markets and the macroeconomy 9 - world bank

Achieving more equal access to markets isfundamental to greater equity within soci-eties as well as to moving countries ontodynamic growth paths, thus enhancingglobal equity. And both equity and growthare best served by prudent macropolicy(allowing for its countercyclical role). Thischapter is organized around the three mar-kets for capital, labor, and goods (land wascovered in chapter 8) and the macroecon-omy, exploring in each domain the poten-tial and options for leveling the economicplaying field and strengthening voice andaccountability.

How markets relate to equityIssues of design of market-related reformsand macroeconomic policy are often allo-cated to ministries of finance, macro- andtrade economists, financial specialists, andthe like. By contrast, policies for equity,including those for managing the conse-quences of market conditions and macro-conditions, are typically considered thedomain of the providers of schools, healthcenters, rural roads, safety nets, and justicesystems. This division of labor is profoundlyincorrect. The first set of policy domains isas important for equity as the second.

The main issue is access. The playing fieldis typically far from level in the workings ofmarkets. Barriers are intrinsically inequitablewhen they privilege insiders’ access to capital,good jobs, and favored product markets. Butthey are also bad for the innovation andinvestment that lie at the heart of moderneconomic growth. That is why leveling theplaying field has the potential to be bothmore equitable and more efficient. It is alsowhy broadening access typically requiresmore economic competition and more polit-ical accountability.

There are two broad categories ofpathology that make the playing fielduneven (see table 9.1). The first pathologyarises when the influence of powerfulpolitical and economic elites is bad forequity and typically bad for growth—whether this takes the form of outrightpredation by political elites or excessiveinfluence of economic elites in the shapingof policies and institutions, as under “oli-garchic capitalism.” As we read in chapter6, Mexico’s financial system through muchof the country’s history provides an exam-ple of elite capture—a protected, relational,incumbent-oriented financial system.

The second pathology arises when policyefforts to control or manage markets aredirected, at least notionally, to improveequity, but with high costs for efficiency,and are often captured by middle groups(or indeed elites) in ways that harm thepoor. This had its extreme manifestation incommunist economic policy, but it is alsoprevalent in societies in which markets playa large role. Another example is when pro-tection for formal sector workers, whilebringing valued benefits to some, slowsprocesses of restructuring and job creationfor other workers. Both pathologies, butespecially the first, reflect Adam Smith’sconcern that the influential may shape mar-kets to serve the interests of incumbents. Ashe said, “People of the same trade seldommeet together, even for merriment anddiversion, but the conversation ends in aconspiracy against the public, or in somecontrivance to raise prices.”1

The main purpose of this chapter is notto diagnose from where such pathologiescame but to explore possibilities for changethat are feasible within the prevailing politi-cal, sociocultural, and economic context.Casual observation suggests that change is

Markets and themacroeconomy

9c h a p t e r

178

(c) The International Bank for Reconstruction and Development / The World Bank

Markets and the macroeconomy 179

possible. The Mexican financial system hasbeen reformed after the 1995 Tequila Crisis.Moroccan industry was (partially) dispro-tected. And many countries no longer pur-sue populist macropolicy, especially afterthey experienced its ill effects.

Reducing barriers to market access willoften bring initial benefits, or redistribu-tions, not to the poorest but to middlegroups. There may even be temporary risesin inequalities in parts of the income distri-bution, for example when there are increasesin returns to skills. This is desirable for effi-ciency and consistent with equity if institu-tions allow households and individuals torespond to the new incentives, and there aresafety nets to manage those who are hurt. Itis undesirable, however, if it creates newpossibilities for middle groups to “hoardopportunities” at the cost of future growthand gains for the poor.2

Design choices will depend on the mar-ket and local context, including the politicalcontext, but two cross-cutting issues areworth highlighting. First, there is often anapparent paradox: when systems are shapedto favor those with influence and connec-tion, economic liberalization should begood for equity; however, that is not alwaysthe case. Liberalization can also be capturedby the powerful, perpetuating inequitableand inefficient economic structures—andrisking political and social backlash to mar-ket-oriented reforms. This is why liberaliza-tion needs to be designed in ways thatpromote genuine competition and effectiveaccountability structures, whether in theform of regulation, transparency, or otherforms of societal control, and sequencedproperly.

Second, while greater equity can be com-plementary to long-run prosperity, the sec-ond pathology vividly shows the potentialfor inefficient choices in the name of equity.Tradeoffs between equity and efficiencyexist. And even when there are aggregategains, protected incumbents will be losers,at least in the short to medium term (ineconomists’ jargon, changes will often notbe Pareto-improving). Whether societieschoose to compensate losers is a matter ofsocial welfare (especially if they are poor)and political economy (especially if they arenot poor).

We now turn to the three markets forcapital, labor, and goods and the macro-economy, exploring in each domain thepotential and options for broadening accessand strengthening accountability. Box 9.1illustrates some of the interactions amongequity, inequality, and growth in China.

Achieving equity and efficiencyin financial marketsThe performance of enterprises drives eco-nomic growth. An innovative and dynamicenterprise sector requires low barriers toentry, effective guarantees for propertyrights, and access to finance. We focus onthe latter here. Unequal access to finance isassociated with reduced productive oppor-tunities and reflects unequal influence.Financial market liberalization can in-crease access, but it can also be captured.Sound technical design and strengthenedaccountability can help expand accesswhile reducing both the risk of captureand disincentives to broader lending, thusenhancing opportunities.

Table 9.1 Two pathologies in the interaction between equity and growth

Domain Policy capture by powerful elites Ill-designed attempts at equity with large inefficiencies

Financial markets Protected, relational, incumbent-oriented financial system in Directed subsidized credit in India and elsewhere, with Mexico for much of its history dismal repayment largely from better-off farmers

Labor markets Repressive labor market conditions in the predemocratic Excessive protection of formal sector insiders in the middle Republic of Korea of the distribution—India, South Africa

Product markets Clove and timber monopolies in Indonesia Protection for inefficient agricultural food production (Philippines) and industry (Morocco) before trade liberalization

Macroeconomic management Regressive resolution of macroeconomic crises in Latin Populist macroeconomic policies (Peru under García) that America and Indonesia fuel future (regressive) crises


Unequal access to finance is associated with unequalproductive opportunities and reflects unequal influenceAs discussed in chapter 5, the access tofinancial services and their cost are un-equally distributed, especially in developingcountries. Many firms and householdscomplain that the right financial servicesare not provided, that procedures for open-ing an account or getting a loan are toocumbersome and costly (with high rejec-

tion rates), and that financial institutionsdemand collateral, which (poorer) borrow-ers typically lack.

Financial institutions respond that theycannot provide services profitably for tech-nical and economic reasons. Poorer groupshave small savings, and seek small loans andinsurance (life, health, crop), which arehard to provide. Smaller clients borrow fre-quently and repay in small installments,making serving their needs very costly. Andthe underserved are new and not experi-enced in business, making them poor creditrisks. But such reasons form only part of thestory. The microcredit movement and largebanks, such as Bank Rakyat Indonesia andICICI Bank in India, show that it is possibleto provide financial services profitably topoorer customers and small firms. Access isalso unequal in areas of finance in whichenforcement is not as much of a concern—such as deposit-taking.

Inequalities in access are also, in part, aproduct of unequal influence. Incumbentswho benefit from restricted patterns offinance may lobby to limit access to finance,or erect other barriers to protect the rents ofestablished firms. Barriers to entrepreneurialactivity are indeed generally more onerous inpoorer, more corrupt, and more unequalcountries.3 Weak property rights are part ofthe problem. But weak property rights can bethe outcome of political economy forces—economic elites have an interest in the selec-tive protection of property rights, becausethey stand to gain more when security ofcontracts and property depends on theirposition, connections, and wealth.4

We are primarily concerned here withthe first pathology mentioned earlier,namely the influence of economic elites onthe shaping of financial systems. In manycountries, a small number of wealthy fami-lies or groups exert extensive control overthe corporate sector, notably through con-trol pyramids in which cross-shareholdingslead to dominant control rights in extensiveparts of the corporate sector, often substan-tially in excess of the share of capital owned.These wealthy families are typically linkedto political elites through economic deals,family connections, and shared social and

180 WORLD DEVELOPMENT REPORT 2006

China looms large in any attempt to inter-pret development, especially the role ofequity in development processes. Hasn’t itmoved from a highly equitable form ofcommunism to extensive use of domesticand international markets? And didn’t thislead to both rising income inequality andthe most extraordinary pace and scale ofreduction in poverty and expansion insocial welfare in history? This looks, at firstglance, like a brute fact refutation of a cen-tral message of this report: that equity canlay the basis for prosperous development.

An account along these lines misreadschange in China in important ways: many ofthe changes were equity-enhancing in thesense of leading to expansion of opportuni-ties of the bulk of the population (chapter 6discussed the institutional underpinnings ofthese changes). Consider some of the majorshifts in Chinese policy that the literatureinterprets as having driven growth andincome poverty: the institutional shift to thehousehold responsibility system allowingpeasants to produce for themselves (1979and early 1980s), the expansion of townshipand village enterprises (TVEs) and the mas-sive indirect effects of opening to interna-tional trade (whole period), the opening toinward foreign direct investment (especiallyin the 1990s), and the huge internal migra-tion flows. All these led to major expansionsin opportunity (and were major sources ofgrowth) for large segments of the popula-tion. Rural reform quickly expanded oppor-tunities for most peasants.TVEs werebroadly dispersed.While the effects of inter-national opening were concentratedinitially in coastal areas, they havebroadened in scope, both through the indi-rect effects of migration and the relocationof industries inland.

By contrast, where investment has beenlinked to connections and corruption, it isclearly inequitable, in the sense of lackingfair process and equality of opportunity toall potential investors. In the long term, intro-ducing fairer and more transparent processwill be important to sustained growth.

There were periods in which policy-related shifts (such as selective opening, thepricing of foodgrains, tighter controls oninternal migration, and access to urban jobs)were associated with biases either againstinner provinces of China or against ruralareas.These were factors behind the rise ininequality in outcomes and stagnatingincome poverty between the late 1980s andearly 1990s.This was probably inequitable interms of rising inequality of opportunity. Forthese cases there may have been sometradeoff, but few observers argue that suchpolicy-induced biases were essential to Chi-nese growth, in contrast to the overall insti-tutional change and opening.

Moreover, even using the muchnarrower lens of income inequality, the peri-ods when inequality fell (notably the early1980s and the mid-1990s) actually had thehighest growth rates, not the lowest. Andthe provinces where rural inequality rosethe least had the highest growth rates.

There are rising concerns in China overthe adverse consequences for developmentof growing inequality, including in some areasof social provisioning (in health, for example),and concentrations of wealth through con-nections.But there is no evidence that thesebrought benefits in income growth,the issueof concern here,and most observers (and theChinese government) would see this as anarea in which policy could be improved.

Sources: Ravallion and Chen (2004), World Bank(1997b).

