South Korea, and Surinam), two centrally planned economies (Poland and Hungary), and four developed market economies (the Netherlands, Italy, Germany, and Spain). The classification of activities in these SAMs had to be limited to three large groups of sectors: agriculture, industry, and services; whereby industry includes mining, manufacturing, and energy utilities, and services include construction and transport among other private and public services. Distinguishing more sectors would reduce the uniformity and comparability of the 16 SAMs reported here. The disaggregation of households in the SAMs of the developing countries emphasizes dualities in the location of population in urban and rural areas, and the differentiation within urban and rural groups by level of income earned. This differentiation is done by a categorical split-up among urban households leading to the distinction between the three groups of employers, employees, and self-employed; and a split-up among rural households by size of land ownership leading to three groups of large landowners, medium landowners, and small/landless households. As a result, there are six groups of households. For a couple of countries a seventh residual group was incorporated to accommodate for classifications that did not fit the standardized six categories. The SAMs of the European countries distinguish household groups by income classes obtainable from personal income distributions.

Long-Range Convergence and Displacements 387

Testing equations (4) and (5) requires data by country on the exogenous share of government and exports in national income, X/Y, and the income multiplier m, which are obtainable from the SAMs and the matrix inversions, respectively. Data on a third variable is needed, this is the GNP per capita, Y/N, expressed in US$ for the 16 countries and their related years. These are obtainable from published tables of the World Bank Atlas, which are especially suitable in our context as they are based on conversions that smoothen the impact of annual fluctuations in exchange rates. Table 10.1 brings these data together. Note that the value of X/Y varies from a lower value of 0.12 for India (poor country) to a highest value of 0.89 for the Netherlands (rich country). The income multipliers start from 7.06 for a poor country and fall to 0.85 for a rich country. The regression results of equations (4) and (5) are found in Table 10.2. Equation (4) describes a quasi-logistic function that makes the level of the exogenous share dependent on the income per capita. To account for a particularly lower share in case of a large-size rich country, e.g. Germany, Italy, and Spain, and too high a share of exports for a few particularly foreign trade oriented small countries, e.g. the Netherlands, Surinam, and Kenya, a dummy variable is included that takes the value of 1.0 for the first group and –1.0 for the second group. The equation is Table 10.1 Country

SAM features and GNP per capita of 16 countries Year

Poor countries Non-weighted average India 1968/69 Pakistan 1979 Sri Lanka 1970 Indonesia 1975 Iran 1970 Kenya 1976 Colombia 1970 Egypt 1976 South Korea 1979 Suriname 1979 Rich countries Eastern Europe Non-weighted average Poland 1987 Hungary 1990 Rich countries Western Europe Non-weighted average Spain 1980 Italy 1984 Germany 1984 The Netherlands 1987

GNP per cap. 1000$

Exogenous share = X/Y

SAM income multipliers of demand injections from Average value = m

Rank (a)

Highest/ Lowest (b)

0.55 0.09 0.17 0.17 0.21 0.22 0.24 0.34 0.35 1.51 2.21

0.34 0.12 0.24 0.23 0.37 0.13 0.45 0.22 0.43 0.43 0.76

2.89 7.06 6.11 2.32 2.90 2.82 1.28 2.47 1.15 1.79 0.95

ASI ASI ASI ASI ASI ASI ASI SAI ASI ASI SAI

1.54 1.20 1.24 1.24 2.15 1.40 2.03 1.18 1.86 1.66 1.48

2.26 1.93 2.59

0.45 0.40 0.49

0.85 0.92 0.77

SAI SAI SAI

1.52 1.57 1.46

8.70 5.40 6.42 11.13 11.86

0.54 0.29 0.43 0.57 0.89

1.30 1.53 1.50 1.32 0.85

SAI ASI SAI SAI SAI

1.32 1.26 1.42 1.47 1.13

Notes: (a) ASI = Agriculture-Services-Industry; SAI = Services-Agriculture-Industry. (b) For example in case of India dividing average income multiplier of agriculture by that of industry gives 1.20.

388

Economic Systems Analysis and Policies Table 10.2 Regression results of equations (4) and (5)

Item Eq. (4)

Explained, explanatory variables and coefficient estimates X/Y =

Coefficient t-value Eq. (5) Coefficient t-value

ln m =

b (Y/N) /

[a + (Y/N)]

R2

+ w4 D4

0.632

0.369

–0.201

(12.95)

(3.25)

(–4.84)

ln g +

d ln (X/Y)

+ w5 D 5

–0.077

–0.619

–0.799

(–0.58)

(5.41)

(–6.39)

0.813

0.890

estimated by non-linear least squares. The regression performs very well, in terms of the signs of the coefficients, their t-values, and goodness of fit as indicated by R 2 (above 0.8). The predicted highest value of the exogenous share in the observed sample, disregarding the dummy, can be calculated at 61 per cent for the richest country. The predicted and observed lowest values of the exogenous share are the same, at 12 per cent for the poorest country. Because Y is determined by the whole system including equation (4), the question is raised on possible correlation between the explanatory variable, per capita income Y/N, and the disturbance term, yielding a biased non-linear least square estimator. Note that the explanatory variable is expressed as Y/N and not in terms of Y only. Furthermore, the residuals in equation 4 were found not to correlate with the explaining variable of national income per capita (r = 0.34), giving no ground for applying more sophisticated regression methods than the followed non-linear least squares method. Equation (5) describes a convex function between the income multiplier and the exogenous share. For estimation purposes the equation is formulated as ln m = ln g + d ln (X/Y) and tested by ordinary least squares. One dummy needs to be introduced to account for a high-income multiplier bias in the SAMs of both India and Pakistan: the available SAMs of India and Pakistan do not register complementary imports to the full extent or at all, and hence underestimate the leakage and overestimate the multipliers. Another dummy is required to account for the differential impacts of economic systems, e.g. Poland and Hungary. Although one should expect higher multipliers for the less rich Eastern Europe (Poland and Hungary) as compared to the richer Western Europe, they have about the same levels. This under-performance of Poland and Hungary is due to the presence of institutions that do not make full use of the potential internal leakage effects within the system. The variation of income multipliers among the West European countries as represented by the ratio of the highest/lowest sectoral multiplier can be calculated as 1.44. For Eastern European countries the variation is higher. It is noted too that Poland has a wider variation (1.57) than Hungary (1.46), which reflects a more balanced and well-knitted economy in this respect.

Long-Range Convergence and Displacements 389

Equation (5) was tested with two separate dummies as well as with one dummy carrying the value of –1.0 for India and Pakistan and 1.0 for Poland and Hungary. The results are very similar so that we can work as well with the simpler case of one dummy, which is reported in Table 10.2. The regression performs very well in terms of all prerequisites. If the mean of m over the 16 countries in equation 5 was anything meaningful, we would have obtained values of 1 for g and for d (curve I in Figure 10.2), but we do obtain values of ln(g) = –0.077 and d = 0.619 (curve II in Figure 10.2). These results are not due to whether the values of m are calculated as weighted or nonweighted sectoral impact multipliers, but they are due to the shapes and significance of linkages changing with economic development as was previously stated. We calculate m as a non-weighted sectoral average. It can be readily seen from Table 10.1 that if m was calculated as a weighted sectoral average the curve of equation 5 would fall more steeply and flatten earlier with values of ln(g) and d even further away from g = d = 1. Note that in Table 10.1 agricultural multipliers score highest and have the highest share in poor countries. Using weights (for example, multiplying sectoral multipliers by sectoral shares) would result in higher aggregate values of m for the poor countries as compared to rich countries causing the curve to shift further away from curve I, Figure 10.2.

10.5 Demonstration With the estimates of a, b, g, and d we are now in a position to predict for a poor and a rich country respectively, such growth rates as (X/Y)gh and mgh for assumed values of Y gh. Inserting these in equation (3) for the average poor and average rich country separately and solving gives the realizable growth rates of income of the poor and rich countries Ypgo and Yrgo. Recall equation (3) for the poor and rich country:

X gh Ypgo <> m pgh + ⎛⎜ ⎞⎟ + Ypgh , ⎝ Y ⎠p

and

X gh Yrgo <> mrgh + ⎛⎜ ⎞⎟ + Yrgh ⎝ Y ⎠r The above simulations are done in Table 10.3 where we start from an initial income, population and income per capita for a poor and a rich country (poor and rich as was indicated by the averages in Table 10.1). We assume for both types of countries the same annual rates of growth of 2 per cent per income, 1 per cent for population, and 1 per cent for income per capita. Using the estimates of a, b, g, and d we obtain the predicted values of growth rates of X/Y and m. These are used in solving for the realized growth rates of income of the poor and rich country in the last column. The calculations show that the realized growth rate of income of the poor country will exceed that of the rich country. The poor country would achieve an annual growth rate of 2.16 per cent while the rich country would grow annually at 2.02 per cent. Another scenario is run with assumed growth rates of

390

Economic Systems Analysis and Policies

Table 10.3

Selected simulations: Initial runs for rich and poor countries

Year

Assumed growth Income per capita Y/P

Poor 0 1 1

8703 8790 8877 551.0 556.5 556.5

Table 10.4

Income Y

growth growth growth (mn. $) rate (mn.) rate rate

($) Rich 0 1 1

Population P

Predicted solution Exogenous share X/Y

(%)

growth rate

Multiplier m

value

growth rate

Income growth rate

0.01 0.02

220.0 222.2 222.2

0.01 0.01

1914660 0.606 1.2612 1953145 0.0201 0.607 0.00040 1.2609 –0.00025 0.02025 1972483 0.0302 0.607 0.00080 1.2606 –0.00049 0.03051

0.01 0.01

880.0 888.8 897.6

0.01 0.02

484880 0.379 1.6879 494626 0.0201 0.380 0.00399 1.6838 –0.00246 0.02163 499523 0.0302 0.380 0.00399 1.6838 –0.00246 0.03173

Selected simulations: Alternative runs assuming different income levels

Year

Assumed Income per capita Y/P

($) 0

100.0

1

101.0

Population P

growth growth (mn.) rate rate 220.0

Predicted solution

Income Y

(mn. $) 22000

growth rate

Exogenous share X/Y

(%) 0.135

growth rate

Multiplier m

value

growth rate

Income growth rate

3.1977

0.01

222.2

0.01

22442 0.0201 0.136 0.00785 3.1822 –0.00483 0.02312

0 1

1000 1010

0.01

220.0 222.2

0.01

220000 0.462 1.4928 224422 0.0201 0.463 0.00268 1.4903 –0.00165 0.02113

0 1

10000 10100

0.01

220.0 222.2

0.01

2200000 0.610 1.2571 2244220 0.0201 0.610 0.00035 1.2568 –0.00022 0.02023

0 1

20000 20200

0.01

220.0 222.2

0.01

4400000 0.621 1.2432 4488440 0.0201 0.621 0.00018 1.2430 –0.00011 0.02017

income per capita for the poor and rich at 3 per cent, this scenario results also with a higher rate of realized growth for the poor than the rich, 3.17 per cent compared to 3.05 per cent. In a more general way, Table 10.4 simulates the annual growth rate of income for rising levels of income per capita. The table shows lower growth rates of income at higher levels of income per capita, the growth rates diminishing slowly and approaching stability as the income per capita goes beyond US$ 20,000. The convergence tendency, Ypgo > Yrgo, is thus decomposed into a part due to (X/Y)g and a part due to mg. The positive but diminishing contribution of (X/Y)g standing for an exogenous growth potential at a lower level of economic development and an exhaustion of possibilities for exogenous growth at higher levels of economic development dominates the negative effect of mg, standing for the diminishing multiplier effects.

Long-Range Convergence and Displacements 391

10.6

More convergence through transfer mechanisms

The analysis concentrated so far on the endogenous effects of exogenous injections in sectoral allocations originating from government and the rest of the world, X. How significant are the endogenous effects of exogenous changes in transfers originating from government and rest of world, say T for transfer multipliers, and in which direction do they act? In principle, the above analysis can be repeated but with reference to injections in T. It is also possible to demonstrate the effects via shortcuts. Recalling equation 1 that gives the vector of endogenous variables y as function of multiplier matrix M and vector of exogenous variables x. y = Mx This can be specified for variables of interest: endogenous income Y, exogenous allocations X, and exogenous transfers T.

Y =m

X T + m’ Y Y

Dividing throughout by Y gives

1=m

X T + m’ Y Y

This equation can be specified for poor and rich countries as

X T 1 = m p ⎛⎜ ⎞⎟ + m ’p ⎛⎜ ⎞⎟ ⎝ Y ⎠p ⎝ Y ⎠p

(6.1)

X T 1 = mr ⎛⎜ ⎞⎟ + m ’r ⎛⎜ ⎞⎟ Y Y ⎝ ⎠r ⎝ ⎠r

(6.2)

Inserting the average values of the above parameters for the two groups of countries gives the following results:3 1 ≈ (2.545)(0.356) + (2.423)(0.078) ≈ 0.83 + 0.17 1 ≈ (1.3)(0.543) + (1.648)(0.242) ≈ 0.63 + 0.27

Estimated (6.1) Estimated (6.2)

These results show the effect of X to be about 2.5 to 5.0 times that of T in determining economic growth. At higher levels of economic development the relative strength of X and T effects shifts from X to T. This happens via an increase in the share of T/Y (and a lower share of X/Y) as well as less reductions in m' (as compared to m). At still higher levels of economic development the increases T/Y are restricted by the same constraints that apply to X/Y. First, the T/Y share for individual rich countries has reached its ceiling in the late 1990s/early 1990s and is falling in

392 Economic Systems Analysis and Policies

others, cf. Bayens and Cohen (1994). Second, the growth effect of transfers in rich countries, m'r, forms 68 per cent of that for poor countries, m'p. Therefore the conclusions reached on converging tendencies due to the X effects apply to the T effects as well.