B O X 9 . 1 Markets and development: policy, equity, and social welfare in China


cultural capital. Examples include the Mex-ican banking system, until the reforms ofthe second half of the 1990s, and the con-centrated wealth and close connectionsbetween economic and political elites inEast Asia (figure 2.8).5

Concentrated corporate control andwealth should be a concern if it leads tobiases in access toward the influential and,even more, if it is associated with reducedinnovation and dynamism. Reduced inno-vation can occur through direct restrictionson opportunity and the indirect effects ofweaker property rights. Cross-country evi-dence suggests that there is a relationship.Countries with more self-made billionairestend to grow faster, whereas those withmore hereditary billionaires grow moreslowly, suggesting costs of dynastic familycontrol over economies. Societies withgreater family control over the corporatesector also grow more slowly.6

More compelling evidence on the linksbetween unequal power and financial sectordistortions comes from case study material,from the historical experience of now-developed societies, and from contemporarydeveloping countries.7 Table 9.2 provides aselective list of results from recent studies ofdeveloping and transition countries. Thesecase studies illustrate that unequal wealthand influence and low political accountabil-ity can be bad for entry and bad for thebroad protection of property rights—and socan hurt the efficiency, growth, and thehealth of the financial system.

Such adverse long-term effects can bemagnified through crises, further dampen-ing growth and reducing equity. Connectedlending lowers asset quality and makesfinancial systems more vulnerable. Andwell-connected interests do disproportion-ately well in crises, through looting orsecuring greater protection and bailouts, as


Table 9.2 Financial policy and institutions are often captured by the few: case study evidence

Country Evidence

Brazil Public financial institutions in Brazil appear to have served larger firms more than private banks have (Kumar 2005).

Chile Following liberalization in the late 1970s, many privatizations of state-owned banks went to groups of insiders (Larrain 1989).

Czech Republic Mass privatization in the Czech Republic delayed the establishment of a securities and exchange commission, facilitating tunneling(stealing assets by channeling to another firm owned by insiders) (Cull, Matesova, and Shirley 2002).

Indonesia Market attributes large financial value for political connections, suggesting politics rather than economics determined access orrents (Fisman 2001b).

France, pre-1985 Banks, protected and dependent on government support, lend to less productive firms (Bertrand, Schoar, and Thesmar 2004).

Korea, Rep. of The opening up of new segments of financial services provision was dominated by insiders. Increasing openness primarily expandedand strengthened the politically most connected firms (Haggard, Lim, and Kim 2003, Siegel 2003).

Malaysia The imposition of capital controls in September 1998 primarily benefited firms with ties to Prime Minister Mahathir (Johnson andMitton 2003).

Mexico late 1800s There was capture of the financial sector in Mexico in the late 1800s blocking entry in emerging industries (Haber, Noel, and Razo2003).

Mexico early 1990s Lending to connected interests in the early 1990s was prevalent (20 percent of commercial loans) and took place on better termsthan arms’ length lending (annual interest rates were 4 percentage points lower). Related loans were 33 percent more likely todefault and had lower recovery rates (30 percent less) than unrelated ones (La Porta, López-de-Silanes, and Zamarripa 2002).

Pakistan Insider activities have significant economic costs. Politically connected firms borrowed twice as much from government banks andhad 50 percent higher default rates between 1996 and 2002, with economywide costs of rent-seeking estimated to be 0.3 percent to1.9 percent of GDP per year. Brokers trading on their own behalf earned annual rates of return 50–90 percentage points higher thanthose earned by outside investors. Hence, price manipulation by intermediaries helps keep equity markets marginal with fewoutsiders investing and little capital raised (Khwaja and Mian 2004, 2004b).

Russian Federation Russia’s free-for-all banking entry, combined with its choice of a universal banking system, gave great discretion to insiders toconduct asset stripping through the loan-for-shares scheme. The weak political accountability could not stop the capture of stateresources or protected rents (Perotti 2002, Black, Kraakman, and Tassarova 2000).

Thailand Connected lending was large before the 1997 crisis and firms with connections to banks and politicians had greater access to long-term debt (Wiwattanakantang, Kali, and Charumilind forthcoming).

United States, early 1800s New bank licenses went largely to insiders in New York state (Haber 2004).

Ghana, Kenya, Tanzania, Firms that have an owner of Asian or European descent have a 0.34 higher probability of obtaining credit from suppliers Zambia, and Zimbabwe (Fisman 2003).


discussed in the section on macroeconomicmanagement.8

The liberalization paradox: Rapid and premature liberalizationcan also be capturedA seemingly obvious implication of thepathology sketched above is that a moreopen and liberalized financial systemshould be good for access, innovation, andgrowth. Yet overly rapid liberalization canbring new perils. Table 9.2 includes exam-ples of liberalization and privatization offinancial systems leading to highly concen-trated benefits. Rapid privatizations ofstate-owned banks often meant that bankswent to powerful insiders or corporategroups, as in Chile in the 1970s, Mexico inthe 1980s, and the Russian Federation in the1990s.9 In Chile and Mexico, the largestbanks were sold to a small number ofwealthy families in dubious auctions, withforeigners stopped from bidding. The buy-ers were allowed to fund the purchases withloans from the banks themselves, leading toextremely poor incentives for solvency. Inboth countries, the owners used the banksto grant themselves large loans, aimed in

part at accumulating control over otherfirms. In Mexico, this was associated with amajor consumer credit boom.

In the Republic of Korea, chaebols (fam-ily-run conglomerates) came to dominatenonbank financial institutions. This causedserious conflicts of interest and “producednumerous incidents of illegal and unfairactivities, where funds from affiliated finan-cial institutions were exploited for the bene-fit of chaebol’s ailing subsidiaries.”10 And inthe particularly dramatic case of Russia, thefree-for-all liberalization was a source ofboth rapid concentration of assets andincreased financial vulnerabilities (box 9.2).

Rapid or premature liberalization in acontext of low political accountability canincrease financial fragility, and the risk ofopportunistic default.11 Reckless lendingstrategies in Chile and Mexico createdextreme vulnerability for the financial sys-tem, which collapsed when there wereshocks to interest and exchange rates. Agreater percentage of large loans defaultedand subsequent losses on large loans werelarger than losses on smaller loans; losseswere particularly large on loans to partiesconnected with the owners, who escapedsignificant sanctions. In both countries, thebanking system had to be bailed out atenormous public cost, while much of thelent capital probably disappeared in capitalflight, as in Russia. These cases suggest thatrash liberalization with limited scrutiny canresult in concentrated control of the bank-ing system, with owners putting up limitedamounts of their own capital, and weak orcorrupt supervision and public guaranteesto depositors. In all these cases the rise inlow-quality liabilities (and the associatedmoral hazard) became a major factor in thesubsequent financial crises.

In countries with greater accountability,financial liberalizations went a differentway. In France, before the 1985 financialreforms, government subsidies and limitson competition led banks to support lessproductive firms and provide poor-qualityloans. After 1985, the loan allocationsimproved and employment increased.12

Although the reforms exposed some prob-lematic lending patterns, there was no


Within a couple of years of liberalization, thenumber of banks in Russia had risen fromfour to around 3,000. One could argue thatthis was prime evidence that no elite wasblocking entry. But such rapid entry in a reg-ulatory power vacuum precluded anychance of regulatory oversight. It compro-mised the public perception of what a bankis and how it operates, undermining the veryfoundation required for the development ofthe domestic banking sector. In practice,many of these “banks”were not banks butprivate fund management entities used tochannel capital flight.Those raising depositsfrom the general public lent the cash toinsiders, gambled it irresponsibly, or simplyshipped it abroad, leaving the banks asempty shells full of liabilities.

Banks could get away with such behaviornot just because rapid entry overwhelmedthe (rather unprepared) regulators, but alsobecause the banking lobby further promoted

laws that granted banks an extraordinaryfreedom to operate and dispose of otherpeople’s money. Russia endorsed the “univer-sal bank”model, for example, hardly a struc-ture suited to a legal and regulatory vacuum(although there is debate as to whether thiswas a key factor in itself ). Bank lobbyists alsoensured that banks were exonerated fromthe new commercial bankruptcy code (thebankruptcy code established before the 1998crisis vaguely stated that banks would besubject to a specific bankruptcy legislation,which was not even tabled before 1998).

The universal banking structure andlack of bankruptcy system contributed tothe severity of the financial crisis of August1998, resulting in massive losses to deposi-tors, foreign investors, and cost to the statebudget (as many liabilities were transferredto the state-owned Sberbank).

Source: Claessens and Perotti (2005).

B O X 9 . 2 Too much and too little regulation: Russia before and after the transition


financial crisis or capture by the few. Thesystem was less concentrated to begin with,and the reform process received more pub-lic scrutiny.

Premature or ill-designed liberalizationcan also lead to reform backlash, if the ben-efits are perceived to be concentrated in afew powerful groups while the losses arebroadly socialized. There is less specific evi-dence on this for the financial system, but itforms part of a broader pattern of reactionagainst liberalizing processes. Witness thedramatic fall in support for privatization inLatin America between the mid-1990s andearly 2000s (as documented by the Latino-barómetro surveys). Such a backlash islikely to be particularly sharp when associ-ated with gains for particular groups—”economically dominant minorities” in theinterpretation of a series of case studies byChua (2004)—that can heighten the senseof horizontal inequities for other groups. Itcan undercut support for the very reformsthat are critical for equity and growth. Thisis why policy designs need to consider bothtechnical and political economy concerns.

Increasing access to financial services:Technical design, accountability,and competitionIf both financial systems and financial liber-alizations are often captured, what does thisimply for the design of reform? The answer iscomplex and to some degree specific to theinitial financial and legal institutions andpolitical context of a country. But we canoutline some general principles. Options toexpand access entail moving financial insti-tutions closer to the country’s “access possi-bilities frontier.” This will not necessarilyimply finance for all: for all the success ofmicrocredit for the poor, the major benefici-aries of greater access will be small andmedium entrepreneurs from the middleclass. But this is good for the broad-basedgrowth that will benefit all groups. Thisinvolves both issues of technical design anddeveloping the political and social account-abilities that will support and sustain change.

Technical design issues. For financial institu-tions, expanding the client base has much to

do with scale, which is often too small. Recentexperiences like those of ICICI bank in Indiashow that the high transaction costs for smallvolumes and the large cost of expandingreach can be overcome. One option is theinnovative use of existing networks. Postalsystems, with their broad coverage, can beused to deliver new services by many privatefinancial services providers. Many technolog-ical solutions now exist for small-scale bank-ing, from mobile banking to broadening therange of delivery points—through kiosks,small branches, and joint ventures with non-banks. Simpler banking products, like the“Mzansi” account in South Africa, and pre-paid cards for small transactions can lowercosts. Handheld computers have been usedfor quick approval of microfinance loans.Reverse factoring (lending on the basis ofreceivables from a creditworthy institution)using an Internet platform has allowedNacional Financiera (NAFIN) in Mexico toextend trade finance. There has also beenmuch innovation in the market for interna-tional remittances, which many banks haveentered.

Some of these innovations need regula-tory changes—for example, customer iden-tification, anti-money-laundering rules andother rules can hinder access to a bankaccount, as when individuals do not have afixed address or formal job. Better regula-tory approaches for consumers can involveadopting “truth in lending” requirementsfor small borrowers and educating peopleon the risks of (new) financial services.However, a general lesson is to be wary ofregulation in weak environments: all toooften regulation ostensibly designed to pro-tect savers and borrowers is ineffective inprotection but still hinders access.