10.7 The displacement hypothesis: Future outlook for China and India While the convergence in economic growth that was treated in the previous section can be viewed as a matter of catching-up, displacement of today’s most advanced economies by less developed economies in the global economic leadership goes further than convergence or catching-up. This section discusses questions on the likely displacement of US and EU by China and India some time in the future. There are two main questions. First, what will be the relative magnitudes of agents and economies of major countries in about a decade from now if past trends are continued and how robust are such predictions? Second, what will be the effects of new dominant economies for the world economic systems, taking into consideration that the new dominant economies embrace different socio-political-economic systems than the current dominant economies? Any discussion of this second question is bound to be more speculative than the first, but equally relevant and significant to explore. In this section we treat the first question, and in the next section the second question. What will be the expected relative magnitudes of agents and economies of the major competing countries in about three or four decade from now, say in 2040 or 2050? As regards the number of agents the experience of the past and present is that UN demographic projections tend to be realized and can be trusted. See Table 10.5, drawn from these sources, which give projections of country shares in the total world population. The current ranking of China and India as number one and two is reversed by 2040. Their population shares will be 16.4 and 18.1 per cent, respectively. EU and US would follow at 5.1 and 4.4 per cent, respectively. As regards the relative size of the economic transformations (GDP) of countries, this is more difficult to predict; however, there has been a stable improvement in the ability of economic models to produce realizable conditional forecasts. Although there are a few robust and well functioning world economic models which focus on issues of economic growth, foreign trade, agriculture, energy, pollution, etc., and which distinguish between world regions, these models do not focus on individual countries and their inter-competition. The so-called BRIC model by Wilson and Purushothaman (2003) was a first attempt to use simple country models, for Brazil, Russia, India, and China among others, hence BRIC, to examine the likely outcomes of displacement scenarios for major countries. Their method and results are reviewed below. The authors use a standard five equations and five variables model for each country they treat. The first equation is a Cobb-Douglas production function Y = AKa L1–a where Y is GDP, K is capital stock, L is working age labour, and

Long-Range Convergence and Displacements 393 Table 10.5

Future outlook: Country shares in the world population, and the world GDP

Country

2000 Population mn

World total

6124

2040 GDP US$ bn

31,800

Population mn 8823

2050 GDP US$ bn 119035

Population mn 9191

GDP US$ bn 170721

percentage US

4.7

30.7

4.4

22.9

4.4

20.6

EU

6.9

25.3

5.1

12.8

4.8

10.4

Japan

2.1

14.6

1.3

5.1

1.1

3.9

Russia

2.4

1.2

1.3

3.8

4.2

3.4

China

20.7

3.4

16.4

22.2

15.3

26.0

India

17.1

1.5

18.1

10.4

18.0

16.3

Rest of world

46.1

23.3

53.5

22.8

52.1

19.4

100.0

100.0

100.0

100.0

100.0

100.0

13.7

70.6

10.8

40.8

10.3

34.9

World FIM: US, EU, Japan

Sources, note: Population figures are from UN Population Division at http://esa.un.org/unpp/ GDP figures for 2000 are from World Bank at http://devdata.worldbank.org/query GDP projections for 2040 and 2050 for the individual countries, expressed in constant price of 2003, are from Wilson and Purushothaman (2003). We used their projected aggregated growth path for France, Germany, Italy, and UK to obtain the projections for the EU, which consists of the 15 Western European countries. The projections for the Rest of World Group are from Fogel (2007). The projected world total for the GDP is thus obtained by summing the regions, and the percentage distribution by region is calculated.

A is technical progress. The second, third, and fourth equations lay out projections of L, K, and A. While L is exogenously taken over, K grows on the basis of assumed depreciation and investment rates. A is positively related to the catch-up achieved in GDP per capita, reflecting benefits of the developing country from positive externalities. Finally, there is an important equation that determines the country’s real relative exchange rate to the US$, E. The assumption is that E is determined by the differential in labour productivity with US, thus, Δ ln (E) = Δ ln (Y/L) – (growth of Y/L in US). Currencies tend to approach their purchasing power parity exchange rates as higher productivities are achieved. The results obtained for 2040 or 2050 are startling. The BRIC countries would overtake OECD countries in terms of GDP especially the economies of China and India will be bigger than those of US and EU, respectively. But the income per capita gaps would remain, though lower. The framework sees countries go richer at the back of real growth (equations 1–4), and at the back of appreciating currencies (equation 5). About two-thirds of the increase in BRIC’s GDP in US$ is from real growth and one-third is from appreciating currencies. In Table 10.6 we make use of the BRIC projections and supplement them with others to obtain a full picture of the world economy in the future.

394 Economic Systems Analysis and Policies

Without going into details, compared to economy-wide economy models commonly used at the World Bank and UN, it is obvious that the BRIC model can be criticized on counts of simplistic assumptions. Above all, their projections are based on individual country models that are not linked to each other in a world model. Price and volume interactions between the individual countries, and gains of one country meaning a loss for the other, are excluded. For example, as higher growth leads to higher returns, it can be speculated that capital flows will move accordingly prompting shifts in portfolio investments, currency realignments, and possibly further currency appreciation. The latter may affect economic growth negatively. These interactions are excluded. The main argument in defence of the BRIC results is that the authors looked at ways to cross-check the plausibility of the forecasts, which were positive.4 Since the appearance of the BRIC model, more studies on the prospects of the emerging economies by investment as well as academic circles have come out in support of a conditional displacement hypothesis.5 The studies emphasize risk factors. The depicted trends may be obstructed or stopped due to world economic recessions, financial crises, governance crises, civil disorder, and social unrest due to increasing income inequality gaps and/or dissatisfaction of ignored ethnic groups, next to natural disaster, epidemics, and wars. One uncertainty that is seldom touched, and that applies to China and India, in particular, is that it is not likely that the majority of the vast populations of these two countries would be absorbed in commercial firm settings in the near future, implying that economic growth may be retarded when the boundaries of economic absorption are reached. Another uncertainty relates to how the economies of China and India would differently respond to economic recession and financial crises. Which of the two economies would be more damaged in a major business cycle? With the above considerations in mind, the future outlook of GDP in Table 10.5 needs to be treated with reservation but deserve consideration as a realizable one. China and US are forecasted to have equal shares of the world GDP, about 23 per cent, in 2040, but China would surpass US by some 5 percentage points in 2050. By then, India would surpass EU by 4 percentage points. The top four countries in 2050 are thus China, US, India, and EU, with the following GDP shares: 26.0, 20.6, 16.3, and 10.4. These four big countries are followed by the group of four smaller countries of Japan, Russia, Brazil, and Mexico with GDP ratios varying between 3 and 4 per cent. In Table 10.5 Brazil and Mexico are not shown separately, they are part of the Rest of world. There are important economic and political features that accompany the achievement of a high economic growth, such as a greater command of foreign exchange reserves and ability to lend and invest abroad, greater ability to influence trade and investment decisions in other countries, an enhanced role of the state and state agents in the country and abroad, and so on. Although these aspects cannot be modelled or quantified they are usually perceived as implied results. It should be taken for granted therefore that the higher economic growth of China and India and the higher GDP shares that are predicted would increase their economic and political influence in the world at large.

Long-Range Convergence and Displacements 395

Box 10.1

The comeback of China and India

China and India are recorded to have been leading economies in the world until about the eighteenth century. After two centuries of downfall their economies have risen again and are forecasted to regain their leading positions by 2040. After 2040 the growth rate in India’s GDP is forecasted to be higher then that of China’s GDP. The forecasts assume the absence of economic calamities at the foreign front that are caused by world recessions, credit crunch, trade protectionism, inelastic supply of energy resources; and at the domestic front caused by financial mismanagement, severe epidemics, ethnic conflicts, inequality divides, poverty extent, civil disorder, and polity shake-up. There is some debate on which of the two countries is more immune from the above risk factors.6 Our review of the two economies in Chapter 8 comes to the conclusion that China is stronger on some counts while India is stronger on other counts, but there is no way of weighing these counts.7 There can be also some or much truth in the hypothesis that the future prospects for India’s economy are not independent from those of Chin’s economy, and vice versa. Important sources of economic growth for both countries are foreign trade and foreign investment with the rest of the world, ROW. If, for some unforeseen externally caused economic downturn, such as the financial meltdown and its accompanied economic recession of 2008–09, the foreign trade and foreign investment flows get diminished and become inelastic worldwide, importers and investors cannot escape making economic choices between the two giant economies. The then would-be-held expectations of the relative future prospects of the two economies could play a significant role in determining the future courses of the two economies.

45 40 35 30 25 20 15 10 5

US

EU

China

2050

2025

2000

1975

1950

1925

1900

1875

1850

1825

1800

1700

1600

1500

1400

1300

1200

1100

1000

0

India

Source, note: The vertical axis denotes the percentage share of a country’s share in the world GDP. The horizontal axis denotes years. Years 1000 to 1975 are reported in OECD, see Maddison (2003). Year 2000 and forecasts for 2040 and 2050 are from Table 10.5.

396

Economic Systems Analysis and Policies

10.8 The displacement hypothesis: Implications for system competition and the relative dominance of alternative economic systems What will be the relative influence of the rising new economies, given their systemic features, for the other world economic systems? Because we are addressing the question form a systemic point of view it is necessary to quantify the relative influence as much as possible. We have postulated in Chapter 1 that the relative distribution of agents and the relative distribution of transformed value added in competing settings determine the dominant setting. We suggested starting in a preliminary way with assuming equal weights for these two relative distributions. We have applied this approach in Chapter 7 to the combined concentration of agents and GDP in 2000 in the household settings related agricultural activities and similarly for firm settings related industrial activities to obtain insight into the relative dominance of the two settings. The approach was again applied in Chapter 8 to the relative distributions of agents and GDP among countries within a region to obtain an index of the relative influence and dominance of the individual countries in the whole region. This same approach can be applied here to predict the relative influence of the alternate contenders in the future outlook Table 10.5. The results are found in Table 10.6. There are two striking results shown in Table 10.6. The first striking result is that there would be a clear shift of interactive influence from the US, EU, and Japan, who represent the firm intensive system, some increase in the interactive influence of Russia that is closest to the state intensive system. But the significant gainers in interactive influence are China and India. Their interactive influences are almost doubled, with India’s increment greater than China’s. These changes in relative influences will not pass unmarked on the other interacting economic systems. What is typical of the social systems in China and India that Table 10.6

Future outlook: Country Index of Interactive Influence

Country

2000

2040

2050

US

17.7

13.7

12.5

EU

16.1

9.0

7.6

Japan

8.4

3.2

2.5

Russia

1.8

2.6

3.8

China

12.1

19.3

20.7

India

9.3

14.3

17.2

Rest of world World FIM: US, EU, Japan

34.7

38.2

35.8

100.0

100.0

100.0

42.2

25.8

22.6

Source, note: Table 10.5. The first entry of 17.7 is the average of 4.7 and 30.7 from Table 10.5.

Long-Range Convergence and Displacements 397

will influence, be passed to, or adopted in other social systems? We shall try to reflect on this question below. The second striking result is even more striking. The index of interactive dominance varies at around 20 percentage points for any country and its related system, confirming that a dominance of any one system is excluded in 2050. The FIM configuration consisting of US, EU, Japan and a few smaller countries is reduced to some 23 points. The China system is stuck at 21 points and India at 17 points. Looking at the world future from the systemic viewpoint it will be less influenced or dominated by any one system in the future than today. The table suggests the evolvement of a stable balance of power between the countries and related systems. Would intercourse between parties with equal influential powers lead to more confrontation or more understanding? This question will become relevant if the results of Table 10.6 are approached. We described the bigger and highly dualistic countries of China and India as less fitted to the classification into HIM, FIM, and SIM. We emphasized the significant and stable extent of rural household settings in these countries as well as significant roles for firm and state settings; a highly segmented system with a low degree of communication between the segments. We used the term multipolar system, MPM, to distinguish these countries from others, while emphasizing salient differences between China and India as was shown in the previous chapter. We postulated that in a multipolar system there is an important role laid for persuasion settings in the coordination and streamlining of responses between the segments. It was stressed that persuasion settings are economically beneficial and can accomplish greater cooperation between political, business, and other leading circles; giving China and India an economic edge. Differences between the MPM type and other types of economic system show up in a lesser degree of separation of decision-making and agent rewards when joint familial, commercial, and state interests are involved, and in frequent consultations between leaders in business, government, scientific, and intellectual leaders in evaluating, formulating, and executing policies and defending them. It is likely that in a future world, with regard to agent interaction and GDP, there will be a greater role for MPM related countries (with significant portions of household oriented agents contained in them) than FIM or SIM related countries, as predicted by Table 10.6. In addition, as the incremental economic performance achievable in MPM countries would be higher than in FIM or SIM countries, it will be more attractive for agents everywhere to pursue MPM attitudes rather than FIM or SIM attitudes. Following the logic of our analytical framework, these tendencies would set into motion agent interactions that favour the prevalence over time of MPM over FIM and SIM.8 Such changes in attitudes will be reflected in changes in institutions in today’s FIM and SIM related countries. How can a future outlook as described above be interpreted in terms of thesis, antithesis, and synthesis? If the thesis in the nearby future is that a persuasion intensive system, such as found in China and India, performs economically better than the firm intensive system, such as found in US and EU then one likely

398 Economic Systems Analysis and Policies

response scenario, the antithesis, is a new non-collaborative systems competition between MPM and FIM. The implications for the FIM are that many of the well established institutions in US and EU may come under pressure, such as separation between business and government, free competition, transparent governance, merit goods, and social benefits of the welfare state. The fiscal budget may shift in favour of capital and firms at the cost of labour and consumers. The national economies will likely apply more protectionism and state corporatism. The polity may also be affected as transfer of decision-making powers take place from open parliaments to appointed commissions, and new forms of non-elected political leaderships are introduced. Personal leadership, social trust, and familybased networks regain importance when such shifts take place. The new non-collaborative system competition would have also consequences for the MPM related countries. There will be no incentive to incorporate, test, or adapt some of the institutions that proved successful in the FIM context such as those of the free market, welfare state, and parliamentary democracy. The new non-collaborative systems competition will force agents, firms, and states within each nation to come closer to each other in organizing and raising the performance of their national economies. As individual nations seek more national economic efficiency in a sphere of national protectionism, some would succeed more than others; but the total success of all nations together may turn to be less than what that success could have been without national protectionism.9 The next likely response scenario is a synthesis that can be termed as a new collaborative systems competition. The collaborative scenario is collectively superior to the non-collaborative scenario in its socio-economic and political consequences. The collaborative scenario promotes borrowing, testing, and adapting successful institutions from one competing system to another and instituting new rules for prosperous cooperation between alternate systems. Reason and knowledge are combined to realize institutional changes in the systems and greater satisfaction for agents of all systems. Behavioural settings that are most suited to promote the above are persuasive settings that employ reason and knowledge. In particular, they are persuasive settings that are able to formulate consensus strategic solutions to externality problems at the national and global levels. The pivotal actors in persuasive settings are the so-called wise leaders – these are thinkers, knowledgeable, persuasive, and globally oriented. They are trusted and followed by large groupings of agents that are allied to them. It will be relevant to give attention to documenting and digesting recent national reactions in both directions. For instance, in reaction to the increasing influence and acquisition moves of foreign state-led corporatism such as of China, Russia, and India in the EU, business and state circles in several EU countries, as well as the European Commission, have called for concerted action and protective measures to obstruct foreign take overs, and for joint corporate–state efforts in strategic sectors to combat foreign-led corporate–state collaborations of MPM type countries.10 The tendencies in the Anglo-Saxon countries of US and UK in this respect are rather mixed as yet.11 It is very hard to predict national response especially when the national loss cannot be identified as the result of fair play or

Long-Range Convergence and Displacements 399

strategic trespassing. And if protectionism is justified, counter-protection usually follows. In a similar vein, the credit crunch of 2007 and the financial meltdown following it in 2008 that started in US and spread to other FIM countries and globally has necessitated partial nationalization of the banking sector in most FIM countries, bringing them closer to how the banking system is working in non-FIM countries. However, these new waves of state interventions need not be a real departure from the firm-driven structure of the FIM countries. Equally important is the realization that the containment of the financial crises would require global coordination among major FIM countries and jointly with major non-FIM countries. Truly persuasive scenarios at the global level appear to take place regarding issues of global pollution, climatic changes, natural disasters, threatening epidemics, free trade, and poverty reduction, to name a few. There is no available way of assessing whether this synthesis scenario would be maintained and flourish, and how effective it will be in tackling inter-system externality problems. Nevertheless, the following can be stated in support of an optimistic note. It can be generally maintained that when the contending parties have influential powers that are more or less equal, i.e. an equal balance of powers, and perceive the situation as such, the parties are more inclined to use reason and knowledge and adopt cooperative attitudes in resolving frictions between them. Under a skew distribution of influential powers it is more likely that a non-collaborative attitude emerges. Referring back to Table 10.6 we have found that for some future year, 2050, the values of the index of interactive influence varies narrowly around 20 percentage points for any one system or group of countries affiliated to one system. This predicts a future world with a much more equal balance of powers than in 2000 and thus feeds the expectation that the new systems competition ahead will be more of the collaborative than the non-collaborative type with a greater role of reason and knowledge. In summary, a displacement of US and EU by China and India in the rank of leading economies in the distant future has implications for the interaction between different economic systems and system competition. It is more likely than not that the multi-partnership system, MPM, would gain more strength than the FIM and SIM in the future. But the probability of dominance or convergence towards one global system is very remote given the values of the index of interactive influence that do not exceed the 20 per cent for any particular country-system. This may foster a new systems competition that is more collaborative than non-collaborative. What is certain, if the future outlook is realized, is that some of the new elements in a synthesis system may have to be contributed by China and India. Both countries have configurations of behavioural settings that lean more towards household settings, i.e. the traditional and sharing behavioural type, than firm settings. And more important, persuasion settings in China and India are highly active in coordinating and streamlining the social system, which is logical, given the demographic dynamics and the multipolar differentiation of the social system

400

Economic Systems Analysis and Policies

in these two giant countries. It is thus likely that a synthesis system would make more frequent use of sharing and persuasive mechanisms. It is interesting to note that other thinkers, working from other disciplines than economics and using different argumentation, are arriving at similar conclusions.12

10.9

Summary and concluding remarks

In this chapter we investigated two issues. The first issue dealt with whether the gap in the income per capita between rich and poor countries, which happen to belong to different economic systems, is widening or diminishing. The second issue went further to examine the likely displacement of the current leading economies of US and EU, classified as FIM related countries, by other countries such as China and India that feature other economic systems, and the implications thereof for the relative influences of alternate economic systems worldwide. On the first issue, while most empirical literature relied mainly on supply side models of economic growth, we offer a demand side model, based on the social accounting matrix is estimated for 16 countries. The latest evidence from the supply side pointed to a conditional convergence in the income per capita. The results of the SAM based demand side approach can be also interpreted in terms of conditional convergence. The SAM model, after adjusting for peculiarities of economic systems, predicts higher economic growth at lower as compared to higher levels of income per capita. This is indicative of a convergent tendency. The main cause behind this convergent tendency is the ability of a poor country to increase significantly the shares in the economy of injections of exports and government, and reap growth benefits from the associated changes in the compositional patterns of goods and services, while rich countries are, in relative terms, near satiation in these demand categories. The conditional results were thus obtained after adjusting for system-country peculiarities. The need to adjust for systemic behavioural peculiarities strengthens the case for pursuing a behaviourist paradigm: one where distinct behavioural types circumvent the economy, and thus determine the organization, functioning, and performance of the economic system.13 A behaviourist paradigm would allow the mutual existence of different societal orders that are predominantly driven by different behavioural types, for instance, social, political, or economic motives, respectively. These behavioural types characterize the societal orders that shape economic systems that are in turn observed in differing country groups. On the second issue, we examined future outlook forecasts for 2040 and 2050 that would displace US and EU as the two economies with the largest GDP, and shift China and India to the foreground. We made use of our analytical framework to compute for each contender an index of interactive influence that combines shares of interacting agents and transformed GDP. The index shows an increased dominance of China and India over others, and by implication, a growing influence of household and persuasive settings typical of the newcomers, and a decreasing influence of FIM and SIM related settings in the world at large. But no one country (system) is predicted to command an index above 20 per cent.

Long-Range Convergence and Displacements 401

We see thus that in spite of the occurring convergence tendencies in economic growth and systemic features between counties, the relative influence of alternate systems worldwide will tend to hold each other in balance. The chapter discussed situations of conflict in interactions between countries belonging to different economic systems and different behavioural traits. Country displacements in global leadership when the countries involved follow different rules of the game, i.e. belong to and act in accordance with rules of their own economic system, carry risks of confrontation and protectionism, i.e. noncollaboration. But they open also opportunities for resolving problems of intergroup externalities in the framework of persuasive inter-group leaderships, i.e. collaboration. The predicted equal balance of influence is likely to promote more collaborative than non-collaborative systemic interactions.

Appendices Appendix A: Social Accounting Matrices of China, SAM of China 1989 (billion Yuan) Wants

Factors

Food

Cloth

Misc.

Educ.

Serv.

Urli

Ruli

1

2

3

4

5

6

7

Institutions profit Urban Urban empl. selfempl. 10 8 9

1 Food 2 Clothing 3 Miscellaneous 4 Education 5 Services

123.8 31.2 35.9 19.8 17.1

6.2 1.7 2 1.1 0.5

14.1

4 5.1

488.0 241.9

20.6

6 Urban lab inc 7 Rural lab inc 8 Profits 9 Urban employee 10 Urban self-emp 11 Rural Farm 12 Rural non-farm 13 Firms

237.7 20.6 301.1 77.7 483.1

14 Government 15 Capital 16 Agriculture 17 Industry 18 Services

4.9 230.9 29.9 69.1

6.7 46.6 13.3

10.6 73.9 21.0

32.3 10.8

9.8 13.1 42.7

329.9

66.6

105.5

43.1

65.6 258.3 378.8

19 Rest world Total

402

Appendices 403

Institutions Rural farm

1 Food 2 Clothing 3 Miscellaneous 4 Education 5 Services

11

Rural Nonfarm 12

159.8 25.9 52 17 44.6

40.1 7.8 15.6 5.2 3.4

Activities

Firms

Gov.

Cap.

Agr.

Ind.

Serv.

13

14

15

16

17

18

14.9 324.0 75.4

9 Urban employee 10 Urban self-emp 11 Rural Farm 12 Rural non-farm 13 Firms 2.2 3.4

5.3 5.2 15.5 110.2 128.9

95.4 242.3 243.7

19 Rest world

Source: Cohen (2002b).

113.9 129.5 43.5 11.3 228.9 183.7

258.3 378.8 488.0 241.9 20.6 301.1 77.7 483.1

483.1

16 Agriculture 17 Industry 18 Services

Total

19

4.2

1.8

28.7 134.6 3.4 12.6

201.7

77.7

Total

329.9 66.6 105.5 43.1 65.6

6 Urban lab inc 7 Rural lab inc 8 Profits

14 Government 15 Capital

Row

483.1

258.8

581.4

604.1

162.5 20.0

79.9 20.0

101.6 33.7 752.8 295.9 173.8 60.4 185.9

7.0

28.7

258.8 581.4

71.2 604.1 51.3 1782.9 54.3 821.4 205.5

1782.9 821.4 205.5 7114.3

404 Appendices

Appendix B: Social Accounting Matrices of Russia SAM of Russia 1990 (billion rubles) Products Food 1

Factors

Institutions

Alc. N.food Serv. Wage Sosec. Wcol. Iprif OthIn. <200 <300 2 3 4 5 6 7 8 9 10 11

1 Food 2 Alcohol 3 Non-food 4 Services

33.8 2.6 19.5 5.0

30.1 2.5 23.9 5.8

2.4 2.7

3.9 6.7

66.0

72.9

5 Wages in enterprises 6 Soc. Sec. in enterpr. 7 Wages in collect. farm 8 Income from priv. farm 9 Other income 10 Hh.< 250 Rbl. p.m. 11 Hh. 250–300 Rbl. p.m. 12 Hh 300–350 Rbl. p.m. 13 Hh. 350–400 Rbl. p.m 14 Hh. > 400 Rbl. p.m. 15 Firms 16 Government 17 Capital 18 Agriculture 19 Mining & ind. 20 Services 21 Rest of world Total

26.3

2.7

0.9

3.5

38.0

2.0

4.0

3.6

53.4

2.4

5.7

4.5

57.0

2.5

6.5

4.2

280.8

6.5

38.8

19.5 404.3 49.2

150.3 66.5 143.2 20.5 180.6 11.5 26.4

2.5

61.6

28.4

236.1 23.0 220.5

61.6 455.5

150.3 16.1

55.9

488.8

Appendices 405

Institutions

Activities

Row

Total

<350 <400 >400 Firms Govern. Cap. Agric. M+ind. Serv. 12 13 14 15 16 17 18 19 20 1 Food 2 Alcohol 3 Non-food 4 Services

34.2 32.8 105.2 3.0 3.0 11.9 32.1 33.3 111.7 7.4 7.3 36.1

236.1 23.0 220.5 61.6

5 Wages in enterprises 6 Soc. Sec. in enterpr. 7 Wages in collect. farm 8 Income from priv. farm 9 Other income

29.7 152.1

88.0

150.3

13.4

1.3

1.4

16.1

2.9

55.9

226.2

488.8

30.2

66.0

22.8

72.9

25.1

94.1

23.9

96.9

100.8

459.5

99.4 281.1 115.0

4.7 8.0

41.7 188.9

47.0 130.1 47.9 622.0

184.3

41.0 269.5

307.6

21 Rest of world Total

48.3

32.4 230.2

18 Agriculture 19 Mining & ind. 20 Services

20.9 94.1 96.9 459.5

Source: Cohen (2002b).

455.5

14.0

53.0

10 Hh. < 250 2.4 Rbl. p.m. 11 Hh. 250–300 2.5 Rbl. p.m. 12 Hh 300–350 3.0 Rbl. p.m. 13 Hh. 350–400 2.8 Rbl. p.m 14 Hh. > 400 13.1 Rbl. p.m. 15 Firms 92.6 16 Government 5.9 6.6 47.7 17 Capital 11.5 13.9 146.9

273.7

496.9

395.4

7.1

63.9

23.1 49.0

496.9 11.6 47.0 16.0

395.4 435.8

2.8 0.7 288.8 212.7 173.7 1589.5 68.8

4.5 948.8

13.7

162.9

435.8 288.8 1589.5 948.8 162.9 6815.3

Notes

1

Analytical Framework for Understanding Economic Systems

1. See Eckstein (1971). 2. A market setting is equivalent to a firm setting, whereby goods are transformed (produced or exchanged) with the objective of creating for the transacting agents a maximum value added at lowest cost. Similarly, a feudal landlord-peasant setting is very close to a state setting. 3. The following are basic notations used in order of occurrence. g = setting, with specifications of types h, f, and s for household, firm, and state settings, respectively. i = agent, with specification of k for agents with state authority. m = economic system. B = benefits of agents. Q = costs to agents. V = value added from transformation in a setting type. E = engagement lines of transactions and communications of agents. N = intensity of engagement lines of agents. A = share of agents participating in a setting type. C = share of demanded commodities transformed in a setting type. L = labour. D = demanded commodities, specified by setting type in which their transformation is most suited. 4. The notions of loyalty, voice, exit, and entry, emphasized by Hirschman (1970), help explain the dynamics of social systems. Entry and loyalty lead to growth of settings and organizations. Voice and exit lead to their decline. If in communicating economic systems m1 and m2, performance m1 > performance m2, this will lead to tension in m2 (voice and exit) and pressure on m1 (hostility and entry). 5. There is a significant amount of literature, to be listed in the next chapter, that relate to logarithms of convergence that lay emphasis on the mechanisms of integration causing the spread and dominance of particular behavioural types, and that give support and background to our statement. The following mechanisms can be mentioned: imitation, convention, focal points, information cascades, reciprocal behaviour, group learning, social networking, and Markov chain inversions. 6. This means, for instance, that the economy and polity in the social system of the US are consistent with and reinforce each other to the extent that one can speak of an integrated whole of economy and polity. Likewise, Russia has a different social system, with its own consistently integrated economy and polity. A fruitful comparison of the US and Russian economies would require giving due consideration to their corresponding polities. 7. As agents in US are intensively engaged in firm settings where the profit motive dominates, the agents adopt this inclination when they participate in household and state settings, and over time these settings converge towards the same profit motive. In Russia the significant preoccupation of agents with state settings that pursue political motives tends to reorient agents’ behaviour in most settings towards a rent-appropriating political behaviour. 8. The point is elaborated in Chapter 8. 9. Historical records for India and China show that distribution of agents between the three distinguished settings has been intact for many centuries in spite of significant regime changes in the polity and economy. The point is treated at some length in Chapter 8. See also Maddison (1971). 10. Persuasion settings are not restricted to big developing countries only like China, India, Indonesia, Pakistan, Bangladesh or Egypt; they are also crucial in smaller 406

Notes 407

11.