Are there shortcuts to enhancing access,especially when overall institutional improve-ments will take time? Too often there isemphasis on the more complicated andsophisticated aspects of financial systems,while, some of the basics—broadening accessto financial services, including deposit-takinginstitutions—can be more important froman equity viewpoint. Information sharing canhelp improve competition in banking sys-tems and can be encouraged more quickly in



some segments, including allowing nonbankfinancial institutions access to existing net-works (such as payments systems). There canalso be some scope for specific governmentinterventions. But government interventionsto broaden access through directed credithave typically been unsuccessful, causing inef-ficient distortions with few access benefits—the second type of pathology discussed inthis chapter. Many governments, especiallyin the 1960s and 1970s, used various formsof subsidized directed credit, typicallythrough state banks, to try to channelfinance to poor farmers and small enter-prises. Directed credit undermines institu-tional development because banks have noreason to develop credit analysis skills, asplentiful examples of defunct developmentbanks show. By one account, default ratesranged from 40 to 95 percent throughoutthe developing world.13

Moreover, subsidies for housing, lendingfor small and medium enterprises, and agri-cultural finance are often captured by thewell connected. Some schemes do reach thepoor: India’s social banking program did so,but at a high cost.14 Such schemes thenbecome, at best, an inefficient means ofsupport for the poor, fostering unsustain-able models of financial sector develop-ment. For example, India’s Integrated RuralDevelopment Program provided loans tosocially excluded groups (certain castes andtribes, and women) with high levels of sub-sidy (25 to 50 percent of the loan volume tosuch weak sectors). By 2000, loan recoverywas only 31 percent, and there was little evi-dence of repeat borrowing.

Microfinance clearly has a role in ex-panding access. It is best viewed as a com-plement, not a substitute, for more equi-table financial reform and core financialsystem development. In most countries,microcredit and similar microfinance insti-tutions reach less than 2 percent of the pop-ulation. Only in a few countries is accessreally extensive—Bangladesh, Indonesia,and Sri Lanka stand out with coverageratios in the order of 8 percent or more.15

Subsidies are often used to encourage thesetup of microfinance institutions, but theyneed to be designed carefully because they

can increase final costs, by encouraging theformation of institutions that are too smalland that are forced to raise prices to recoverfixed costs. Co-sharing costs and risks withthe private sector is a key market test. Start-up subsidies and other support can fosterexploration of alternative business models,phasing out support over time. Maintaininga segmented system makes sense until themicrofinance sector matures, with strongermicrofinance institutions coming into thecore financial system as they evolve.

Accountability and competition. Technicaldesign is important, but the core of a reli-able reform is building political and regula-tory accountability. Public scrutiny has akey role, given the risks of capturing reformprocess and institutions. Potential actors tohelp oversee the process include associa-tions of small firms, consumer groups,NGOs, media, and labor unions. But giventhe technical and complex nature of finan-cial sector functioning, societal accounta-bility is likely to be most effective if groupswith an interest in a more open financialsystem are empowered, engaging independ-ent nongovernmental technical bodies withthe capacity to analyze financial sector con-ditions. The shadow regulatory commis-sions established in almost all regions, andsuch research centers as the recently formedCenter for Financial Stability in Argentina,can be sources of education and avenues forinterest groups to express their voice. It willremain important to design these mecha-nisms with care to avoid the creation of vetopowers to reform (which can lead tocounter-reform capture!)

It is possible to promote reforms thatbuild more reliable and inclusive financialsystems in a context of unequal influence.Formal regulatory structures can comple-ment societal accountability. The develop-ment of the stock markets in Poland and theCzech Republic show what regulation anddisclosure can do. At the transition fromcommunism in 1989, these two countrieswere quite similar in economic structure andhistory. But the design of financial reformswas very different, driven primarily by differ-ences in philosophy toward markets.16



The Czech Republic went for a radicalvoucher-based privatization of state-ownedassets, convinced of the power of the mar-ket to organize itself: with property rightstransferred to the private sector, it wasexpected that private actors would effi-ciently contract with one another. Polandpursued a more gradual approach, based oncase-by-case privatization and a measuredinstitutional development effort to buildregulatory and supervisory capacity. Com-pany and securities laws in the two coun-tries reflected these differences in approach,with much greater requirements in Polandthan in the Czech Republic for disclosure tothe public, more protection of minorityshareholders, and more power for the inde-pendent regulator.

The results were quite different. Thestock market in the Czech Republic startedbigger but was quickly dominated by cor-porate insiders, who captured “58 percentof the values of companies over and abovetheir legitimate shareholding, comparedwith an insignificant 1 percent in theUnited States.”17 There was widespread“tunneling,” a form of asset stripping byinsiders through transfers to other institu-tions they controlled. The Polish stock mar-ket, by contrast, started more slowly, butthen overtook the Czech market (figure 9.1)Public scandals led to the regulator effec-tively pursuing violations, using the greaterlegal protections, and laying the basis formore broad-based property rights, greaterconfidence, and openness. By the late 1990s,there were already several initial publicofferings in the market.

Segmentation provides another exampleof the need for appropriate accountabilitymechanisms. Financial sector regulation inmany countries, including developed ones,enforced segmentation for long periods—both on a geographic basis and by type offinancial services, as among commercialbanking, investment banking, and insurance.The Italian experience with dispersed localbanking suggests that mutual and coopera-tive banks performed an important functionin supporting local activities, which wasmuch better than state-owned banks orbanks dominated by politicians.18 But regu-

latory capacity has been eroded by techno-logical change. Given that segmentationoften resulted in capture by local elites, theerosion of barriers has likely improved accessas often as not. Yet there is room for smaller,locally managed intermediaries to promoteaccess. Such locally focused intermediariesneed explicit disclosure and accountabilityrequirements to local users (as opposed tolocal politicians), which has been the tradi-tion in cooperative or mutual banks, to limitthe undue political influence of the few.

Opening the financial sector to competi-tion from foreign financial institutions canalso spur financial broadening. Foreignbank entry can help by improving efficiencyand stability, reducing protected profits,and forcing (local) financial institutions tofocus more on providing financial servicesto all. Financing obstacles are perceived tobe much lower by borrowers in countrieswith high levels of foreign bank penetra-tion, with evidence that even small enter-prises benefit. But note that allowing theentry of foreign banks is not synonymouswith capital account liberalization. Rapidlyopening the capital account before ade-quate domestic regulatory and supervisorystructures are in place can be dangerous,especially in a world of large, and oftenherdlike, international capital flows, cou-pled with politically connected lending ofpoor quality. This increased the vulnerabil-ity of Indonesia, the Republic of Korea, andThailand in the East Asian crisis.

Finally there is the potential for externalcommitment. The relative success of Cen-tral European countries in strengtheningaccountability has been attributed to theconstraint on abuse induced by the need toprepare for accession to the EuropeanUnion. In Slovakia, after a decade of influ-ence-peddling and slow reform in thefinancial sector, the pendulum swungtoward reform only as the date of possibleEU accession approached.19

Achieving equity and efficiencyin labor marketsFor most of the world’s people, economicopportunities are primarily determined, or


01991 1992 1993 1994 1995 1996 1997 1998

20,000

15,000

10,000

5,000Poland

Czech Rep.

25,000US$ millions, end of year

Figure 9.1 Poland’s stock marketstarted slowly but then surpassed theCzech Republic’s

Source: Glaeser, Johnson, and Shleifer (2001).


at least mediated, by the labor market—informal and informal work. The wages andemployment conditions in the labor marketaffect the quality of life of workers and theirfamilies, sometimes in ways that may seemharsh or unfair. The functioning of thelabor market has a profound effect onequity—across workers, in patterns ofaccess to work, and between workers andemployers. Government intervention toachieve greater equity is frequent in labormarkets, but often with costs in terms of effi-ciency—exemplifying the second pathology.While this is an area in which genuine trade-offs exist between protection of weaker work-ers (which is good for equity) and flexibility(which is good for growth), elite capture andgross inefficiencies can be addressed throughbetter design and broader accountability.

Equity and efficiency reasons to intervene in the labor marketLabor markets are different from other mar-kets. Unlike the markets for many com-modities, labor markets generally are notcompetitive. They may be characterized byuneven market power (between employersand workers), by imperfect mobility ofworkers, by insufficient information, or bydiscrimination. These imperfections gener-ate rents in the employment relationship,which both sides can try to capture. Thiscan lead to unfair and inefficient outcomeswhen the bargaining position of the work-ers is weak. For example, employers mayunderpay workers who are not mobile,force workers to work in hazardous condi-tions, or discriminate against vulnerablegroups. Private markets, left to themselves,also do a poor job of protecting workersagainst the risk of unemployment. In theabsence of perfect access to financial mar-kets, or complete insurance markets, work-ers may not be able to smooth consumptionin response to labor income shocks. If theycannot gain access to financial markets,they may also be prevented from movingfrom bad jobs to good.

All governments, irrespective of income,intervene heavily in the labor market. Gov-ernments typically intervene to correct these

failures: to protect workers and endow themwith rights and “voice” in the employmentrelationship, to empower unions to repre-sent workers in negotiations with employ-ers, to ensure compliance with labor lawsand regulations, and to provide insuranceagainst income shocks. Public interventioncan improve market outcomes and lead tosignificant equity gains: more equal oppor-tunities for workers, better working condi-tions, and less discrimination. It can alsolead to large gains in efficiency: for example,by allowing full use of the labor of discrimi-nated groups, by increasing labor mobility,or by better managing income risk.20

The problem is that poorly designed orinappropriate government intervention canalso make things worse, with results that arebad for equity and efficiency. For example,excessive protection of formal sector insid-ers can lead to “rationing” jobs in the formalsector, pushing surplus labor into eitherinformal employment (as in India) 21 orunemployment (as in South Africa). 22

The problem is particularly acute indeveloping countries, because labor marketregulations and standards typically applyonly to formal sector workers, leaving themajority of the workforce uncovered.23 Pro-tecting workers through legislation and reg-ulation that is enforced only in the formalsector, without other measures to improveworking conditions in informal employ-ment, can reinforce the segmentation betweenformal and informal employment in waysthat are inherently unfair. In Colombia,workers are legally entitled to severance pay-ments for dismissals deemed unjust, butthese entitlements are not enforced in theinformal sector, which employs more thanhalf the workforce. Not only do Colombianinformal sector workers not benefit from thelegislation, but arguably they are harmed byit, because the resulting higher cost of laborin the formal sector limits formal employ-ment opportunities for “outsiders” (mainlywomen and youth).24

In reality, the distinction between formaland informal employment is often blurred.Some authors argue that the informal econ-omy functions partly as an unregulatedentrepreneurial sector, often voluntarily



entered even at the expense of lowerincome.25 It is clear that the informal sectoris heterogeneous, and includes both thosewho choose to work there and those whowork there out of necessity. Those in the topstrata—microentrepreneurs who hire oth-ers and many of the self-employed—do rel-atively well in average earnings. Those at thebottom—intermittent casual laborers andindustrial outworkers—do not. Womentend to be underrepresented in the topstrata and overrepresented in the bottom.26

They also often earn less than men withineach strata—although some of these differ-ences may reflect voluntary choices formore flexible, part-time work. In a recentstudy, the International Labour Office(ILO) argued that the formal and informalsectors are part of a continuum of workingconditions, earnings, and rights.27 A signifi-cant share of formal sector employees hadsome of the (poor) working conditionsassociated with informality, while a fractionof informal sector workers enjoyed condi-tions more typically associated with formalsector jobs. The challenge for governmentsis to shift more jobs along this continuumtoward better working conditions andhigher wages, and to do so in ways that donot come at the expense of efficiency.