12.

13.

14.

15. 16. 17. 18. 19. 20.

21.

countries with pockets of quickened modernization next to relatively larger numbers of agents living in traditional household and kinship settings, i.e. Iran and the Arabian Peninsula. For a discussion of the active role of persuasive settings in advanced economies, see Murphy and Shleifer (2004). Compare checks and balances restricting power of the state that were built by the founding fathers in the US Constitution and passed by the Congress in 1789–91, with the unlimited powers legitimized to the state by the Russian Revolutionary Council in 1917–21, about 130 years later. North et al. (2006) take the position that interactions between economy and polity are inseparable, which stops the analysis short of reaching fruitful conclusions. We argue here that there are proofs for the supremacy of the economy on the polity, and likewise the opposite. While in the US the focal points are the economy, firms, profits, and exchange, with a subordinated polity to the economy, in the Russian context the focal points are the polity, state, rent, and authority; and hence, a subordination of the economy to the polity. The countries of the Gulf Cooperating Council (GCC) are in order of population size: Saudi Arabia, United Arab Emirates, Oman, Kuwait, Bahrain, and Qatar. The World Bank labels the GCC countries generally as ‘high income: non-OECD’, which is true but less meaningful. There is no standardized definition of MENA. The countries included in MENA usually vary according to the subject of interest. In our context, we are close to World Bank practise, and as the GCC is considered separately, the MENA region consists in order of population size of Egypt, Iran, Algeria, Morocco, Iraq, Yemen, Syria, Tunisia, Jordan, Libya, Palestinian territories, and Djibouti. See Chapter 8 for country listings in developing regions. Canada, Australia, and New Zealand can be also categorized as most close to FIM. See Jackson and Deeg (2006). Korea, Singapore, Hong Kong, and Taiwan are categorized in the same group with Japan. See Beck and Laeven (2006). GCC countries are listed by the World Bank as high income non-OECD countries and are explicitly excluded not only from developing countries but also from the developed countries. The explicit inclusion of GCC in a comparative analysis of economic systems is essential in view of the distinct economic features of the region, and of the significant impact of the GCC on neighbouring regions. Examples are North Korea in EAP, Zimbabwe in SSA, Cuba in LAC. Another exception is the dominating alignment of state settings and belief settings as regards Iran in MENA.

2 Elaborations on the Analytical Framework and Its Application 1. This loss in X-efficiency may rightly be called the Soviet-disease, which can be strong enough to disable the patient. 2. See Banerjee (1992), Bikhchandani, Hirshleifer and Welch (1998), Frank (1988), Goodin (1993), Schelling (1978), Brueckner and Smirnov (2004), Simon (1993). 3. See Milgram, Sabini and Silver (1991), among others, on small world phenomena. 4. A clear example is that of norms which can be imposed by a higher organization such as prohibition of private ownership of means of production; this has been functional in the evolvement of the state ownership economic systems. 5. This can be extended to allow the D decision to stay or exit made dependent on the profile of the person as well, which can also change over time. 6. North et al. (2006) see a substantive degree of physical violence in primitive society as the pre-condition for the creation of state institutions, which they call a limited access order. This view is narrow and restrictive. They describe also a transition from

408 Notes

7.

8.

9.

10.

11.

12. 13.

14.

15.

the limited to an open access order in which the Western industrial democracies are classified, but they do not enter into the micro behavioural mechanisms that characterize the transition, and how features of the new order become typical and prevalent. Although the limited and the open access regimes have some correspondences with the state intensive and firm intensive economic systems that we have modelled in this chapter, our approach and the implications thereof are basically very different. Take y equal 100 and x and z fixed at 10% below and above y, and take I/K to be 100 implying 100 citizens per one state official, the transaction can then create in the extreme case an income for agent k of 200 as compared to 90 for agent i or i’. To secure a sustainable income, the state agents would pursue a measured exploitation. Too much extraction would cut into the earning base of agents i, i’, and threaten a reduction in the income of k. For brevity sake, we formulated state agents k as a unified party. Of course, an elaborate treatment would distinguish between governing agents and those aspiring to govern, bureaucrats and various intermediary groups and clients who are aligned to and are materially supported by the state. In spite of the tension between these categories of state and quasi-state agents, the presumption of self-enforcing arrangements among them to preserve their monopoly status and role in state matters is generally valid. Rent seeking can occur also in firm settings, but in a FIM the counteracting forces towards profit maximization would mobilize more firms to act for greater competition and free entry, which would make the realization of rent seeking only temporary and neutrally distributed over rent takers. Rent seeking in SIM is permanently institutionalized and is tied to the office of the authorized rent taker, whoever holds this office. Finally, the demarcation line between rent seeking and profit maximization is not arbitrary since profit maximization abides by the institutional rules that hold for all firm agents, while rent seeking in a state setting strives strategically to adjust and reinterpret the institutional rules towards the benefit of the state authority in the current and future periods. The checks and balances restricting power of the state in the US Constitution, passed by the Congress in 1789–91, stand in distinct contrast with the unlimited powers legitimized to the state by the Russian Revolutionary Council in 1917–21. The two shares are not independent of each other. For instance, Cf affects Af positively in the long run; while as relatively more agents go in f, thus increasing Af, the potential for demanding and producing the f type of commodities is enhanced, and thus Cf is influenced positively. In spite of the interdependence the two shares stand for different aspects that feature the identification of the economic system. It can be expected that the two shares correlate, which is an argument for following a simple aggregation equation and giving them equal weights in equation 3. The weights can be simply set at v1 = v2 = 0.5. See for example Simon (1993). This point can be highlighted when per capita demand growth gf in equation 6.1 is broken down into aggregate demand growth g f ˆ and population growth p, to give the following Aft = Afo (12lf ) t (1 + gf ˆ) t/(1 + p) t. A higher population growth p increases Aht and reduces Aft. A higher intrinsic aggregate demand growth g f ˆ drives the economic system away from household settings towards firm state settings. The same applies for equation 6.2 for the case of state settings. Prospect theory, due to Kahnemann and Tversky (1979) is based on the subjectives framing which agents apply to transactions they undergo. One of the many implications of relevance here is that utility becomes reference based. This means that when people assess utility they consider not only the value they receive but also the value received by others. See Chayanov (1966), Firth (1951), Herskovits (1952), Lipton (1968), Polanyi (1944), Sadie (1960).

Notes 409 16. This compares closely with the economic system in a state intensive system, SIM, where the economy can be viewed as being embedded in political relations and where the economic structure, conduct, and performance are by-products of the polity. 17. Although communist rule is past history in Russia, current checks and balances imposed by the state on business is overwhelming, to the extent that the state is in a position to canalize and determine the future of corporate firms to the advantage of state agents as well as apportioning rent sharing arrangements between state agents and corporate firms. 18. There is a third view that if there is a realized rent, then some rent sharing takes place between interest groups appropriating the greater part and state agents (politicians and bureaucrats) getting the remainder. 19. Krueger (1974) was among the first to point out to the negative behavioural consequences of the spread of rent seeking in society. 20. To be elaborated in Chapter 3. 21. See Jackson and Deeg (2006). 22. It is interesting to note that other thinkers, working from other disciplines than economics and using different argumentation, are arriving at similar conclusions on the inevitability of more reliance on sharing and persuasion mechanisms in running our complex social systems, i.e. Rosser and Rosser (1999). 23. The questionnaire collects information on different types of attitudes, preferences, and beliefs, as well as information on demographic and socio-economic attributes of respondents. The responding national samples vary from several hundreds to several thousands. See for more details http://www.worldvaluessurvey.org. 24. The score for the EAP region is greatly influenced by tendencies in China. The quick pace of economic growth in the periods between the last two World Value Surveys is accountable for a reduction of the percentage of respondents quoting family as ‘very important’ from 76.5 in 1995 to 60.2 in 2002. 25. Within the industrial countries the Anglo-American countries show a greater valuation for familial institutions than Western European countries and Japan. At the other end, Russia and the Baltic countries score lowest on the importance of the family within the transition countries and across the world at large. 26. The country group scores on family importance in Table 2.2 and on pro-private attitudes in Table 2.3, printed in bold, correlate positively and significantly with each other. The six observations for the industrial and transition country groups taken together give R 2 = 0.42. The six observations for the developing country groups taken together give R 2 = 0.54. However, the correlation is not significant when individual countries serve as observations. This is due to the influence of other intervening factors at the individual country level that need to be neutralized to determine a rigorous validity of the association. Correlations reported here are based on country group averages. These correlations allow for a simplified, though incomplete, way of eliminating the influence of intervening factors at the individual country level.

3 The Firm Intensive System: Economic Challenges and Agent Responses in US, EU, Japan 1. Most economists use the term perfect market economy. Our use of the term firm intensive economy is preferred here as it highlights the dynamics and significance of the spread of profit maximizing behaviour of the firm to other settings in the economy, without necessarily claiming full dominance of the profit maximizing behaviour. 2. Most figures in this chapter are adapted from Cohen (2001a). 3. For a review of compensation issues, see Johanson (1991) and Ng (1971). 4. For example, a private profit-maximizing railway company would close most nonprofitable railway lines, but the community might judge that this will severely reduce

410 Notes

5.

6.

7. 8.

9. 10.

11.

12.

13.

the welfare of citizens in remote areas or promote regional dissent; hence, government is called upon to take over production directly to run the industry in the interests of the nation as a whole. The results of various studies on the formulation of privatization programmes, which draw on the experience accumulated by staff and advisers of the World Bank, are reviewed in World Bank (1997), pp. 44–65. Deadweight loss and transfer bias can be related to each other via areas a, b, c, d, e in Figure 3.3. Under competitive conditions of Q0 and P 0 consumer surplus is the sum of areas a + b + c while a producer surplus can be shown by areas d + e. Under imperfect competition with Q1 and P1 consumer surplus is reduced by −b − c while producer surplus is increased by +b − e. This results in the net deadweight loss of areas −c − e. The monopoly position is not a permanent one in HIM, in contrast to SIM where the institutional setup allows a permanent monopoly position for the state authority. There are usually several gateways that can be recalled to justify the practice. These are (a) The restriction is necessary to protect the public where the use of the goods requires special knowledge or skill. (b) The removal of the restriction would deprive buyers and users of substantial benefits. (c) The restriction is a necessary defensive measure against an outside monopoly. (d) The removal of the restriction is likely to have an adverse effect on the general level of employment in some area, or is likely to cause a substantial reduction in the export trade. See also the paragraphs on the changing nature of industrial and trade policies under more globalization, Section 3.4.2. The thesis of Barzel (1989), pp. 49, is that ‘in the long run, ... the structure of rights is designed to allocate ownership of individual attributes among parties in such a way that the parties who have a comparative advantage in managing those attributes that are susceptible to the common-property problem will obtain rights over them’. Also termed STIP. As an example, a few European governments were uncertain that McDonnell-Douglas would stay in, and provide effective competition to Boeing, risking buying American planes in the future at highly set non-competitive prices; hence their commitment to launch Airbus. STIP worked well. Two decades later, the fused American incumbents, and Airbus have now roughly equal shares of world orders for bigger aeroplanes, and there is more global competition, this in addition to the positive external effects created from having an airline industry in Europe. See Neven and Seabright (1995) for an analysis of other global effects. Beason and Weinstein (1996) and El Agraa (1997) demonstrated this in a ranking of 13 Japanese industries by their annual output growth in the period 1974–90 from highest to lowest. The industries were also ranked by significance of industrial promotion measures they received. Four measures were reviewed: (a) subsidies share in sectoral output, (b) share of Japan Development loans to the sector in total loans to the sector, (c) effective tariff rates of protection for the sector, and (d) tax relief by sector. The results showed that some of the sectors with low growth rates received relatively high support. For example, the mining sector that had an annual growth of 0.19% ranked highest in subsidies and JDB loans. On the contrary, the highest growth industry like electrical machinery (rank 1) did not receive much support from the government industrial promotional measures (ranked at 8). Pooling all sectors together gave negative correlation between sectoral growth and sectoral support. It is also observed that the application of promotion measures across industries has not been very systematic: some sectors received high support in terms of one instrument but low support in terms of the other (e.g. textiles). The conclusion is that high growth industries do not seem to have received as much support as did the low growth industries. For example, a WTO panel rejected the complaint filed by US on behalf of American Kodak against Japanese Fuji for using non-competitive practices to dominate the Japanese market, because the WTO does not have jurisdiction over restrictive practises. See also Section 2.3 of this chapter on the overlapping jurisdiction on non-competitive

Notes 411

14.

15.

16.

17.

18.

19.

20.

practices across nations and absence of global standards. The phenomena can be seen as evidence of the lobbying power of incumbent firms in influencing national governmental attitudes towards international integration, which is characteristic of those firm intensive economic systems that are less open-to-open competition for all firms. According to Coase (1960), a property-rights arrangement of some sort can, in some circumstances, effectively deal with pollution. Note, however, that although in certain circumstances there is a ‘natural’ way to define the property rights, in many settings it is not clear who should have what rights. Apart from the problem of defining property rights, there is the difficulty of enforcing and transferring property rights, which are costly activities. There is no easy way to disentangle public goods by whether the prime demanders/users are firms or households. Firms and households use together, for example, security, airports, roads, communication networks, etc. However, some rough idea can be gathered from Box 3.7. To the extent that private consumption expenditure that includes spending on health, education, culture, community development, and the like associates more with public goods directed to households, while public capital expenditure tends to associate with public goods directed to firms; then Box 3.7 would suggest the ratio of household related public goods to firm related public goods is about 21% to 7%, or approximately three to one, on the average for FIM related countries. Note from the figure that while the poorest 20% of the population may have 5% of the income but does only 2% of the hours of work, the richest 20% receive 43% of the income but does only 35% of the work. It is the middle groups who do a larger percentage of the work than the percentage of income that they receive. There is a direct relationship between the percentage of the work performed and the percentage of income received by each of the five groups in Figure 3.10. The poorest and the richest groups each obtain a bigger fraction of the income than the fraction of the work that they perform, while the middle groups perform a bigger fraction of the work than the fraction of the income that they receive. This paradoxical feature of the distribution of income and work reflects the fact that the poorest families receive a large amount of their income directly from the government while the richest receive a large amount of their income in the form of dividends and interest. Among the modern contributors to the normative approach are Rawls (1972), Nozick (1976), Sen (1982), and Schotter (1990). See Cohen (2001a) for a discussion of the issues. The operationalization of the concept of blame-freeness by Schotter (1990) has very much in common with that of entitlements by Sen (1982). According to Schotter blame-freeness should have a unanimity requirement. All people in a relevant population should agree on what they call blame-free actions. Considering solely the judgement of representative, average, wise, judicial, or reasonable persons can weaken the requirement. The term ‘big trade-off’ is due to Okun (1975). The idea behind it is that to achieve greater equality taxes have to be imposed on more productive activities and transferred to less productive activities. Taxing people lowers their income and makes them work and save less. A reduction in factor supplies results in a smaller output and less consumption not only for the rich but also, possibly, for the poor. Furthermore, any redistribution must be administered by tax-collecting and transferring agencies, which costs recourses. If all these effects are considered the poor person may receive only a small proportion of the dollar tax collected from the rich person. As a result, for a growing economy the optimal distribution of income would always involve some inequality, because the total amount of income in society is not independent of how it is distributed. See Duncan et al. (1984) and Ulla (1984).

412 Notes

4 The Firm Intensive System: Polity Functioning and National Accommodations in US, EU, Japan 1. In pre-war and wartime Nazi Germany the collaboration between the state and large firms across the board was more or less the rule. Pockets of state-firm collusion can be also documented in some protected sectors and where the state is a major shareholder until recent times in individual countries, for example, aerospace in France. 2. This does not exclude state agents from behaving, at times, in benevolent or predatory ways in a FIM country, but the dominant behaviour of state agents in FIM will tend to coincide with the organizing principle of maximization of material benefits, which is the most widely spread behavioural type in the firm intensive system and related countries. 3. For example, Downs (1957), Hartley and Tisdell (1981), among others. 4. Most figures in this chapter are adapted from Cohen (2001a). Figures 4.4 and 4.5 are redrawn and modified making use of a priori reasoning in Stiglitz (1988). 5. This does not mean, however, that productivity increases are impossible in the public services. They do in fact occur, but only occasionally or at a very slow rate. The problem of introducing technological change in the public sector is that consumers expect a certain degree of labour content in the production of public services. As a result the scope for improving technology is very limited. 6. Even if the analysis is restricted to considering regulation and spending the task of determining the degree of state power is not an easy one. Comparative analysis of the degree of public regulation between countries is limited due to difficulties in standardizing diversified measures of regulation. In the case of public spending there are readily available comparative statistics on the extent of public spending. Sole reliance on public spending in assessing the influence of the state tends to underestimate the role of the state in the economy. There is some evidence for OECD countries of a positive correlation between the degrees of public regulation and public spending correlate. In such an OECD context, comparative shares of public spending in the GDP are helpful indicators in judging the relative influence of the state. See Borcherding, Ferries and Garzoni (2002) on the correlation between public regulation and public spending. 7. See Peacock and Scott (2000). 8. Attention was drawn to these aspects in Chapter 2, Sections 2.5 and 2.6. 9. See Chapter 3, Sections 3.5 and 3.6. 10. Bjornskov, Dreher, and Fischer (2005). 11. The studies referred to are by Boyer (2004) and Amable (2004). 12. US is closely followed by UK as having a liberally oriented economic system. 13. While the corporatist profile is typical of Japan and Korea, elements of this style are also common in Germany among some big corporate firms that encompass banking and state interests. Reconciliation, but at lower levels of decision-making such as regional or district levels, are also common for the Scandinavian countries. The so-called polder model, known for the Netherlands, which aims at reaching consensus among differing interests, fits also in the reconciliation variety. 14. The sharing features of the Japanese economy are documented and analysed in Weitzman (1984). However, the slow growth of the Japanese economy in the past two decades caused a rising unemployment and a weakening of sharing features. For instance, Peck (1986) pp. 430 investigates the recent tendencies for adoption of variable wages and labour layoffs. For elaborate accounts on the past and changing organization of the Japanese firm see Aoki and Dore (1996). 15. Alesina and Perotti (2004) emphasize the presence of dirigisme and rhetoric in the handlings of the EU Parliament and EU Commission and give examples from declared plans on competition policy, technology policy, and employment targets. On the other hand, the successful institutionalization and the politically independent

Notes 413

16. 17. 18.

19.

20.

functioning of the European Central Bank (ECB) is a significant indication of the strong characterization of the EU as a basically economically driven firm intensive economic system. Lindbeck (2003). See, for example, Alesina, Ditella, and Macculloch (2001), and Benabou and Tirole (2005). Alesina and Angeletos show that if a society, i.e. US, believes that individual effort determines income it will choose low taxes and low transfers. In equilibrium individual effort and market outcomes will be high and will be seen as confirming the beliefs. Conversely, if in the EU the belief is that wealth is determined less by voluntary effort than by involuntary precedents then the policy tendency is to tax more and redistribute. This leads to market distortions, estrangement of effort and benefits, and a self-sustenance of the belief and the associated policy. Benabou and Tirole (2005) develop similar models emphasizing interactions between a widely held just-world belief among the population and the followed laissez-faire policies, typical for the US, as compared to a widely held view of unfair outcomes and extensive welfare state policies typical of the EU. Their conclusion justifies the existence of two equilibria. Sinn (2002).

5 The State Intensive System: Past Polity of the Soviet Union and Allied Countries 1. This is different than a commercial setting where economic agents seek economic gains. 2. It is sometimes asked why did it take so long for the communist regime to fall given the mounting internal and external pressures? The answers lie in intervening circumstantial factors over the years that postponed the downfall, such as the cold war and mutual coexistence in world politics, which elevated the Soviet Union to a super power and the communist regime to a viable alternative social order whose promises can be seriously taken. Paradoxically, the Soviet claim for a super power diverted scarce capital resources to defence and space, accentuated consumer shortages, and reinforced the disintegration of the regime.

6 The State Intensive System: Economic Transitions 1. For a modelling of agent responses in transitional processes and an appraisal of outcomes under gradual and abrupt reforms, see Dewatripont and Roland (1996). 2. China, which is conventionally placed apart from the transition countries, is a case of gradual change. When broadly defined, examples can be extended to include India and many developing countries that introduced gradual liberal reforms replacing state control. 3. A meaningful disaggregation of BCEE would distinguish between the Baltic countries (Estonia, Latvia, and Lithuania) and Central European countries (Czech Republic Hungary, Poland Slovakia, and Slovenia), and the remaining Eastern European countries. The Baltic and Central European countries formed the first batch of new members in the EU. Presentation of data in this chapter will follow this ordering. 4. See Garibaldi et al. (1999). 5. See De Mello et al. (1997), and Falcetti, Raiser, and Sanfey (2000). 6. See Fischer and Gelb (1991) and Fischer and Sahay (2000). 7. Values for 1995 and 2005 are in columns 6 and 7, Table 6.7. These are plotted among values for other years in Figure 6.3.

414 Notes 8. The index is a weighted average of estimates of liberalization of domestic transactions (price liberalization and abolition of state trading monopolies), external transactions (elimination of export controls and taxes, substitution of low to moderate import duties for import quotas and high tariffs, current account convertibility), and entry of new firms (privatization and private sector development). The weights on these components are 0.3, 0.3, and 0.4 respectively. See World Bank (1997), pp. 14. 9. The index scores nations on 10 broad factors of economic freedom using international statistics in ten areas relating to business:. state regulation, foreign trade, fiscal sphere, government practices, monetary sphere, foreign investment, banking sphere, property rights, black market, and labour market. The 10 factors are averaged equally into a total score. A score of 100 signifies an economic environment or set of policies that is most conducive to economic freedom. See http://www.heritage.org/research/features/index/ countries.cfm. See also Box 3.2, in Chapter 3, which reflects on the ranking of FIM countries with regard to the same index. 10. See Section 6.2 above. See also Fischer and Sahay (2000) 11. The GDP figures in this ratio are in billion US$ in constant prices of 2000. The ratio for 2005 is shown in Table 6.2, column 8. 12. This holds for most Central and Eastern European and Baltic countries 13. For example, in Russia and some ex-Soviet republics. 14. Governance structures in US and EU and Japan were shown in Chapter 2 to differ with US as the example of an outsider governance and EU and Japan as combining outsider and insider governance. 15. Russian firms face a large number of different taxes and business fees. Broadman (1999) lists 11 types at the national level, 4 at the republic level, and 15 at the local level, 30 in total. 16. See Cohen (2001) for an analysis of recent performances of these emerging markets and the risks that they bear for portfolio investors in these markets. 17. Risk and uncertainty leading to adverse selection and moral hazard, discussed so far in the framework of principal–agency theory, can be placed more generally in the framework of property rights theory. Barzel (1989) defines ‘property rights of individuals over assets’ as ‘rights, or the powers, to consume, obtain income from, and alienate these assets’. To obtain income from an asset and to be able to alienate it, exchange is necessary (usually through contracts). So, property rights are very much influenced by past-accepted behaviour, but they are not constant. Property rights change too as a result of people’s own effort at protecting these rights, as well as other people’s capture attempts, government protection, and technological changes. 18. These are sale of parliamentary votes on laws to private interests, sale of presidential decrees to private interests, mishandling of funds by the central bank, sale of criminal court decisions, sale of commercial court decisions, contributions paid by private interests to political parties, and election campaigns. 19. While Jeltsin’s presidency relied for its survival on support from the wealthy oligarchs in exchange for political influence (and economic gains), Putin’s presidency went after eliminating the political influence of oligarchs. The prosecution and jailing of the top man of Yukos is seen by many observers as a case in point for the tacitly held standpoint by the Russian polity that while politics is for politicians, economics is for businessmen, and the state. This standpoint on the division of spheres of influence can be seen as a subtle modification on the actual division of power that existed before the transition, and hence allowing Russia to hold to major features of the state intensive economic system. 20. Foreign exchange reserves of Russia are reported to amount to US$ 243 billions per end of June 2006. According to Olivier and Ranciere (2005), foreign exchange reserves of Russia hold fourth position after China, Japan, and Taiwan. 21. The three Baltic countries show an average poverty headcount of 40%, which is double that of the BCEE group as a whole. This has to be considered in the context of a deeper

Notes 415 recession in the Baltic than in BCEE. Real GDP decline amounted to an average of 45% in Baltic, as compared to 28% for BCEE. In later years, GDP increased at higher rates in Baltic, and poverty headcount lowered to comparable levels with BCEE. 22. The New Russia Barometer Survey found that in early spring 1998, three in five Russians routinely did not receive the wage or pension to which they were entitled; quoted in Rose (1999). 23. Most Russians are not socially excluded – they have a variety of networks on which they can rely. The New Russian Barometer Survey, quoted in Rose (1999), finds that from 60% to more than 90% can draw on some social capital in hard times. Among the surveyed persons, 66% report that they could borrow a week’s wages or pension from a friend or relative. Only 7% of Russians place themselves at the bottom, feeling no control of their lives. 24. In most transition countries the aged population above 65 years forms about 20 to 25% of the population. Other eligible persons for social transfers and employment benefits count about 5 to 10%. On average, coverage of public transfers for income maintenance is about 30% of the population. If the norm for income maintenance is fixed at 50% of the average GDP per person, then the requirements for total public transfers for income maintenance as a share of the GDP can be rounded at 15%.

7 Economic Systems in the Developing World: Regional Differences 1. Understood as traditional comprising rural, informal, and modern comprising urban, modern. 2. This is a case where the kinship setting has its bearing on the state setting. 3. See Acemoglu, Robinson, and Verdier (2003) on kleptocracy. 4. Some military leaderships succeeded in transforming their military into civil regimes that were subsequently nationally endorsed, i.e. Egypt, Libya, Indonesia, among others. 5. Religious identity combined with regional ethnicity form the backbone of separatist movements in India (Kashmir) and Indonesia (Banda Aceh), and less pronounced confrontations in China, Malaysia, Thailand, and Philippines. 6. See also Szirmai(2005), pp. 448–49, and 452, for a similar analysis. 7. Civil casualties are high in Colombia and some Central American countries. 8. Caldwell et al. (2006). 9. Section 7.4 of this chapter will elaborate further on the dualistic nature of the economic system. 10. See related works of H. Chenery, S. Kuznets, and W.A. Lewis among others. For an updated review see Ranis (2003). 11. Among the successful examples of achieving an early outward balance are Korea, Hong Kong, Taiwan, and Singapore, which served as leading examples that countries of the EAP and SA would follow later on. Although China and India are relatively latecomers in the outward orientation, the large size of their economies and diversification allows them to capture accelerated gains in world exports. Brazil, Mexico, Chile, and Argentina took the lead in the outward orientation in LAC. 12. See Myrdal (1968) on agrarian reform, and Griffin (1972) on the green revolution, and Cohen (1978) on related aspects between agrarian reform and the green revolution. 13. See Rosenstein-Rodan (1943) on the ‘Big Push’, and Krugman (1981) on economies of scale and scope. 14. See World Bank (1997) on privatization in LDC 15. In a later section on economic performance, Table 7.7 shows EAP and SA to be far ahead of MENA and SSA in economic growth. LAC occupies an intermediate position. 16. Mohan et al. (2000) elaborate on differences between SSA and other developing regions regarding the functioning of the state and its bias towards liberalization.