Indeed, poorly designed or inappropri-ate government intervention can also beinefficient and bad for long-term growth.Recent research on India, for example, sug-gests that starting from a common legalframework (the Industries Disputes Act of1947), the states that amended the legisla-tion in the direction of reinforcing securityrights of workers and other prolabor meas-ures had lower output and productivitygrowth in formal manufacturing than thosethat did not change it or that made laborregulations more flexible.28 Relatively pro-tective legislation may have reduced oppor-tunities for workers—especially the major-ity without a formal sector job.

A look at some African labor marketsillustrates the impact of government poli-cies (figure 9.2). Many countries—includ-ing Ghana, Uganda, and Tanzania—havelarge self-employment sectors, which absorbincreases in the labor supply and help keep

unemployment low. South Africa stands insharp contrast, with a small informalsector—absorbing only about 19 percent ofthe total workforce in 2002, much lowerthan the share of nonagricultural employ-ment in other African countries—and highunemployment (42 percent in 2003).29 Partof the story lies in much larger wage differ-ences between formal and informal sectorwork in South Africa than in the othercases. But it also appears to be caused by theunusually small size of the informal sector(compared with Latin America, for exam-ple). Some suggest that the legacy ofapartheid that inhibited the development oftraditions of small-scale entrepreneurialactivity, and labor regulations that areenforced for firms of all sizes (depending onthe industry and region), may explain thelack of entrepreneurs and small firms inSouth Africa.

In Ethiopia, on the other hand, the major-ity of the urban unemployed are well edu-cated and from middle-class households.30

They also tend to be young, have never heldpaid work, and have a median duration ofunemployment of nearly four years. Indeed,about half of young unemployed males aresearching for public sector jobs, which pay onaverage a 125 percent premium over self-employed work.

Addressing links with unequal powerGovernment intervention in the labor mar-ket is often a reflection of the underlying dis-tribution of political agency. Governmentsmay (and often do) intervene in the labormarket in pursuit of goals other thanaddressing market failure. They may inter-vene to buy off the support of certain groups(for example, urban formal sector workers)or to suppress social dissent under anauthoritarian regime or to serve the interestsof those with greater political influence. Oli-garchic capitalist societies can be associatedeither with labor repression or with union-ized and (relatively) advantaged formal sec-tor workers who share in the rents.

Interventions aimed at shifting aggregatewelfare toward politically powerful middlegroups, often in the name of equity, at theexpense of others (an illustration of our


SouthAfrica

Ethiopia(urban)

Ghana0

25

50

Percentage of total labor force

75

100

Employment by sector for selectedAfrican countries

UnemployedSelf-employment(including agriculture)Private wage jobPublic wage job

Figure 9.2 Patterns of employment andunemployment vary widely acrossAfrican countries

Source: Kingdon, Sandefur, and Teal (2005).Note: Ghanaian data are for 1998/99 and publicwage employment includes government andstate enterprise workers. South African data arefor 2003 (Labor Force Survey). Ethiopian data arefor urban areas in 1997 (Labour Force Survey)and because of definitional issues may not befully comparable.


second pathology) are inherently bad forequity and usually bad for efficiency. Politi-cally influential energy sector and teacherunions in Mexico, for example, have pro-tected their employment and wage entitle-ments by blocking reforms that would leadto, respectively, energy sector reform andhigher-quality and more equitable school-ing. Public sector workers in France haveused their political force, with the aid of mas-sive strikes, to curtail attempts to bring theirnonwage benefits and other entitlements inline with those of the private sector.

Stronger civil and political rights andbroader mechanisms for voice can reducethe likelihood that the government’s laborpolicy agenda will be hijacked by politicallypowerful groups. There is a strong associa-tion between democracy and the level ofwages, both across countries and withinsocieties that have experienced a politicaltransition, such as the Republic of Korea,and Taiwan, China.31 Stronger respect forcivic rights in Latin America has also beenassociated with greater formalization ofemployment and a higher wage share.32 InSpain, the transition to democracy in themid-1970s led to demands for greaterequity that were associated with the legal-ization of free trade unions,33 the rapid

introduction of extensive social transfers(including pensions and unemploymentinsurance), and the implementation of pro-gressive income taxation. The result was ashift from a regulated state, in which pro-tection for workers came mainly throughpermanent jobs and controlled housingrentals, to a liberal economy with flexiblemarkets, and more extensive public provi-sioning of services (see focus 3 on Spain).

Better design: Can labor marketinstitutions be designed to be pro-growth and pro-equity?The challenge for governments is to designinterventions that balance equity and effi-ciency goals in ways that are within a coun-try’s institutional capacity. History suggeststhat this is a complex task, and there are realtradeoffs that need to be assessed. Differentsocieties are likely to make different choices.

Scandinavia and the United States havevery different sets of labor market institu-tions, yet they share a good track record ofsolid growth and high employment-to-population ratios (figure 9.3). The Nordiccountries have mandated generous benefitsand protection for workers, financed by ahigh tax effort. But they also have a highlycoordinated and centralized approach towage-setting and policymaking, whichallowed all parties to internalize the conse-quences of their actions, with the unionmovement historically an advocate foropenness and competition. The UnitedStates leaves the setting of wages and workconditions, including benefits, much moreto discretion and employer-worker negotia-tion. This fits well within its tradition ofdecentralized bargaining, which gives free-dom to individual firms to bargain withtheir workers in response to their varyingeconomic and financial conditions. It leadsto greater wage inequality and more work-ers without health and other forms ofinsurance. But it is consistent with lowertaxes and high levels of flexibility.34 TheNordic countries and the United Statesopted for different labor market models (inline with their history, legal tradition, andsocietal preferences), but all succeeded indelivering to their workforces a large pool


0

10

20

30

40

50

2000199519901985

Finland

Norway

United States

Denmark

Sweden

198019751970

60Labor productivity (GDP per hour worked, US$)

Figure 9.3 Different labor market institutional setupscan yield equally good productivity growth paths:Scandinavia versus the United States

Source: Underlying series for OECD (2005).Note: Measures used are GDP volumes, in U.S. dollars, at constantprices, constant purchasing power parity (PPPs) prices with abase year of 2000 and total hours worked for total employment.


of job opportunities, productivity growth,and rising incomes over the long term.

What doesn’t work? There are also manyways of getting labor market institutions“wrong.” And when countries get it wrong,one segment of the labor market (typicallypublic and formal sector workers who rep-resent the middle and high end of the usagedistribution) benefits from extra protectionat the expense of others. Outcomes arehighly unequal, and the costs to efficiencyand growth are usually severe. The experi-ences of India, South Africa, and Colombiacited earlier are vivid examples.

Governments also get it wrong if theyintervene extensively in the labor marketwhen product markets are not competitive.A typical example is the unionization ofpublic sector workers. In Mexico, before thereforms of the 1990s, workers in public util-ities and in the public oil sector securedhigh wages by capturing a share of the rentsgenerated in these monopolistic sectors. Buttheir gain came at a cost for employmentand competitiveness in Mexico’s privatesector. Mexico’s experience is not unique: itapplied equally to state enterprise workersin Turkey until the 1990s and to public sec-tor workers in India and many other coun-tries.

Things can also go greatly wrong whengovernments mandate protection with noattention to incentives. In much of Europe,governments implemented generous unem-ployment benefits with little connection toworkers’ actual job search behavior. Theresult was an increase in the duration ofunemployment and the emergence of long-term unemployment, with its destructiveimpact on human capital, loss of employa-bility, weakened ties to economic and sociallife, and for many, high degrees of povertyand social exclusion.35

What works? The key to avoiding these pit-falls is achieving a balance between protec-tion and flexibility. Design specifics mattera lot, as does the underlying structural con-text. Collective organization of workers isone of the main channels for securing bet-ter and more equitable working conditions.Free trade unions are the cornerstone of any

effective system of industrial relations.Unions act as agents for labor, coordinatingthe demands of workers and organizingthem into a single entity whose collectivebargaining power matches that of theemployer. Trade unions can help provide apositive work environment by reducinglabor turnover and by promoting workertraining and higher productivity. Unionshave also been found to reduce inequalityand wage discrimination in countries asdiverse as Ghana, the Republic of Korea,Mexico, and Spain.36 Unions also can havean important noneconomic role. They havebeen a force for progressive political andsocial change in many countries (Poland,the Republic of Korea, and South Africa).

But the involvement of unions in wage-setting can also have significant negativeeconomic effects. Evidence from industrialsocieties suggests that union involvementreduces the employment of young andolder workers (“outsiders”) and benefitsprime-age males and females.37 Unionsoften act as monopolists, improving wagesand work conditions for their members atthe expense of consumers and nonunionlabor. For example, recent studies of manu-facturing wages in Africa show substantialunion wage premiums (30 to 40 percent insome countries).38

Formal trade unions are most effective atimproving conditions for workers withouthuge efficiency costs when product marketsare competitive, so that unions cannot raisewages for their members by capturing rentsat the expense of other parts of society;when collective bargaining arrangementsand institutions have enough flexibility toaccommodate different demand and supplyconditions for different types of workers;and when unions operate in a context thatallows them to internalize and absorb thecost of their actions. On the other hand,when unions are co-opted by political elitesor by the state, their actions can have signif-icant costs for efficiency.

An illustration of the potentially highlypositive role of unions in improving workingconditions while supporting productivitygrowth comes from a study of worker-firmrelationships in high-value export crops in



worker associations in India, South Africa,and Thailand suggest that organizing infor-mal workers decreases the workers’ invisi-bility to policymakers and legislators, helpsthem gain access to information, gives themvoice and self-identity, and in some caseshelps to provide them with a range of socialprotection services (box 9.3).

Providing income security is anotherarea in which the structural context anddesign specifics, which pay attention toincentives and reward desirable behaviors,are critical to policy outcomes (box 9.4).This is also true of minimum wage policiesfor which the key to avoiding large effi-ciency costs is to get the level right and toallow for enough flexibility across types ofworkers to accommodate different demandand supply elasticities for their labor.40

Design specifics and the broader struc-tural context are equally critical to the suc-cess of legislation on other work standards(health and safety) or protection for specificvulnerable groups (such as child laborers,ethnic minorities, or the disabled). There isan international consensus that core laborstandards—freedom from forced and childlabor, freedom from discrimination at work,freedom of association, and the right tocollective bargaining—have such intrinsicvalue that they should always be pursued.But even for these core standards there arequestions about how to achieve them mosteffectively and with minimum cost.41

An example of government interven-tion to protect workers from abuse comesfrom Cambodia’s successful experience withimplementing core labor standards in thegarment industry. Starting in 1999 Cambodiacould earn a higher quota for exports to theUnited States by demonstrating improve-ments in working conditions. A monitoringsystem—developed and implemented by theILO, with support from the U.S. Departmentof Labor, the Government of Cambodia, andthe Garment Manufacturers Association ofCambodia—has virtually eliminated theworst labor abuses, such as child labor andsexual harassment. A recent survey showedenforcement of core labor standards in thegarment sector has boosted Cambodianexports to Europe and North America.42 But


Developing countries have trade unionsand large informal economies, twophenomena commonly thought to beincompatible. But recent work by Women inInformal Employment: Globalizing andOrganizing (WIEGO) has uncovered a sur-prising amount of organizing in the infor-mal economy. Formal trade unions thatextend their coverage to informal workersand trade unions of informal workers aretwo organizational forms that haveemerged. Organizing can also be done bycooperatives, savings-and-credit groups,producer groups, and neighborhood andtrade associations.