416 Notes 17. See Chapter 6 of this book. 18. Results are marginally different whether agent interaction in the services sector is distributed proportionately or evenly. For the sake of simplicity we choose a proportionate distribution. 19. GCC is the exception. Among developing countries, GCC is accordingly closest in distance to the FIM economic system. 20. These are average figures for main countries of EAP. To grasp country differences it can be reported that China accounted for 4.5% of EAP’s share of 16% share in world manufactured exports in 2000. Behind the average of 42% for manufactured exports/GDP in 2000 is China with 20% , Indonesia 23%, Korea 34%, Thailand 43%, Philippines 49%, and Malaysia 88%. 21. The foreign debt crises raised a debate on whether poor developing countries could repay their debts and sustain economic development simultaneously. The debate was followed by initiatives by the IMF and donor lending countries to cancel out and reprieve the debts for poorer developing countries. The reprieve was often coupled with the condition that the developing country formulates and implements a poverty reduction strategy. 22. The leading Asean countries were those most affected by the financial crises that started in Thailand. China was financially less globally integrated at the time and was less affected. 23. See Chapter 5, Table 5.3, for the comparative growth accounting analysis and results between FIM and SIM related countries. 24. See calculations in Bosworth and Collins (1996) and reviews in Crafts (2001). 25. It is also generally conceived that exchange rates based on ppp are realizable equilibrium rates in the long run. In Chapter 10, Section 10.7, several GDP forecasts are examined. These forecasts conclude that one-third of the growth of developing countries can be accounted for currency appreciation towards their ppp exchange rates. 26. SA has higher percentages of the population living below the poverty line, reflecting the lower income per capita in SA. 27. The share of the foreign population working and temporarily residing in the GCC is remarkably high. In the United Arab Emirates, for instance, foreign labour is 90% of the labour force, and the foreign population is 70% of the total population. The average earning of a foreign worker employed in construction or services is estimated at one-fourth of the average earnings of a national public sector employee, this next to rights that give significant benefits in kind to nationals. On the other hand, earnings by the foreign worker, mostly from India and other SA countries are about four times the opportunity cost in India. Assessment of income inequality in such a setting is ambiguous because of the lack of applicable analytical standards. If the analysis takes income per household as the base then foreign workers, who are mostly one-person households, are shown to be well off. This opens uncertain questions, such as should remittances to country of origin be deducted? Should the migration premium paid and other migration costs be deducted? See Cohen (2000) for elaboration and more data. 28. Although there is a lengthy empirical literature on determinants of income inequality in developing countries the applications do not treat at length the income inequality differences between regional groups. Some works have come very close to that; see among others Ravallion (2003). 29. See Section 4 on examples of splitting up a sample of establishments in sub-samples of the formal and informal sectors. For a discussion of the institutional framework of the informal sector, see Mead and Morrison (1996). 30. Schneider and Enste (2000) use various methods to estimate the size of the informal/ shadow economy in various economic systems, defined in the sense of activities that contribute to the gross domestic product, GDP, but that are currently unregistered in the context of tax levies. Although there can be differences in opinion on what to include in the informal as compared to the shadow economy, there are overlapping as

Notes 417

31. 32.

33. 34.

35.

36. 37. 38.

39. 40.

41.

42. 43.

44. 45.

well as correspondences between the two that make such estimates relevant and debatable. They find the average size of the shadow economy in industrialized countries to be about 12% of the GDP, in transition countries at 23%, and in developing countries at 39%. Other sources tend to give higher estimates of the share of the informal/ shadow economy in some individual transition countries, but lower estimates in the case of developing countries, than those just mentioned. It is important to underline, however, that the share of the population that is associated with the informal sector in developing countries, which may vary from 25% to 75% of the total population, is many multiples of that in either industrialized or transition countries. For a comprehensive sourcebook on measurement of poverty and reduction strategies, see Klugman (2002). For instance, in rural India, unorganized employment is 99.6%, with only 0.4% for the formal segment, see Chapter 8, Section 3.2.3, Table 28. In China, most rural employment is of the collective type where traditional and commercial modes are combined, Chapter 8. In SSA, rural employment is predominantly traditional. See Table 7.4, last column. The significance of the informal versus the formal sector is even higher than the figures suggest, as the average family size in the informal sector is greater than the formal sector. International forums quote usually higher shares of poverty, this is partly the case when one refers to the total population instead of total households, or to mediumand small-sized countries in the poorest regions, or when poverty standards are uniformly fixed at a higher level, resulting into absolute rather than relative measures of poverty. See Chapter 8, Section 3.2.3, Table 28. See Cohen, S.I. (2002a). We assume for a typical developing country receipt and payment transactions of government and rest of world as exogenous, so that the remaining variables can be treated as endogenous variables. The output multipliers are higher than the income multipliers due to leakages into intermediate inputs and imports and undistributed earnings of institutions. SAMs of Indonesia were assembled by Biro Pusat Statistik Indonesia (1982) for the calendar years of 1975 and 1980, respectively. The assembled version we shall adhere to is one that falls into an oversized chessboard of 28 rows and 28 columns. For the purpose of this chapter we aggregate the results of the multiplier analysis for Indonesia to represent in some approximate ways the division between a predominantly informal sector and a predominantly formal sector, and the division between households with a high incidence of poverty, and the better-off households, see footnote to Table 7.2. The source of the SAM of Pakistan is PIDE (1885). The multiplier results are aggregated to approximate the distinctions of formal and informal sectors, and of rich and poor groups; see footnote to Table 7.3. This phenomenon supports the contention reached earlier that there can be relatively more incidence of poverty in smaller than bigger countries. Cottage industries, tiny industries = 1 to 4 workers. Small industries = 5 to 20 workers. The difference between cottage and tiny enterprises relates to the nature of the product: traditional versus non-traditional, respectively. Small industry is the outgrowth of tiny industries. The 181 enterprise units are distributed on industrial activities as follows: food 46, textiles 19, wood 36, printing, chemical, and non-metal 29, meta1 23, miscellaneous, workshops 28. Moving to the modern sector often requires received modern education that is more present in the second than the first generation. The subdivision was accomplished as follows. A sliding scale of five indicators was designed and applied. The five indicators were the share of hired workers; share of local sources of raw material; share of local outlets of product scales; size of fixed

418 Notes capital investment and whether the enterprises is legal1y registered. For each of these five indicators threshold values were specified for qualifying in the modem segment. If an establishment is assigned twice or more times to the modern segment then it was counted as definitely belonging to the modern segment. The other establishments were then counted as belonging to the traditional segment. The subdivision resulted into the grouping of 153 firms (19%) in the modern segment and 653 firms (81%) in the traditional segment. The empirical results on averages and standard deviations for 30 other indicators on enterprises characteristics showed that the resulting division of the sample in the two segments is significant and analytical1y consistent with economic theory. 46. Cf. Lipton (1977) and a contemporary overview of the urban bias in Eastwood and Lipton (2001).

8 Economic Systems in the Developing World: Country Profiles 1. See Chapter 1 note 20. 2. Certain aspects in two other major countries, Indonesia and Pakistan and Indonesia, belonging to EAP and SA, respectively, have been treated at some length in the previous chapter. 3. The financial crisis of 1997–98 started with currency devaluations and was quickly followed by defaults in debt repayment, cuts in spending, and a recession. Main causes of the crises are overinvestment by many suppliers, weak internal governance of bankers, business and government allowing corruption and non-transparency, greater exposition to external movement of financial capital and speculation. The recession was further reinforced by the weak performance of Japan, which is a major buyer and investor for the region. 4. Here are some countries that experienced long periods of military rule, civil instabilities, and political and economic isolation from other countries in EAP. The economies of Cambodia, Laos, and Myanmar are least industrialized and most inward oriented when compared with other EAP countries. 5. See also Chapter 2, Section 5 on the construction and implications of the index for dominance of economic systems. 6. See ‘The Asian Model’ in Gregory and Stuart (2004) and Pryor (1980). 7. These special treatments were among the causes of the financial crises of 1997. 8. UN projects an urbanization level for China in 2030 that slightly exceeds 50%. 9. This view will be subjected to modifications when we deal with the economic system of China in the next section. 10. Simon Kuznets was the first to point out the positive relationship between economic growth and income inequality that tends to occur in the take-off stage of economic development. The relationship has been empirically verified in many studies that use cross-section as well as time series analysis. While the direction of the relationship is established, the degree of the trade-off differs among the countries examined. The results of Table 8.3 suggest that the trade-off between growth and inequality is higher in China than in other EAP countries. 11. The population figures are quoted in Maddison (1998), pp. 20. The urban estimates are based on Rozman (1973), pp. 279–82, in accordance with descriptive definitions denoting urban settlements. The 5% urban population in the tenth century contrasts with about 30% urban population at the end of the twentieth century. 12. The first view is elaborated in Kerr et al. (1977), the second view in Wong (1988). Both views are evaluated and the second is given more empirical support than the first in Whyte (1996), pp. 37–57. 13. Gernet (1982), pp. 393. 14. Moreover, according to Maddison (2003), China’s share of the World GDP until the beginning of the seventeenth century was higher than that of Europe. The

Notes 419

15. 16. 17. 18. 19. 20.

21. 22.

23.

24.

25. 26.

27.

28. 29. 30. 31.

32.

historical statistical estimates by Maddison of the GDP for major regions are displayed in Chapter 10, Figure 10.3, where we examine catch-up and reverse tendencies in the GDP size of competing world regions. There were the major reforms. For a fuller list of minor related reforms in agriculture see Perkins (1988), pp. 609. See Walder (1996), pp. 74 and 78. See Perkins (1988), pp. 612. Provinces in China have 30 to 40 million populations. For elaborations see Perkins (1988), pp. 614, and Walder (1996), pp. 146. Table 8.8 shows that in 2000 the state owned enterprises contributed 23.5% of the gross output, in the third row; while all state owned and state holding enterprises contributed 47.3%, in the P.M row. The figures for 2003 are 13.0% and 37.5%, respectively; reflecting thus the greater indirect role of state participation in state holding enterprises. This stands in contrast with Russia where the hierarchical structure is based on functions and specializations and is more of the U-form. For example, Qian and Xu (1993) show that comparable figures for China and Russia in 1988 were 75 and 290 for food processing, 80 and 402 for textiles manufactures, and 145 and 806 for other manufacturing. Taking a simple average gives a SOE size for China of 100 compared to Russia at 499. The figures for Czechoslovakia, Hungary, and Yugoslavia were 3713, 564, and 352, respectively. See Li (1996) pp. 1–19. The argument is that when local government may block entrepreneurial growth, it becomes efficient to invite it in sharing the ambiguous ownership. Furthermore, because claims for compensation are settled ex-post, individual agents as well as bureaucrats may be inclined to put more work effort during the year and use the records to support higher claims ex-post. These incentives would realize higher outcomes for the whole. This is reflected in Table 8.8 showing that in 2000 collectives and cooperatives produced 11.2% of the GDP, while the commercial companies produced 36.7%. The comparable figures for 2003 of 8.9% and 62.5% respectively, show the dominant role of the commercial companies in shaping the industrial structure. Maddison (2003), pp. 84 For instance, Chinese exports in real terms doubled from 1970 to 1978, and rose by about tenfold by 2000. The share of manufactured goods was very small in 1970, this expanded to around 90% in 2000. The share of manufactured exports by foreign direct investment enterprises and joint ventures in total manufactured exports increased from 1% in 1986 to 29% in 1994. Sources: The China Quarterly, various issues over 1992–2000. The balance of foreign debts amounted in 2003 to 1936 (US$ 100 million), against foreign exchange reserves of 4033(US$ 100 million). Half of the debts were international commercial loans; the rest was evenly divided between loans from international financial institutions loans from governments and trade loans. Source: China Statistical Yearbook, 2004. See Chapter 4 on growth limiting effects of higher public shares. Bosworth and Collins (2007), appendix table 4. Annual growth rates of consumption expenditure per capita in 1985 prices are from Perkins (1988), pp. 636–38. Incidence of extreme poverty in rural China under the expenditure line of $0.5 a day has been estimated at 4.5% of the rural population for 1990–91; and falling down to 3.0% in 2002, Yuan (2006). At an expenditure line of $1.0 a day the poverty headcount ratio is estimated to jump to 7.0% in 2002. In India, where the PHR is significantly higher than in China, absolute poverty can override relative poverty as a major issue of socio-economic performance of the economic system.

420

Notes

33. In 2003, the RAND Corporation identified and assessed eight major risks to the continued rapid growth of China’s economy over the next decades, including among others, financial fragility, pollution, unemployment, HIV/AIDS. The probability of these adverse developments occurring before 2015 was considered as very low. See http:// www.dni.gov/nic/NIC_globaltrend2020_s2.html 34. Pittinsky (2005) coins the term ‘Allophilia’ to denote positive inter-group attitudes. Allophilia is essential for the success of persuasion settings. Foundations of strong intragroup leadership are often stepping stones to inter-group conflict. There is an ingroup– outgroup leadership trade-off. This trade-off is minimum where there is allophilia. 35. The philosophy of Confucius emphasized personal and governmental morality, correctness of social relationships, justice, and sincerity. Confucius moral system appreciated duty, empathy and understanding and cooperating with others Although Plato’s blueprint of the Republic is archaic by today’s norms, Plato assumed that some persons, a selected niche of wisemen, are more equipped than others in the above-mentioned traits; in his view such persons should be the leaders of the polity, and they should demonstrate exemplary behaviour for the rest of the population. 36. This is higher than China’s dominance in EAP, which has an index of 70%. 37. At the turn of the century, external liberalization and opening up of financial markets in SA reached comparable levels to those in EAP, while state enterprises in India and Pakistan counted about 10% of the industrial output, compared to EAP with about highest in China and least in Philippines. 38. In 2000, ODI/GDP figures in SA amounted to the following: India = 0.32% , Pakistan = 0.96%, Bangladesh = 2.39%, Sri Lanka = 1.80%, and Nepal = 6.82%. Source: World Development Indicators database. 39. Myrdal (1968). 40. For example, Thorner (1956), Myrdal (1968), Bardhan (1974), Joshi (1975), and Cohen (1978). 41. Some compare India with China in this respect and suggest that the caste system in India associates with the relative passivity of India towards foreign invaders and rulers in the past as compared to China that is free from the caste system and is more nationally assertive. 42. It was estimated that a third of the domestic net savings was transferred out of the economy to overseas, with negative effects for economic growth. Similar tendencies applied to occupied colonies elsewhere, see Acemoglu, Johnson, and Robinson (2001). 43. While economic performance was lagging under British rule, contrastingly it is generally acknowledged that modern political institutions with a British accent prospered remarkably. 44. This is the group of capitalist farmers in embryo, in the womb of the old order, and their power was to grow remarkably in later years, Byres (1974). 45. A main advocate of this is Joshi (1975), pp. 96. A sophisticated analysis of this type can only be suggested here. Presently, the scope must be a limited one. In spite of his call for a disaggregated approach, Joshi does agree that for India as a whole, which is our reference here, the duality of behaviour between landholding and landless households in rural India and the political dominance of the first on the second, are undeniable. 46. Exemplary of the duality and the opposite life styles and viewpoints in India is that while Gandhi extolled the traditional village community with its focus on agriculture as the ideal economic organization. Nehru went for modernization and the need for its realization via the state machinery and an industrialization strategy. 47. Democratization started when a group of concerned British citizens in India and well off Indian professionals gathered in Bombay in 1885 to form a political debating society, the Indian National Congress. After 1900, the Congress party led the drive for a home rule that encompassed elected assemblies and parliamentary procedures. The Congress party played a crucial role in passing the Indian Constitution in 1951.

Notes 421 48. See Chapter 10. 49. This early character of state planning and regulation reflected the orientation of the field of development economics in the 1950s, 1960s, and 1970s in which Indian economists and statisticians were actively engaged, i.e. P.C. Mahalanobis and S. Chakraverty, the economic and political successes of the Soviet Union, the extended employment in the public sector and the related enhancement of bureaucracy, and the traditional urge to secure a living for the great numbers of self-employed and small establishments and protect them from large-scale competition. 50. Joshi and Little (1994), pp. 327. 51. Rodrik and Subramanian (2004) introduced the distinction between the two reform phases. They argue that the policy change in the 1980s was not motivated by a desire to enhance the economy but was grounded in political calculation (faced by the threat of the Janata party, the Congress party and its two Gandhis went for business rather than socialism to mobilize political support). They find evidence for their view in a more pronounced post-1980 growth in states where the ruling state government was in alliance with the national government (under Congress Party). Furthermore, India is about 15% to 25% lower than its steady state of income given its strength in economic and political institutions, so that what was required was some ignition to bring the country back on track. The evidence also shows that the beneficiary of the attitudinal shift was the formal sector, built up under the earlier policy regime that was highly state oriented. 52. Annual economic growth dropped to around 4.0% in 1984–88 from its height of 7.2 in 1980 but rose again to stable rates of 6.0% and above from 1993 onwards, coinciding with favourable effects of the liberalization reforms. 53. See Table 8.23 and related footnotes. 54. In terms of GDP modern services form only 40% of all services. Traditional services account for 60%, Table 8.21. 55. This does not mean that India has a disadvantage in the export of manufactured merchandise. About two-thirds of Indian exports are goods, and 70% of which are manufactured merchandise; Tables 8.23 and 8.24. The comparative advantage argument relates to relative accents. 56. In 2000, manpower with higher education in India was 5.6% of the labour force, in China 3.1%. See Bosworth, Collins, and Virmani (2007). 57. Figures reported in Arora and Athreye (2001) for software production between 1995 and 2000 show revenue per employee/wage in India to amount to 2.2 compared to Israel 2.6, Ireland 1.2, France 2.1, Finland 1.2, and USA 1.3. 58. Sources of foreign exchange reserves (FER) accretion differ among accumulating countries. India’s FER are driven by foreign capital inflow, this applies to many LAC countries as well; Russia by a trade surplus; and China and a few other Asian countries combine capital account and foreign trade surpluses. On end June 2006, FER of India amounted to 157 US$ billion behind China 944, Japan 850, Taiwan 262, Russia 243, and Korea 226. See Olivier and Ranciere (2005) on FER and their optimal level. 59. Bosworth and Collins (2007), appendix table 4. See also this chapter, Section 8. 2.2.3., explanations for China below after Table 8.15 60. For the organized segment a profit part should be deducted from the GDP/Employment index to obtain wage rates. 61. Some support for this view lies in the following. The Indian economy has been able to expand its foreign orientation through private entrepreneurship and despite existing labour and investment regulation barriers and poor infrastructure. There is more potential for exports and FDI to be realized when state interventions are removed, and public investment in modern industrial infrastructure is done. As China has already passed this phase, there is less leeway ahead. Furthermore, the energy and pollution contents of Indian economic development are less than in China. Indian multinationals appear to have more success than Chinese multinationals entering the foreign

422

62. 63. 64. 65.

66. 67. 68. 69. 70. 71. 72. 73. 74.

Notes corporate market. Outward movement of factors to ROW involves both labour migrant agents and capital in the case of India, but solely capital in case of China. However, China can afford to do much more than India in terms of foreign exchange reserves. In 2006, China had 944 US$ billion FER, India’s 157 US$ billion about five times as much. See Chapter 10, Sections 10. 7 and 10.8, and Box 10.1. Abed and Davoodi (2003). The unemployment rates for major MENA countries in 2000 were Egypt 8%, Iran 16%, Algeria 30%, and Morocco 14%. Cf. Gardner (2003). In the period 2000–05, the percentage of foreign labour in the total labour force amounted to 90% and above UAE and Qatar, was in the range of 75% to 90% in Kuwait and Oman, and in the range of 60% to 75% in Saudi Arabia and Bahrain. Cf. Cohen (2008) Cf. Cohen (2008). See Posner (1980), Collier (1998). See Nkurunziza and Bates (2003). Rodrik (2008). Nkurunziza and Bates (2003) See Chapter 7, Table 7.15. UNDP (2007). That is, various whites, native, mixed, and black.

9 Comparative Performance of Countries Relating to Different Economic Systems: A Social Accounting Approach 1. See, for instance, Koopmans and Montias (1971). 2. Bornstein (1979) calls these comparative systems and comparative economics. The first studies the entire economic system. In contrast, the comparative economics approach is a partial or sectoral view which compares economies in relation to certain components, for example, labour markets, the nature and operation of large enterprises, agricultural organization, or the conduct of foreign trade. 3. See Chenery, Robinson, and Syrquin (1986). 4. See among others Cohen (1989) and Pyatt (1991). 5. The disaggregated SAM tables and details on their construction for the six countries are found in Cohen (2002b). This material forms the sources for tables in this chapter. 6. For example, for average S-system the ratio GDP/Gross output is (35.2 − 19.4)/35.2 = 0.45, or alternatively obtaining value added as the sum of labour and capital returns (11.5 + 3.2)/35.2 = 0.45. 7. The closure for Russia and China is thus different than for Western and Eastern European where the expenditure of the capital account was considered endogenous. 8. See equations 8, 9, 10, and 11.

10 Long-Range Convergence and Displacements in Economic Development and Interactions between Economic Systems 1. Should one consider economic welfare variables other than income per head, such as attainment in education or health, then the catching-up trends are very significant and beyond doubt. 2. m is a weighted sum of multipliers by sector, i.e. y = ¦ v m v X v = ¦ v m v s v X = m X , where sv is sectoral share of the exogenous variable X. 3. The sum of equation (6.1) does not tally to one because of unweighted values over sectors and countries. The same applies for equation (6.2).

Notes 423 4. Their forecasts for the first ten years show that they were not out of line with IMF estimates of potential growth. Furthermore, they generated similar results from applying an econometrically estimated economic growth equation with related arguments to theirs such us the initial income per capita, investment rates, population growth, and educational effort. See Wilson and Purushothaman (2003). 5. More studies along the same lines have focused on second-rank countries in the developing world, including among others Indonesia, Thailand, Egypt, Iran, South Africa, Nigeria, Mexico, and more on Brazil. See Cooper, Antkiewic, and Shaw (2006), among others. 6. See among others Fogel (2007). 7. See Chapter 8 Sections 8.2.2.3 and 8.3.2.3. 8. It can be argued that as China and India become richer they would substitute the MPM profile for the FIM profile, so that the FIM would become more prevalent globally and thus causing no pressures of change on the FIM related countries of US and EU. However, our analysis of Chapters 7 and 8 have emphasized that the size and distribution of the population (agents) in China and India would allow a limited absorption of agents in firm settings; and therefore, a prevalence of an MPM-environment rather than an FIM-environment. 9. See Sinn (2000) for elaborations on consequences of the new systems competition and protectionism. 10. The call by Germany to veto take overs of EU companies by Chinese and Russian state controlled companies is a case in point. The French opposition to India’s Mittal takeover of Arcelor is another, as well as the French policy of close collaboration between companies and the state to strengthen and consolidate French global industrial players. 11. There are in the US indications of concerted interventions to prohibit Chinese take overs in the energy sector as in the case of the unsuccessful bid by the Chinese oil company CNOOC for the California-based oil producer Uncoal. On the other hand, in less strategic sectors, no obstacles were laid down when parts of American IBM were sold to China’s LP, without raising controversy. 12. See Rosser and Rosser (1999). 13. In support of a behaviourist paradigm the following can be added. Baumol (1986)’s study of national income convergence patterns suggested that there are clubs of countries that show different performance patterns, i.e. the Western developed bloc, the ex-Soviet bloc, and loosely defined regional groupings of developing countries. The differences could not be explained in terms of long-term changes in economic development. The clustering, in our opinion, suggests that the economic performances in these blocs are different because their economic systems are embedded in different societal orders that are dominated by different behavioural types.

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Author Index

Abed, G.T., 422 Acemoglu, D., 3, 415, 420 Aghion, P., 189 Akerlof, G., 75 Alesina, A., 48, 141, 412–3 Amable, B., 412 Angeletos, G.M., 141 Antkiewicz, A., 423 Aoki, M., 412 Arora, A., 421 Athreye, S., 421 Atkinson, A.B., 103 Audretsch, D.B., 86

Caldwell, P., 415 Chayanov, A.V., 408 Chenery, H.B., 386, 422 Choi, J.P., 207 Clark, C., 386 Clements, B., 216 Coase, R.H., 77, 411 Collier, P., 422 Collins, S.M., 295, 315, 318, 416, 419, 421 Cohen, S.I., xxii, 92, 260, 351, 392, 409–22 Cooper, A.F., 423 Crafts, N., 416 Cullis, J., 116

Banerjee, A., 407 Bardhan, P.K., 420 Barrett, S., 92 Barro, R.J., 3, 379, 380 Barzel, Y., 76, 410, 414 Bates, R.H., 422 Baumol, W.J., 122, 379, 423 Bayens, R., 392 Beason, R., 410 Beck, T., 3, 411 Becker, G.S., 34, 37 Benabou, R., 141, 413 Berliner, J., 120 Bhargava, S., 79 Bikhchandani, S., 407 Bjornskov, C., 412 Black, B., 191 Blanchard, O., 189 Bleaney, M., 377 Bokros, L., 217 Borcherding, T.E., 412 Bornstein, M., 422 Bosworth, B., 315, 318, 416, 419, 421 Boycko, M., 191 Boyer, R., 412 Broadman, H.G., 192, 414 Brown, E., 415 Brueckner, J.K., 407, 411 Buchanan, J.M., 39 Byres, T.J., 420

Davoodi, H.R., 422 De Mello, M., 413 De Soto, H., 252 Deeg, R., 3, 409, 411 Denizer, C., 413 Dethier, J.J., 217 Dewatripont, M., 414 Ditella, R., 141, 413 Dore, R., 412 Downs, A., 125, 412 Dowrick, S., 379 Dreher, A., 412 Duncan, G.J., 411

Caldwell, B.K., 415 Caldwell, J.C., 415

Earle, J.S., 189 Eastwood, R., 418 Eckstein, A., 406 Eggersston, T., 163 El Agraa, A.M., 410 Ellman, M., 164 Enste, D., 416 Ergas, H., 85 Estrin, S., 189 Falcetti, E., 413 Ferries, J.S., 412 Filatotchev, I., 189 Firth, R.W., 31, 408 Fischer, J., 412 Fischer, S., 170, 181, 413–4 Fisher, A., 386 Fogel, R.W., 393, 423 Fox, K.A., 3, 22

433

434 Author Index Frank, R., xxii, 407 Fries, S., 200, 203

Krugman, P.R., 380, 415 Kuznets, S., 252

Gabisch, G., 141 Galbriath, J., xxii Gardner, E., 324, 422 Garibaldi, P., 414 Garzoni, A., 412 Gelb, A., 413 Gemmell, N., 379 Gernet, J., 418 Giuliano, P., 48 Goodin, R.E., 407 Greenaway, D., 377 Gregory, P.R., 158–60, 418 Griffin, K., 415 Gupta, S., 216

Laeven, L., 3, 411 Lee, J.W., 381 Lewis, A.W., 251 Lewis, D.K., xxii Li, D.D., 419 Lindbeck, A., 141, 413 Lipton, M., 252, 408, 418 Little, I.M.D., 421 Lucas, R.E., 380 Lysenko, T., 200, 203

Haavelmo, T., 379 Hare, P., 212 Hart, O., 77 Hartley, K., 116, 412 Hayek, F.A., 42 Hellman, J., 199, 200, 203 Herskovits, M.J., 408 Heston, A., 379 Hicks, J.R., 31 Hirshleifer, D., 407 Hirschman, A.O., 25, 406 Hoff, K., 52, 192, 208 Hughes, G.A., 212 Jackson, G., 3, 409, 411 Jefferson, G., 287 Jensen, M., 79 Johanson, P.O., 409 Johnson, S., 206, 420 Jones, G., 199, 203 Jones, P., 116 Joshi, P.C., 420 Joshi, V., 421 Joskow, P.L., 64 Kaliberda, A., 408 Kahnemann, D., 408 Kaufmann, D., 199, 203–4, 206 Kerr, C., 418 Kidron, M., 234 Klugman, J., 417 Koopmans, T., 377, 422 Kornai, J., xxii, 120, 144, 165 Kraakman, R., 191 Krastev, I., 205 Krueger, A.O., 409

Macculloch, R., 141, 413 Maddison, A., 309, 395, 406, 418–9 Mankiw, N.G., 379, 380 McDonald, P.F., 415 McMoillan, J., 206 Mead, D.C., 416 Meng, L., 295 Milanovic, B., 217–8, 220 Milgram, S., 407 Milward, B., 415 Mohan, G., 415 Montias, J.M., 377, 422 Mora, N., 414 Morrisosn, C., 416 Mueller, D.C., 125 Murphy, K., 407 Murphy, K.J., 79 Murrell, P., 125 Musgrave, R.A., 132 Myrdal, G., xxii, 415, 420 Neven, D., 410 Ng, D.C., 409 Niskanen, W.A., 116 Nitzan, S., 123 Nkurunziza, J., 422 North, D.C., xxii, 3, 407 Nozick, R., 411 Olivier, J., 414, 421 Olson, M., 124 Okun, A., 411 Peacock, A.T., 133, 412 Peck, M.J., 412 Pejovic, S., 163 Perkins, D.H., 295, 419 Perotti, R., 127, 412 Pittinsky, T.L., 420 Polanec, S., 200, 203