Organizing in the informal economydiffers from organizing in the formal econ-omy along several dimensions. Collectivebargaining can take many forms. Bargain-ing partners are not just employers but canalso include municipal authorities, police,wholesalers, and other interest groups.Activities of informal workers’ trade unionscan also extend beyond collective bargain-ing and include a range of services, such assavings, credit, social security, andadvocacy. Because members do not work ina standard workplace or for a singleemployer, membership in trade unions cantake unusual forms.

• Registered as a trade union, the Self-Employed Women’s Association (SEWA)in India is both an organization of poorself-employed women workers and amovement combining elements of thelabor, cooperative, and women’s move-ments. It offers a broad range of servicesto its nearly 700,000 members, includingbanking, health care, child care,insurance, legal aid, housing assistance,and capacity building (www.sewa.org).

• StreetNet International, launched in 2002in South Africa, has 15 affiliates (unions,cooperatives, or associations) in Asia,Africa, and Latin America that organizestreet vendors, informal market vendors,and hawkers. As of early 2004, these affili-ates represented 128,000 members(UNRISD Gender Policy Report).

• HomeNet Thailand is a network thathelps organize informal home-basedsubcontracted and own-account workers(mainly women). It drew attention to theplight of these workers following thefinancial crisis in 1998.

Sources: United Nations Research Institute forSocial Development (UNRISD) (2005); Womenin Informal Employment Globalizing and Orga-nizing (2005).

B O X 9 . 3 Organizing in the informal economy

northeastern Brazil. Union activity amonglandless agricultural laborers in this case wasan important factor behind improvementsin work practices that led to higher quality(critical for export crops), higher productiv-ity, and better working conditions for land-less workers. To effect this change, however,the union had to shift from defending theinterests of its traditional base of support(small farmers) to representing the interestsof a larger group of landless laborers. Successwas also facilitated by the fact that, on theemployer side, the union was negotiatingwith large firms from southeastern Brazil.These southeastern firms had experience incollective bargaining, in contrast to themore traditional large farmers of the north-east, which were accustomed to morerepressive and conflictive labor relations.39

Collective organization of workers canalso secure greater bargaining power andthus better working conditions for informaleconomy workers. Studies of informal


http://www.sewa.org

whether the system will survive the end of theU.S. quota incentives remains to be seen (seechapter 10).

How to reform a “bad” set of labor market institutionsReforming labor market institutions istechnically and politically difficult. It istechnically difficult because reforms needto be coordinated across a variety of labormarket institutions, and often also withreforms outside the labor market. It ispolitically difficult because there usuallyare vested interests in maintaining the sta-tus quo. Moreover, the short-term costs ofreform can be large and unevenly distrib-uted. Take reforms to reduce employmentprotection: those currently protected seethemselves as having much more to losefrom reform than to gain from such areduction. And if they are also politicallyinfluential—represented by unions andwith political voice—their power to block

reforms may be an insurmountable bar-rier.

Several countries have implementedsubstantial labor market reforms more orless successfully: Ireland, the Republic ofKorea, the Netherlands, New Zealand, andthe Slovak Republic among OECD coun-tries; Chile and Colombia among develop-ing countries (see box 9.5 for Colombia andthe Slovak Republic). China is in the midstof a large labor market transition, and theBalkans are struggling through dramaticlabor market reforms.

Experience suggests that effective changeinvolves a combination of factors: designingand implementing a consistent and com-prehensive policy package; tackling vestedinterests; broadening societal accountabil-ity, including increasing the voice of poorergroups; and, in some cases, compensatinglosers. Macroeconomic and financial shockscan facilitate change, although not always apositive one. Reforming institutions in the


Left to itself, the labor market does a poor job ofprotecting workers against a sharp loss in incomeassociated with unemployment. As a result, mostsocieties have developed ways to cope with thethreat of job loss. Often this involves some com-bination of informal support mechanisms, privatesavings, and obligations on employers.Whenthese mechanisms break down—as they dowhen the shocks are large, sudden, protracted, oraffect an entire community—the governmentneeds to step in. Government intervention typi-cally involves one or several of the followinginstruments: job security regulations, mandatedseverance pay, unemployment insurance, ormandatory self-insurance mechanisms.

Job security legislation is typically aimed atprotecting jobs and preventing job destruction.Most evidence suggests that it is quite effectiveat doing so. Across countries, more stringentemployment protection legislation (EPL) appearsstrongly associated with more stableemployment. But EPL reduces job destruction ata significant cost, as the expectation of high sep-aration costs makes firms more reluctant toexpand employment, and makes it lessprofitable to start new ventures or create newfirms. So, employment protection also reducesjob creation. For example, researchers found thatstrict new job-security laws enacted in the 1980sreduced employment in many industries in Zim-

babwe (Fallon and Lucas 1993). Overall, the neteffect of job security legislation on employmentis ambiguous (Bertola 1990; OECD 1999; Bertola,Blau, and Kahn 2001; Kugler 2004).

What is clear is that EPL changes the natureof unemployment. Lower job destructionreduces the incidence of unemployment. Butlower job creation increases the duration ofunemployment and can lead to the emergenceof long-term unemployment.

Not surprisingly, EPL appears to have a dif-ferent impact on different groups of workers. Inboth Colombia and Spain the reduction of dis-missal costs and job security provisions wasassociated with moderate increases in theemployment of young men and women (Kugler2004; Kugler, Jimeno, and Hernanz 2003). ForChile, Montenegro and Pagés 2004 find that jobsecurity regulations reduce the employmentrate of youth and the unskilled to the benefit ofolder and more skilled workers. A study acrossthe countries of the Organisation for EconomicCo-operation and Development arrives at a sim-ilar conclusion: consistent with the story thatEPL protects “insiders,” stricter EPL increases theemployment of adult men and reduces that ofyoung workers and women (OECD 1999).

Given the complex effects of EPL, how cangovernments best intervene to help protectworkers against temporary drops in income

associated with unemployment? Some EPL maybe efficient, reducing excessive volatility inturnover. But too strong EPL—as is typical ofmany formal sectors in the developing world—slows the pace of creative destruction central toinnovation and growth, with disproportionateadverse effects on those without “good” jobs.Yetreducing EPL needs to be complemented bygreater worker security that is not linked to spe-cific jobs, both on social welfare and politicaleconomy grounds.

The design of the optimal solution dependson the institutional and administrative capacityof government and on the structural characteris-tics of the labor market (Blanchard 2004). Coun-tries with significant administrative capacity andmedium to high incomes can implement unem-ployment insurance systems with incentives forjob search (declining benefits with duration andprovision of benefits conditional on acceptanceof acceptable job offer). Middle-incomecountries reluctant to implement a full-blownunemployment insurance system can supportself-insurance mechanisms, such as mandatorysavings accounts (but because of the limits toself-insurance, these are not as effective). Low-income countries can opt for public worksschemes, which if effectively designed are self-targeting and can be implemented even whenlevels of informality are high (chapter 7).

B O X 9 . 4 Employment protection legislation


midst of widespread job loss and highunemployment (as in the Republic of Koreafollowing the 1998 financial crisis) is partic-ularly difficult, even though it may be easierat such times to achieve societal consensusfor reform.

Designing a consistent and coherent policypackage. One of the strongest lessons fromcountry experience is that piecemeal reformdoes not work (tinkering at the margin usu-ally has perverse distributional effects).Moreover, reforms need to cover a range oflabor market policies and to be linked withreforms in social protection systems.Reform is more effective and more equi-table when different labor market instru-ments are coordinated: measures to reduceinsider power and increase flexibility bylowering the restrictions and costs of firingcan be linked to setting up of unemploy-ment insurance mechanisms and eliminat-ing dual status contracts. Reforms in othermarkets and the public sector are often keyto the success of labor market reform. The

depth and competitiveness of other markets(including product and financial markets)are critical.

Tackling vested interests. Reforms are oftenheld hostage by politically more powerfulgroups. For example, policies to reduceemployment protection, allow for submini-mum wages, or streamline and improve pub-lic sector employment typically encountersharp resistance from unions. Building broadsocietal consensus for reform is often theonly way to tackle these vested interests. As afirst step, this may require documenting thehigh costs of bad labor market policiesthrough good data collection, analysis, anddissemination (as in the Slovak Republic).

Broadening social accountability. Buildingsocietal consensus in support of labor marketreform may require specific measures toempower the groups of so-called outsiders ordisenfranchised workers who bear the costsof nonreform. It helps to have political partiesand societal organizations with broad bases


Comprehensive reform in the SlovakRepublicIn 2000 unemployment in the Slovak Republicreached 19 percent of the labor force—the high-est in the OECD at that time.The main factor wasthe substantial job reallocation generated by thetransition to a market economy, compounded bylow labor mobility because of skill and regionalmismatches. But the impact of the transitionshock on the labor market was worsened by aninadequate set of institutions: high rates of taxa-tion of labor and overly generous unemploymentbenefit and social assistance systems, which dis-couraged job search and encouraged informality.

Reforming these institutions in the midst ofhigh unemployment was extremely difficult,particularly for a reformist government with asmall majority in parliament. But in early 2003,bolstered by its reelection, the reformist Slovakgovernment undertook a comprehensive andambitious reform of social and labor market pol-icy.The government’s multipronged strategycombined measures to reduce the taxation oflabor, increase the incentives to work throughreform of unemployment insurance and socialassistance, invest in the skills of labor andemployability, improve the matching of workers

and jobs through higher labor flexibility andmobility, and strengthen state administration inlabor and social policy.

The new strategy represented a markedchange in philosophy in labor and social policyin the Slovak Republic: from a system that mixedingredients of insurance and redistributiontoward one that separates social insurance fromequity objectives; and from a tradition of entitle-ments based on subjective or “moral” norms toone that guarantees a certain living standard toall citizens irrespective of the reason they mayhave for being poor, but that rewards individualinitiative and motivation.

The key ingredients in pushing the reformthrough were a reformist government with astrong popular mandate; strong leadership andtechnical competency from the Ministry ofLabor and Social Affairs; accession into the Euro-pean Union as a disciplining device; and wide-spread public perception, built on analysis anddissemination of this analysis, that institutionalreforms were needed. Moreover, labor marketreform was carried out not in isolation but aspart of a broader policy package to make theSlovak economy more competitive in light of EUaccession.This package included a substantial

overhaul of personal income taxes, as well asreform of the education system.

Partial labor market reform in ColombiaIn 1990 Colombia introduced a labor marketreform that substantially reduced the costs ofdismissing workers.The reform reduced sever-ance payments, widened the definition of “just”dismissals, extended the use of temporary con-tracts, and speeded up the process of mass dis-missals.The joint effects of these reforms wereto reduce the costs associated with firing work-ers in firms covered by the legislation. But thereforms did not affect informal sector firms,which did not comply with the legislation.

An analysis of the effects of the reforms sug-gests that they did increase the dynamism ofthe Colombian labor market by increasing exitrates into and out of unemployment (greaterchurning).There was an increase in workerturnover for formal sector worker, greatestamong young workers, more educated workers,and workers employed in larger firms.Thereforms may have also contributed to increasingcompliance with labor legislation by reducingthe costs of formality.

Source: Kugler (2004).

B O X 9 . 5 Two cases of labor market reform: one comprehensive, one partial


of representation and support. When this isnot the case, it may be necessary to look forways to open up institutions and give greatervoice in bargaining (at all levels) to represen-tatives of disenfranchised groups. This iseasier when there are democratic local gov-ernments and strong autonomous associa-tions—independent private business associa-tions, worker associations that represent theinterests of specific groups, and so on. Theindependent private sector is also a naturalally when it comes to reforming public sectoremployment and wage practices.

Compensating losers. The short-term costsof reforms can be high for certain groups ofworkers: unemployment insurance and socialassistance reform in the Slovak Republic dis-proportionately hurt Roma workers andthose living in high unemployment regions.So it may be necessary to compensate the los-ers. It is best to do this in ways that addressthe obstacles that losers face in reentering thelabor market (support for education or train-ing) or that facilitate labor mobility andreward work incentives (transport vouchersfor workers moving from social assistance towork). Such compensatory measures havebeen introduced as part of the Slovak Repub-lic’s labor market reform package.

Product markets and trade reformProduct markets are intimately related toequity, with two-way patterns of causation:product markets shape the distribution ofeconomic opportunities, and inequalities ininfluence shape the functioning of productmarkets. Both the design of external tradepolicy and the workings of internal productmarkets reflect patterns of influence. Re-moving barriers and excessive regulationneeds to be complemented by measures toexpand skills, infrastructure, and safety netsto achieve genuine access and help losers.

Market broadening and deepening arecentral to the expansion of opportunity:directly for firms and the self-employed,indirectly for workers. How equitable thisexpansion of opportunity is depends oninteractions among external trade opening,domestic markets, patterns of infrastruc-ture, labor markets, safety nets, and other

measures to improve the business climate.Product market and trade reforms havegreat potential to bring expansion inopportunity, but there can be costs in theshort to medium term, and these can hitparticular groups, from relatively powerfulprotected incumbents to middle and poorergroups. The costs are associated with howmarkets and investment processes work:labor is typically not fully mobile, new skillstake time to acquire, and new investmentsare often lumpy and can take time, espe-cially when firms face imperfect credit mar-kets (see earlier section) and an uncertaininvestment environment.

The functioning of product markets isembedded in political and social structures.Elite capture ranges from the apparent andegregious—as in the granting of the Indone-sian clove monopoly to a son of PresidentSuharto (a monopoly since disbanded)—tothe less transparent shaping of trade policyto protect the profits of the influential. It isalso true that policies with (genuine orrhetorical) equitable purpose can lead tooutcomes that are bad for growth and mixedfor equity. This is evident in the characteris-tically high levels of protection for relativelylabor-intensive manufacturing and for foodproduction (such as maize in Mexico, rice inthe Republic of Korea, and the infamousagricultural subsidies in the EuropeanUnion, Japan, and the United States). Whilepoorer groups sometimes gain, it is morecommon that middle and elite groups arethe main beneficiaries, while food con-sumers lose out.

While policies that reduce the power ofincumbents in product markets will typi-cally be good for efficiency and equity, aversion of the “liberalization paradox” dis-cussed earlier may often apply. Groups andindividuals with economic capacity andpolitical influence are best positioned totake advantage of market opening. Undersome conditions this can lead to marketbacklash. Chua (2004) documents cases of“market-dominant minorities” who benefitfrom free market reforms, including tradeliberalization. Traditionally dominant eth-nic minorities, such as the Chinese inSoutheast Asia, the Lebanese in West



Africa, and whites in Latin America andSouth Africa, seem to be the primary bene-ficiaries of the marketization of theireconomies. Such outcomes can fuel deep-seated resentments and lead to violence.These political economy and reform back-lash considerations are additional reasonsfor integrating attention to equity into thedesign of product market reforms andtrade liberalization.

Trade liberalizationTrade liberalization changes relative pricesin an economy, causing shifts in output,wages, and employment. Analyses of tradeliberalization are primarily about out-comes, providing only indirect evidence onopportunities. They show that trade open-ness is positively associated with growthand, on average, there are no strong corre-lations with income distribution. Morley(2001), using data from Latin America,found slightly negative effects of trade lib-eralization on income distribution, whileBehrman, Birdsall, and Székely (2003)found positive influences of trade liberal-ization on wage inequality. Another studyusing panel data for 41 countries foundthat trade openness is associated withincreases in inequality, after controlling fora set of other structural and policy influ-ences.43

These average effects mask a great deal ofdiversity in impacts across groups, espe-cially over the short to medium term. Theimpact of trade-induced price changesdepends not only on average pass-throughbut also on exactly which prices change andhow producers and consumers respond.44

For example, the effects of removing pro-tection for agriculture will depend onwhether agricultural prices subsequentlyrise or fall and whether the poor are netproducers or consumers of disprotectedproducts. Normally, it is assumed that tradeliberalization in agriculture will benefitpoor small-scale farmers and be good forequity. After all, “developing countries havetraditionally taxed the agricultural sectorwhile developed countries have protectedit.”45 But the impacts must be analyzed caseby case at the microlevel.

Cereal protection in Morocco offers anillustration. In a simulation analysis ofremoval of wheat tariffs, Ravallion (2004b)finds that, contrary to expectations, ruralfamilies would tend to lose while urbanones would gain. Although the results pre-dict that there would be more gainers thanlosers among the rural poor, aggregatelosses outweigh aggregate gains. Further-more, expected effects would be enor-mously varied, with significant horizontalinequalities: households with the sameincomes were predicted to experiencewidely differing outcomes, depending ontheir specific structure of production andconsumption. Using a similar simulationanalysis, China’s accession to the WorldTrade Organization (WTO) was found tohave a small aggregate poverty-reducingeffect, but this masked considerable varia-tion in impacts across households in ruralversus urban areas and across differentregions.46

While aggregate effects of trade reformon poverty and equity are not alwaysclear—whether diverse impacts translateinto inequalities in opportunities dependson how new activities open up, and whetherlabor can move into them—we do knowthat there will be winners and losers. Out-comes depend on the ability and willing-ness of governments to mitigate losses toparticularly hard-hit sectors, possibly byredistributing some of the gains accruing towinners.

Domestic product markets and equityLack of competition among traders, remotegeography, poor infrastructure, and hightransport costs can all prevent the transmis-sion of border price changes to intendedreform beneficiaries. Addressing such prob-lems can improve the impact of tradereforms on equity.

The case of public or private marketingagencies for export crops is a typical exam-ple. Small farmers in many countries tradi-tionally have had no option but to sell to amarketing agency at prices substantiallylower than the free on board (f.o.b.) exportprice. Legitimate transport and marketingcosts account for some of the price differ-



ence, but monopsonistic profits often do aswell. Marketing agencies can thus preventtrade-induced price changes from reachingfarmers at all.47 A 1998 study found that theVietnamese rice marketing system wascontrolled by a small number of state enter-prises. These enterprises limited the trans-mission of border price changes to farmersand pushed up transaction costs.48 A moreextreme example was when marketingboards became instruments for extractionof surplus from agricultural exporters, suchas for cocoa farmers in the post-independ-ence period in Ghana. Malawi has facedsimilar issues: cartels by companies buyingtea, sugar, and tobacco have forced downthe returns to farmers.49

Abolishing marketing boards does notguarantee efficient marketing, however,they may play a useful role when marketsare thin, or a tradition of trading has notdeveloped, as in the raw cashew exportmarket in Mozambique. Although the statetrading company was privatized in the late1980s, there was insufficient competitionamong private marketers when raw cashewexport restrictions were lifted in the early1990s. Indeed, raw cashews had to movethrough three tiers of intermediaries withnear monopsony power before reachingworld markets. As a result, the trading mar-gin from the farm to the factory was 50 per-cent and the expected liberalization priceincreases never reached farmers.50

Trade reforms in Mexico show how infra-structure and transportation costs can shapeopportunities through their impact on pricetransmission. Mexico’s trade liberalization inthe 1980s and entry into North AmericanFree Trade Agreement (NAFTA) in 1994appear to have led to wage increases in statesbordering the United States relative to the restof the country.51 A different study on Mexicofound that tariff reductions translate intodomestic price reductions less and less as dis-tance from the main port of entry increases.This effect can be substantial (figure 9.4).Studies of Rwanda and Indonesia have alsodocumented the isolation of remote house-holds from border price changes.52

Even when trade liberalization is intendedto be pro-poor, incomplete transmission of

border price changes for both exports andimports means that benefits are not evenlydistributed. In other words, ease of access tointernational markets matters. Unfortu-nately, those who could benefit most fromfavorable price changes—the poor in remoterural areas—are those least likely to beaffected by them.

Many of the factors responsible for trans-mitting trade-related price changes are alsoimportant to the functioning of domesticproduct markets. For instance, competitionamong traders, infrastructure quality, andtransportation costs all influence how prof-its are allocated across a product’s life cycleor value chain. And the percentage of agood’s final price that goes to the primaryproducer, intermediary producer, distribu-tor, and retailer can vary tremendously.

The cashmere sector in Mongolia showshow product market reforms could be bothequity- and efficiency-enhancing. If properlydeveloped, cashmere could be a pillar ofMongolia’s successful transition from a com-mand to a market economy. It is the country’ssingle largest employer and a principal sourceof livelihood for the poor. It provided jobs formore than 16 percent of the workforce andaccounted for more than 6.3 percent of GDP


Changes inhousehold welfare

> 5 percent4–5 percent2–4 percent0–2 percent

Figure 9.4 It’s better for household welfare to be close to economic opportunities

Source: Nicita (2004).Note: Welfare changes were calculated from the effects of trade liberalization–related price changes that affectedboth the purchasing power and incomes of households.


during 1993–2002. But unsatisfactory publicsector policies have meant that the industryhas not lived up to its potential.

One significant bottleneck is in market-ing and distribution. Mongolia’s major cash-mere market is in Ulaanbataar, 600–1,000km from most regional production centers.Herders generally have to sell to traders atthe farmgate or at informal provincial mar-ketplaces at discounts of 10 to 45 percentfrom prices in Ulaanbataar. With littleknowledge of market demand, individualherders can incur costs traveling to marketswith no certainty of a sale. Policies thatencourage regional market centers andherder cooperatives, as well as infrastructureimprovements, could reduce marketingcosts and increase herder’s margins.53

Soybean farming in India offers anotherillustration of how product marketingchannels can improve equity. Ninety per-cent of the soybean crop is sold by smallfarmers to traders, who act as purchasingagents for buyers at a local, government-mandated marketplace, called a mandi.Farmers have only general informationabout price trends and no choice but toaccept prices offered to them by traders orthe auction price on the day they bring theirgoods to the mandi. As a result, traders canexploit farmers and buyers using practicesthat create systemwide inefficiencies.

Under the e-Choupal Initiative, ITC, oneof India’s leading private companies, placedcomputers with Internet access in ruralfarming villages. Each computer—placed ina farmer’s home and serving about 10villages—becomes a social gathering placefor the exchange of information and an e-commerce hub. Farmers can use the com-puters to check prices, learn about farmingtechniques, purchase inputs, and sell theirsoybean crops at the previous day’s marketprice. Farmers then have to transport theircrop to an ITC processing center, where it iselectronically weighed and the farmer isimmediately paid. Farmers selling to ITCthrough an e-Choupal receive, on average,2.5 percent more for their crops, and ITCsaves an additional 2.5 percent on procure-ment costs by cutting traders out of the loop.Farmers also benefit from accurate weighing,

prompt payment, and information aboutprices and price trends that allows them tooptimize their sales decisions. The e-Choupal system continues to grow rapidly,reaching more than 3.1 million farmers bylate 2004.54 The initiative illustrates howimprovements in technology and communi-cations infrastructure can be good for bothequity and efficiency in product markets.