Author Index Polanyi, S.K., 408 Popova, T., 210 Posner, R., 422 Pradhan, S., 204 Pryor, F.L., 418 Purushothaman, R., 392–3, 423 Pyatt, G., 422 Qian, Y., 286, 288, 419 Raiser, M., 413 Ranis, G., 415 Ranciere, R., 414, 421 Ravallion, M., 416 Rawls, J., 411 Rawski, T., 287 Robinson, J.A., 3, 415, 420 Robinson, S., 422 Rodrik, D., 421–2 Roland, G., 414 Romer, D., 379–80 Rose, N.L., 64 Rose, R., 203, 415 Rosenstein-Rodan, P.N., 415 Rosser, J.B., 409, 423 Rosser, M.V., 409, 423 Rostow, W.W., 132 Rozman, G., 418 Ryterman, R., 204 Sadie, J.L., 408 Sahay, R., 170, 181, 413–4 Sabini, J., 407 Sanfey, P., 413 Schelling, T.C., xxii, 407 Schankerman, M., 200, 203 Schindlmayr, T., 415 Schneider, F., 416 Schotter, A., 411 Scott, A., 412 Seabright, P., 410 Seale, J.L., 379 Sen, A.K., 411 Sethuraman, S.V., 252 Setula, P., 207 Shaw, T.M., 423 Shelley, L.I., 197 Shleifer, A., 191, 407 Silver, M., 407 Simon, H.A., xxii, 34, 407–8, 411 Singh, I., 287 Sinn, H.W., 413, 423 Smirnov, O., 407, 411

Smith, D., 204 Solow, R.M., 380 Sprout, R.V.A., 379 Stigler, G.J., 42, 192 Stiglitz, J.E., 42, 164, 208, 412 Stuart, R.C., 158–60, 418 Subramanian, A., 421 Summers, R., 379 Syrquin, M., 422 Szirmai, A., 415 Tarassova, A., 191 Tenev, S., 413 Tiongson, E., 216 Tirole, J., 141, 413 Tisdell, C., 116, 412 Theil, H., 379 Thorner, D., 420 Thum, M., 207 Tversky, A., 408 Ulla, M., 411 Verdier, T., 415 Virmani, A., 315, 318, 421 Vishny, R., 191 Walder, A.G., 419 Wallis, J.J., 3 Wang, X., 295 Watanabe, T., 386 Weaver, J.H., 379 Weil, D.N., 379–80 Weingast, B.R., 3 Weinstein, D.E., 410 Weitzman, M.L., 412 Welch, I., 407 Wilson, D., 392–3, 423 Winiecki, J., 163 Winston, C., 64 Wiseman, J., 132 Woodruff, C., 206 Wong, S.L., 418 Whyte, M.K., 418 Xu, C., 286, 288, 419 Yuan, J., 419 Yarrow, G., 63 Zettelmeyer, J., 414 Zack-Williams, A.B., 415

435

Subject Index

agent attitudes: family, firm, state, 37, 46, 48–53 concentration in settings, 27, 35, 241–3, 255–6, 286, 301, 340–1, 396–8, 400 horizontal interaction, 27, 37 vertical interaction, 27 agriculture, policy, 86–8, 183, 187, 236–2, 248, 252, 260–3, 275–86, 296, 301–2, 311–2, 318–21, 338–41 adverse selection, 59, 76, 78, 195–6 altruism, 31

deadweight loss, 59–61, 66–7, 84–5, 123, 173 demographic change, dynamics, 46, 103–4, 392, 399 growth, transition, 227, 234–6, 248, 271, 312 deregulation, 59, 62–6, 95, 179, 183, 193, 301 displacement hypothesis, 392–6 distribution see GDP distribution by sector see income distribution dualistic development, 226, 251–2, 259, 262, 267, 271–2, 299, 322, 326–8

benevolent ruler, 32, 50–1 blame-freeness, 100 bribes, 196–207 bureaucracy, 109, 117–21, 282–3, 296, 305 capital market capitalization, 189, 194 see also factor productivity capture by state, firm, 21–3, 107–8, 117, 187, 190, 196–205, 208 catching up, 43, 380, 383–5, 392 checks and balances, 108–9, 111, 127–8, 143 collectivities, 57–60, 72–4, 101, 105 colonial rule, 227–32, 271, 300, 310, 330–2 comparative advantage, 238, 283, 311–6 performance, 157–63, 209, 247–51, 279–80, 303–4, 306, 330, 335, 340, 342, 347, 357, 467–9, 377–8, 381, 388, 397–8 compensation principle, 58–9 competition policy, 59, 60, 72, 183, 186, 192, 198, 216 convention, 28 convergence of economic growth, 380–6, 390–2, 400–1 economic systems, 27, 30, 44–5, 394, 401 cooperative, 397–9 corruption anti-corruption policies, 205–6 corruption perception index, 205, 208 magnitudes, 199–204, 207–8, 285 types, 43, 179, 181, 192, 196–209, 215, 282

economies of scale, scope, 74, 85 efficiency inefficiency, 25, 85 Pareto, static, dynamic, 54, 67, 84–5, 94, 344, 359, 363, 374–5 environmental policy, 60, 64, 82–4, 90–2 externalities negative ex., 59, 84, 88–90, 209, 211–2, 223, 263 network ex., 24, 27, 34 positive ex., 59, 72, 84–8, 209–10, 213, 239 factor productivity, 158–9, 165–6, 248–9, 295–6, 314, 318–9, 344 fairness, 99–100 financial industrial groups, 192, 194, 209–11 financial market, crises, 33, 44, 53, 81, 394–5, 399 firm intensive, 8, 17–19, 30–2, 37–8, 40–2, 48–9, 51–6, 70–4, 100–6, 109, 140–1, 235, 275, 306, 325, 336, 394–9 pro-firm attitudes, 50–1 focal points, 28, 46, 52 foreign capital flow, 199, 247, 264, 291–3, 315, 339 direct investment, 198–9, 264, 278, 290, 303, 313, 334, 341, 395 exchange reserves, 183, 215, 234, 238, 244, 247, 290–1, 314, 328, 394

436

Subject Index foreign – continued loan transfers, 244–6, 314 ODA, 244–7, 303, 325, 335, 339 payments balance, 168, 180, 240 trade, 85–8, 91, 174, 183, 212–4, 283, 289–91, 302, 313–6, 318, 387, 395 free riding, 58, 59, 93, 94 GDP distribution by sector, 241–2, 279, 286, 302, 314–9, 340–1 Gini index, 96, 102, 175–7, 250–1, 280–1, 297–8, 303–4, 318–9, 326–9, 336–7, 339 Global integration, 213–4, 223, 227–30, 244–5, 271, 301, 325, 334, 399 leadership, 392, 398–9, 401 Gosplan, 148, 150 governance corporate governance, 78–9, 95, 105, 246, 288–9 insider, outsider, 80, 188–92, 195–6, 199, 205–6, 213, 223, 278, 289 Great Leap Forward, 284–6 growth accounting, 158–9, 165, 295–6, 318 growth and inequality, 97, 99–106, 159, 174–7, 217, 280, 297–9, 303–4, 318–20, 326, 336–7, 394–5 hidden clubs, 195 hidden economy, 179, 196, 206–9 Homo economic, economicus, 4 Homo politic, 4 Homo sociologic, 4 household family importance, 47–8 intensive, 8, 19, 30–2, 37–8, 42, 46 ICT, 313–14 imitative behaviour, 28 income distribution, 58, 96–100, 105, 125–7, 132, 174–6, 185, 215–7, 231, 250–3, 262, 271, 294, 326, 337, 356, 364, 368–9, 375–8, 386 income sharing, 32, 296 Index of Economic Freedom, 71, 184–6 Interactive influence, 34, 242, 276–8, 300–1, 323, 326–7, 331–3, 337–41, 396, 399, 400 Liberalization, 87, 184–6 indivisibilities, 40, 43, 168, 186–7, 223 industrial (ization), policy, 83–91, 211–2, 238, 244, 275–6, 303, 311–2, 325, 334

437

informal sector, 172, 252–71, 319, 326, 337 information asymmetric, 58–9, 74–5, 195–6 cascades, 28 incomplete, 75–6, 195–6 institutional rules, 22–5, 28 insurance, 59, 81, 104 interest groups, 108–18, 123–5, 133, 142, 179, 299 internalization, 82, 95 Jagir, 306–7 kinship, 4, 15, 30–1, 38, 48, 229–31, 274, 281, 297, 305, 321–2, 330–2 Kulak, 307, 310 Kyoto Protocol, 91–2, 106 labour, employment, 226, 241, 253–4, 263–5, 271, 286–9, 295, 315, 319, 324–6 see also factor productivity land reform, 238–9, 307, 309–12 leakage, 262, 360–1, 375, 388 learning, adapting, 28, 37 liberalization policy, 63, 87–8, 105, 173–86, 192–3, 198, 201–2, 223, 240, 246, 278, 289, 313 linkages, forward and backward, 239, 264, 267, 362, 385, 389 Lorenz curve, 96 majority rule, 114 management buyout, 188–9 managerial slack, 59, 66–8, 78–9 market equilibrium, 57, 84, 89 failures, 55, 58–60, 76, 99, 105 material balances, 149–50 mobility, 3, 6–8, 137–41, 227, 252, 264, 267, 300, 304–5, 339 monopoly of firms, 60–3, 68–72, 107, 123 of state, 107, 116–17 moral hazard, 59, 76, 78, 81, 196 multipliers growth, income, output, 260–1, 359–78, 385–91 relative distributive measure, 363–4, 375 SAM multipliers, 260, 358–78 multipole system, 10, 14, 30, 273, 280, 299, 304, 313, 322, 397, 399 nationalization, 63, 64, 192, 237 nation building, 227, 230–2, 271

438 Subject Index needs: collective and personal, 31–6, 40–2 Nomenklatura, 147–8, 153 normal distribution, 97–8 oligarchs, 194, 197, 202, 210–1, 223 Pareto optimality, 54, 111–2, 136–7 Perestroika, 154 persuasive settings, 4, 10–12, 20, 27–8, 30, 33, 46, 283, 299, 300, 398–401 Politburo, 147–63 political market, 109–12, 115–6, 127, 130 political parties, 108–15, 125, 132, 142, 168, 219 political regime, 234 polity failures, 113–5, 129–30, 133, 167, 192, 210–1, 222 polity rules, 112, 144, 162, 165 population size, 252, 256, 274, 380–6, 389–94 poverty headcount, rate, 102–3, 176, 218, 220, 249–50, 253, 298, 320 line, 217–8, 220, 253–8, 261–3, 287–9, 320 principal-agency, 76–7, 195 prisoner’s dilemma, 94 privatization, 59, 62–5, 95, 105, 190–3, 201, 206, 209–10, 221–3, 239, 313 profit sharing, 78, 79 profits, rates, 265–8 property rights, 71, 76–9, 82, 90, 178, 187, 191–2, 197–8, 202, 207 prospect theory, 37–8 protectionist policies, 87–90, 91–2, 395, 398–9, 401 public goods, 59, 93–5, 101, 110, 125–6, 130–7, 179, 186, 215–21, 317, 330 public share, growth, 127, 130–8, 142–3, 221, 224, 303, 325, 334 public spending, 108, 129–36, 139, 143, 216–21, 224, 243, 278, 302, 317, 324–9, 334, 339 RAS method, 370 Ratchet effect, 152, 154 reciprocal behaviour, 28 rent appropriation, seeking, 4, 6, 18, 20, 30–43, 52, 109, 129–30, 143, 174, 181, 186, 191, 196, 209, 215, 223, 243 regulation, 59–65, 71, 81, 91–5, 108–11, 115, 120, 129–30, 137, 142–3, 179, 183, 196–206, 238–9, 243, 286, 311–2, 334 reputation, 75, 95

research and development, 73 restrictive practices, 59, 70–2 Rule of Law, 191–3, 204–7, 307 rural, urban, 226–9, 234–5, 240, 253–61, 264, 270–1, 297–8, 300–10, 320–4, 329, 333–4, 339, 341, 386, 397 shadow economy, 253 social accounting matrix, 259, 272, 342, 347, 358, 370 social security policy, 94, 104–6, 179, 204, 219 soft budget constraints, 152, 155, 164, 168 speculative selling, 81 stabilization indicators, policies, 174, 177–82, 223, 232, 237, 240 state influence, 201, 243, 271, 278–9, 294, 302, 324, 328–9, 334, 338 intensive, 8, 16–19, 30, 38–42, 48–9, 52–3, 144, 162–9, 177, 191–6, 207, 211, 222–4, 396–9 owned enterprises, 179, 187, 209, 285–8, 312 ownership, 147–8, 282, 286–7 pro-state attitudes, 50–1 stock markets, 292 structural adjustment, SAP, 234–5, 237–8, 240, 243–4 structures of settings agent st., 22–3, 28, 161–2 information st., 22–3, 25, 28, 161–2 institutional st., 22–3, 28, 41–2, 161–2 technological transformation st., 22–3, 25, 28, 161–2 system competition, 45, 396, 398–9 system coordination, 26, 30, 37, 299, 321 systemic change, 24–5, 33, 44, 280–3, 297–8, 304, 311, 340, 396, 398–9 synthesis system, 45–6, 397–400 tax policy, 91, 95, 104, 126–33, 136, 139, 141 technological development, 163 technology policy, 59, 73, 86 Tolkach, 153 trade-offs, 60, 73, 102, 299, 303, 340 traditional system, 3–6, 8, 13, 15, 30, 37–8, 42, 45, 226–9, 234–5, 252–3, 260–8, 272, 287, 304–10, 322–4, 399 transaction cost, 77–91, 83–4, 91 transformation process, 3–5, 7, 11–12, 15–18, 23–5, 233–40, 275–6, 300, 306, 333

Subject Index transition countries, economies, 13, 17–18, 47–9, 51, 193, 200–1, 206–23, 342, 347, 368–9 phases, 179, 361, 368, 397 tribal economy, 309 TVE, 288–9 uncertainty, 58–9, 74–81, 173, 186, 191, 194–5 unemployment, 176–9, 218–20, 224, 263, 312, 325 urbanization, 235–6, 253, 254, 274, 328, 333, 338

439

village economy, society, 305–10, 321–2 voters, distribution, median, 116–8, 122–9, 134–6, 142 wages, rates, 56, 79, 98–101, 168, 173, 178, 180, 204–7, 218–9, 237, 240, 252, 265, 286–7, 312 war casualties, 232–3 wealth, wealthy, 59, 76, 97–101 welfare policy, state, 97, 101–6, 141, 224, 244, 250, 252, 399 Zamindari, 306, 307