In addition to better marketing channelsand new technology, there are other ways toimprove product market competition thatcan be good for equity. Measures that facili-tate the entry of new firms often mean thatsmall and medium enterprises benefit at theexpense of large, politically connectedincumbents. Product market competitioncan also drive consumer prices down andmake goods more affordable for the poor.Of course, measures to improve competi-tion benefit efficiency and growth as well,improving the welfare of the poor.

Licensing restrictions—even when de-signed in the name of equity—are one wayto hamper competition. India reserves theproduction of more than 600 manufacturedproducts, including apparel and textiles, tosmall companies. This licensing regimecould cost the country jobs by preventingsmall producers from growing and compet-ing with larger manufacturers in, for exam-ple, China. High regulatory, administrative,and fiscal burdens can also harm productmarkets by keeping firms in the informalsector. Informal firms face a number of con-straints, including limited access to financ-ing, which tend to leave them significantlyless productive than their formal sectorcounterparts. For example, informal Turkishbrake manufacturers achieve only 22 percentof U.S. productivity, while their formal sectorcompetitors achieve 89 percent. Affordableaccess to titled land and reliable infrastruc-ture (chapter 8) can also enhance firm andproduct market competitiveness.55

As discussed, improving transportationand logistical infrastructure can reduce thecost of moving goods. Better transportationlinks with other regions can also provideinsurance against regional price fluctuations.For example, if there is a drought or foodshortage in one area, efficient regional con-



nections would allow consumers to importreasonably priced food from other parts ofthe country. Finally, better transport andlogistics systems reduce inventory costs bymaking the timing of delivery more reliable,again benefiting producers and consumers.56

Interactions between product and labor marketsChanges in product markets, whetherinduced by internal developments or exter-nal trade-related changes, can have power-ful influences on the opportunities facingworkers. Standard trade theory predictsthat countries should export products thatuse relatively abundant factors intensively.Labor-abundant countries that open upshould see relative gains in unskilled wages,as indeed occurred among the East Asiantigers in the 1960s and 1970s.57

The Latin American experience stands insharp contrast. Many countries, includingArgentina, Chile, Colombia, Costa Rica, Mex-ico, and Uruguay, saw wider wage differen-tials with increasing trade openness duringthe late 1980s and 1990s. Some argue that thiswas due to the massive insertion of low-income Asian countries into global markets.Others interpret the evidence as supportinggeneralized skill-biased technical change, inwhich trade opening facilitated processes ofrestructuring, including the destruction ofjobs in inefficient industries, and risingdemand and relative wages for skilled work-ers.58 Whatever the reason, the question iswhether this was a source of rising inequalityin opportunity. Over the short to mediumterm, this was almost certainly the case,because unskilled workers cannot increaseskills quickly. Over the longer term, risingwage differentials provide incentives forinvestment in education, if education systemsprovide equal opportunities (chapter 7).

Effects of economic restructuring onworkers also depend on the extent of labormobility. One study from India shows thatthe effects of trade liberalization in the early1990s on poverty varied by state, dependingon the flexibility of labor laws. In states withless flexible laws, where liberalization did notproduce any measurable effect on the alloca-tion of labor across sectors, the adverse

impact of trade opening on poverty was feltthe most. In states with more flexible laborlaws, movements of labor across sectorseased the shock of relative price changes.59

While greater mobility is desirable, thedesign of measures that increase flexibilityneeds to be balanced with the levels ofworker protection that are appropriate forthe institutional setting (see the earlier dis-cussion on labor markets).

Safety nets and opportunitySafety nets complement product marketdeepening and are often an essential ele-ment of a strategy to ensure that marketexpansion leads to more equal opportuni-ties. General questions of the design ofsafety nets were discussed in chapter 7; herewe highlight the links with product marketchange. As discussed above, trade openingcreates winners and losers. How this affectsequity depends partly on how governmentscan offer support to the losers.

Rodrik (1998) finds that openness isassociated with higher government spend-ing. The argument is that open economiesare more subject to external shocks andspend more on social insurance to mitigateexternal risk. In more advanced economieswith the capacity to manage social welfaresystems, exposure to external risk is stronglycorrelated with spending on social securityand welfare. In less-developed economies,governments rely on a broader set of tools,such as public employment, to reduce risk.

The specific design of safety nets canexpand opportunities to those who sufferadverse effects. For instance, trade adjust-ment assistance programs in the UnitedStates extended unemployment benefits,training, and relocation subsidies to displacedworkers. While the United States was offeringthe programs in response to the NAFTA, theMexican government established Procampo, acash transfer program for grain farmers toease the pain of NAFTA-induced competitionfrom the United States. It was designed toprovide consumption support to compensatefor price declines and to allow farmers todiversify into other activities. While the size ofthe transfers was hurt by the 1995 TequilaCrisis, there is evidence of gains to farmers



and of the use of proceeds for investmentpurposes.60

While the ideal policy mix may be one thatcombines reduced barriers and extensivesafety nets, in practice, this is not always feasi-ble. Many countries phase liberalization toseek to ensure that processes of job creationprecede or accompany job destruction—thishas been a central feature of the East Asianexperience (see discussion of China in chap-ter 6). This carries risks of slowing restructur-ing and extending protection beyond periodsjustified by equity concerns because of cap-ture by influential beneficiaries.

Credibility, political supportability,and the design of product market reform While technocrats can design trade andother product market reforms that appearto be good for growth and equity, theexpected gains will never materialize ifthere is not enough political support.Because of the nature of trade policy—aconcentrated set of winners from trade bar-riers versus a diffuse set of winners fromliberalization (consumers in general)—it iseasy for vested interests to capture policy.Steel tariffs in the United States and agricul-tural subsidies in the United States, Japan,and Europe are obvious examples.

Even after trade liberalization laws havebeen passed, they are still not immune tocapture. If economic actors do not believethat reforms are credible—that is, thatpoliticians will recant at the behest of vestedinterests—the anticipated adjustments willnever take place. Cashews in Mozambiqueagain provide an apt example. In the early1990s, the Mozambican government (work-ing with the World Bank) implemented anew pricing regime that liberalized theexport of raw cashews. But there was nocredible political commitment to the newpricing regime, so neither cashew farmersnor cashew processors adjusted to the newprice signals. Efficiency gains from the real-location of resources never materialized.61

While this section has emphasized the het-erogeneity of effects of product marketchanges, the policy message is not necessarilyone of detailed fine-tuning of reforms. That

brings risks of greater capture. The idealbalance is a combination of gradual but com-mitted liberalization with extensive engage-ment in the complementary measures thatbroaden opportunities for all: education,infrastructure, competition, and safety nets.Societal debate and information can ensurethat governments remain accountable to allgroups, not just those with access and connec-tions. Of particular importance for externalopening is the role of external commitments.Entry into international agreements, such asthe WTO, the European Union, or NAFTA,can effectively lock politicians into tradereforms. When trade regulations are boundby international agreements, reform commit-ments are more credible and less susceptibleto capture by domestic special interests(asymmetries in power among the interna-tional parties to such agreements remain, aswe will read in chapter 10).

Macroeconomic managementand equityMacroeconomic instability is both acause and consequence of inequityMacroeconomic stability is a public good andmight be expected to equally affect all. Thereis a well-established association betweenmacroeconomic stability and long-termgrowth, and growth typically brings expan-sion in opportunities to everyone. But thefact that stability is a public good does notmean that the incidence of benefits is equal.As discussed in chapter 4, the distribution ofincome gains from economic growth is typ-ically as unequal as the initial income distri-butions. Moreover, macroeconomic insta-bility, whether in the form of volatility orhigh inflation, can have differential andpotentially inequitable effects, because thepattern of power and wealth can influencethe distribution of losses—and differentgroups have differential capacities to man-age the consequent shocks.

As in many other areas, there are two-way patterns of causation between macro-economic conditions and equity. Unequalpatterns of power and associated institu-tional structures are at the center ofcausative influences from inequity to insta-



bility and in regressive effects of crises. Byemphasizing these links, we are not arguingagainst the large body of literature on eco-nomic causes of crises. Depending on thetype of crisis, this literature sees the causesas fiscal imbalances, herdlike movements ofinvestors behind exchange rate crises, andinteractions among external liabilities,exchange rates, and financial-corporateconditions, especially under “crony capital-ism.”62 Some of the processes in this litera-ture complement the diagnosis here; othersare manifestations of underlying distribu-tional and institutional conditions.

Figure 9.5 shows the bivariate correla-tion between macroeconomic volatility anda measure of “constraints on the executive”branch of government, which would beexpected to be closely linked to restraints onelite power. Weaker constraints are associ-ated with greater volatility (and a higherpropensity for macroeconomic crises).

The correlation says nothing about cau-sation. But there is evidence supporting theview that “weak and unequal” institutionshave a causative influence on economicinstability. A tradition of work interpretsinstability as a consequence of distributionalstruggles that are ineffectively managed byinstitutions.63 As discussed in chapter 6, theseminal work by Bates (1981) on Ghanainterprets exchange rate overvaluation andinternal pricing policies as mechanisms forgovernments to severely tax cocoa farmersin the early postindependence period toprovide resources to buy off urban groups. Acombination of predatory governments andweak or absent balancing institutions cre-ated the preconditions for fights over rentsand systematic political instability until theearly 1980s. Analyses of hyperinflation, insettings as diverse as Bolivia and Israel,interpret macroeconomic instability as aconsequence of failures to manage societalconflicts.64

Macroeconomic instability caninteract with unequal influence inthe fallout from crisesCrises, whatever the causes, are systemati-cally bad for growth, more so in the pres-ence of distributional struggles. Rodrik

(1999a) argues in a cross-country empiricalanalysis that the effects of external shocks inthe 1970s were significantly worse for sub-sequent growth in societies in which latentdistributional conflicts (proxied by incomeinequality or ethnolinguistic fragmenta-tion) were more severe and conflict-management mechanisms (proxied byinstitutional strength and indicators ofdemocracy) were weaker.

High inflation and macroeconomiccrises can be particularly harmful to thepoor, who are least equipped to manageadverse shocks. For the impacts on distribu-tional outcomes, household survey evidencedoes not display systematic disequalizing orequalizing biases across countries: the Mexi-can 1994–95 crisis was slightly equalizing(although strongly poverty-increasing); the2001 Argentine crisis was disequalizing.There is some evidence that high inflation isworse for poorer groups, for example, in thePhilippines65 and Brazil.66

Mechanisms for crisis resolution tend tobe inequitable as a result of unequal influ-ence. Many of the results are not fullyreflected in household income and spendingsurveys. The reason is that the big actionusually takes place elsewhere, notably inchanges in capital income and fiscal posi-tions that the surveys typically fail to capture.


Constraints on the executive index80 2 4 6

Standard deviation of GDP growth20

15

10

5

0

Figure 9.5 Weaker institutions are associated withmacroeconomic volatility and crises

Source: Authors’ calculations, using World Bank statistics and thePolity IV database for constraints on the executive index.Note: A higher value for the constraints on the executive indexdenotes greater accountability.


There is evidence that crises lead to reduc-tions in measured labor share (strongly influ-enced by formal sector earnings andemployment). Diwan (2001) finds thatlabor shares systematically fall during crisesand don’t fully recover afterward, a cross-country result illustrated for Mexico andPeru in figure 9.6.67 The flip side of this pat-tern is that the shares of corporate andfinancial sector capital income rise relativeto wages. There are also significant interac-tions with structural variables. In particu-lar, closed trade, capital controls, and fiscaldeficits are associated with higher laborshares in normal times, but with larger fallsin labor shares when crises occur. Crises aremechanisms for the resolution of distribu-tional conflicts that are not tackled duringgood economic times. Labor is relativelyimmobile and so typically bears a higherproportion of the cost. Pre-crisis laborshares may, in some cases, have been toohigh for competitiveness and stability, butthe point is that crises are a high-cost formof conflict resolution. And the interactionbetween shocks and weak conflict resolu-tion mechanisms is associated with weakerlong-run growth.68

In addition to any effects through thedistribution of labor and capital income,important mechanisms work through thefinancial sector and associated fiscal action.

Major crises lead to large financial losses,typically financed by both explicit andimplicit fiscal outlays. Case study evidenceindicates that these are highly regressive,through gainers and losers from capitalflights, transfers from those outside towithin the financial system, and the pat-terns of bailout among financial sector par-ticipants.

The fiscal costs of crises are large (table9.3). For example, the post–Tequila CrisisMexican bailout is estimated at $112 bil-lion, with a large additional amount spenttrying to prevent crises through liquiditysupport, sovereign bond swaps, and thefinancing of large investors who withdrawmoney from projects.69 Halac and Schmuk-ler (2003) use the $23 billion decline in thecentral bank’s reserves between Februaryand December 1994 as a proxy, calculating atotal fiscal and quasi-fiscal cost of the crisisof $135 billion. This represents about one-quarter of Mexico’s GDP in 2000 and somefour times the $33 billion in capital receiptsfrom privatization during the 1990s.

What is the pattern of gainers and losers?Some wealthy individuals undoubtedly losetheir shirts. But there are strong tendenciesfor the poor to lose, sometimes to lose a lot.First, the wealthy with information andaccess to international banking systems gettheir money out first. And they may actuallyexperience capital gains when domestic assetprices tumble and the exchange rate goesagainst the currency. In Argentina, the ratioof foreign assets to domestic GDP rose fromabout a quarter to more than 90 percentbetween 2001 and early 2002, because of acombination of capital flight and currencydepreciation (figure 9.7).

Second, the recipients of fiscal bailoutsare those within the financial system—depositors, creditors, and equity owners,who are systematically better off than thoseoutside. (There are of course small middle-income depositors but, as noted below, it ispossible to protect them without providingblanket protection for all.) Case study evi-dence finds biases toward wealthy and moreinfluential individuals and groups withinfinancial systems. Owners of large depositsenjoyed the greatest compensation (and


Table 9.3 Fiscal costs of selectedbanking crises

Country Fiscal cost and episode (percent of GDP)

Argentina, 1980–82 55.1

Brazil, 1994–96 13.2

Chile, 1981–83 41.2

Ecuador 1996– 13.0

México, 1994– 19.3

Venezuela, 1994–97 22.0

Korea, Rep. of, 1997– 26.5

Indonesia, 1997– 50.0

United States, 1981–91 3.2

Source: Honohan and Klingebiel (2000). Note: Costs refer to both fiscal and quasi-fiscaloutlays and the present value of the futurestream of costs. Banking crises in Ecuador,Mexico, the Republic of Korea, and Indonesiawere ongoing at the time of the study.

1973

1970

1976

1979

1982

1985

1988

1991

1994

1997

1973

1970

1976

1979

1982

1985

1988

1991

1994

1997

MexicoLabor share

45

40

35

30

25

20

50

15

PeruLabor share

45

40

35

30

25

20

50

15

Crisis year Crisis year

Figure 9.6 Labor shares fall during crises and don’t fully recover afterward

Source: Authors’ calculations, based on national accounts.Note: Crisis years are defined as years in which at least two out of three of the following occur: a 25 percent (orhigher) nominal devaluation, negative growth, and 50 percent (or higher) rate of inflation.


sometimes capital gains) in crises inArgentina, Ecuador, and Uruguay, oftenthrough getting their money out of thecountry, while small depositors sufferedcapital losses. In addition, there is evidencethat large borrowers with close connectionsto banks were especially favored in crises inChile, Ecuador, and Mexico.70

Crisis costs are paid for by some combi-nation of higher taxes and lower spending.Who pays depends on the marginal patternof taxation and spending. As a first approxi-mation on the tax side, many developing-country tax systems are roughly propor-tional (everyone pays the same proportionof their income, primarily through indirecttaxation). On the spending side, work onLatin America and Asia in the 1990s findsthat marginal spending was generally pro-gressive, as the expansion of social andinfrastructure programs “crowded in”poorer groups.71 Thus, the forgone spend-ing hurt poorer groups the most. The neteffect is a regressive workout financedlargely by regressive fiscal adjustment.

While case study evidence indicates astrong pattern of regressive consequences of

crises, this is contingent on initial struc-tures, patterns of influence, and policyspecifics. For example, the Russian crisis,while undoubtedly costly in social terms,may have led to a surprisingly positive shiftto more equitable structures of resourcemanagement (box 9.6).

Policy directions need to take accountof policy design and accountabilitystructuresMacroeconomic instability is thus bothproduct and cause of underlying inequali-ties and associated weak institutions. Thecosts are large to equity and growth. Whatcan be done? As in other areas, it helps toanswer this question in terms of the com-


Dec.2000

20.0 22.4 21.024.4

28.6

110.0

107.3

102.2

97.295.494.4

94.4

Mar.2001

Jun.2001

Sep.2001

Dec.2001

Mar.2002

Net private foreign assets (US$ billions)Net private foreign assets (percent of GDP)

Capital flight = $12.9 billio

n

Figure 9.7 In Argentina, the wealthy had a way outduring the crisis

Source: Ministry of the Economy, Argentina.Note: The sharp increase between December 2001 and March2002 was because of the exchange rate devaluation.

The Russian crisis was at first glance typical ofcrises of the 1990s—driven by interactionsbetween private capital movements anddomestic institutional structures that encour-aged moral hazard,and with large adverseeffects for welfare.The social costs weresevere,with a fall in GDP of 5 percent in 1998.Between 1996 and 1998 household per capitaexpenditures fell 25 percent,expenditurepoverty rose from 22 to 33 percent and gov-ernment transfers fell by 18 percent,albeitwith better targeting (Lokshin and Ravallion2000).There was also major capital flight,withmany of the rich getting their assets out fast,leaving the rest of the society to share thecosts.This fact alone is a sign of great inequity:the rich had more opportunity to protect theirassets by shifting money out of the country.This (individually rational) behavior imposedcosts on less wealthy groups.

But the transition appears to have hadadditional effects that were, at least to somedegree, more equitable. Russia before thecrisis was in a particularly inefficient andinequitable equilibrium, in which firms didnot pay their energy or tax bills, and theenergy sector didn’t pay its taxes. Firmswere not allowed to go under for fear ofemployment effects, but this was a highlyineffective safety net. Subsidies were esti-mated at 15 to 20 percent of GDP in thethree years before the crisis, fueling corrup-tion and delaying enterprise restructuring.There was extensive asset-stripping at thecost of the broader society.

The crisis triggered major changes ineconomic relationships.The strategy of“devalue and default” led to large relativeprice movements and cut Russia off frominternational capital markets.The cutoff,combined with the authorities’ recognitionof the unpopularity of hyperinflation, finallyforced hard budget constraints on the sys-tem, which had powerful ripple effects ininducing the demise of the nonpaymentssystem, making economic transactionsmore transparent and laying the basis for arecovery in taxes. Real exchange rate depre-ciation made many firms competitive again,and this fed through into employment. Fur-thermore, the big Moscow banks wereallowed to fail (with total costs, largelyincurred before the meltdown, a relativelylow 2 percent of GDP). And the defaultmeant that external holders of Russianpaper took an immediate loss, effectivelyallowing a degree of international burden-sharing.While there were undoubtedly rep-utational costs, there may have been anadvantage in taking this upfront, ratherthan after protracted negotiations. Overall,while a serious analysis of impacts on equal-ity of opportunity is not feasible, the effec-tive shift in regime from a system in whichinfluence played a dominant role inresource allocation to one of hard budgetconstraints and greater transparency wasprobably good for efficiency and equity.

Source: Pinto and others (forthcoming).

B O X 9 . 6 Did the Russian 1998 crisis have equitableconsequences?


plementary role of specific policy designand the deepening of accountability struc-tures and societal mechanisms to manageconflict. The Israeli hyperinflation providesan illustration. Its resolution involved botha full set of financial and macroeconomicpolicies and an intensive process of societalinteraction to manage underlying conflictsbetween organized labor, the corporate sec-tor, and other interest groups.72

There is an extensive body of literatureon design specifics. Thus, we conclude withsome comments on the principles of macro-economic management that emerge from afocus on equity. Some of the principles arefairly familiar, especially the need to buildstronger regulatory and supervisory struc-tures for the financial system and compre-hensive insurance mechanisms while out ofcrisis. Once a crisis hits, it is particularly dif-ficult to design and implement such meas-ures and politically difficult to implementmore equitable outcomes. By contrast exante insurance design—whether for deposi-tors, bankruptcy, or unemployment—ismore likely to be broad based and, if alreadyin place, reduces the case for ex post dealstailored to the influential.

Less obvious is a heightened emphasison fiscal prudence. In public debates,adopting a less stringent macroeconomicstance is often portrayed as a distribution-ally progressive approach, whether in goodtimes or bad. While there will always bespecific judgments about the distribu-tional impacts of a range of fiscal andmonetary policy options, the analysis heresuggests that taking a “superprudent” posi-tion over the course of the cycle providesgreater hope for supporting a more equaldevelopment pattern. On one level, thissharply reinforces the common prescrip-tion to break procyclical policy positions.Macroeconomic restraint in good timeswill facilitate automatic stabilizers and asensible easing of policies to be applied ina disciplined fashion when adverse shocksoccur. Thus, the priority is to build fiscalrules and institutions that help overcomethe political pressures to deplete potentialsurpluses in good times, as well as infor-mational asymmetry problems. These insi-

tutions should also improve the credibilityof countercyclical fiscal policies duringdownturns.73 This strategy would, in par-ticular, provide the macroeconomic foun-dation for broad-based, self-expandingsafety nets.

Finally, there is a case for different formsof accountability. Over the long term, themost effective approach is to move to newfiscal and social contracts built on deeperaccountability structures—to a better polit-ical equilibrium.74 There is then a need foran appropriate mix of stronger regulatoryaccountability shielded from short-runpolitical pressures from all sides—moreindependent central banks and strongerfinancial sector supervision—and greatertransparency and debate about the overalldesign of macropolicy and the incidence ofworkouts. There are important interactionswith external actors and rules for crisismanagement that will be taken up in chap-ter 10.

In sum, we have explored policies that,by leveling the playing field in the marketsfor capital, labor, and goods and by manag-ing the macroeconomy, can lead to greaterequity and prosperity. Financial marketsare typically biased toward incumbents,reflecting the historical political influenceof the powerful. Yet rapid and ill-designedliberalizations can lead to further concen-tration of influence. Greater societal con-trols are needed as well as a more measuredtackling of barriers—especially to smalland medium firms—backed by regulatorystructures and more information to reducethe power of connections.

Labor market outcomes may reflect theweak bargaining position of workers, butlabor policies often lead to patterns of jobprotection that create economic rigiditiesand help those in good jobs, to the detri-ment of those in the informal economy.Support for unions and security for workersare important objectives, but designs needto be adapted to economic conditions inways that reach poorer, informal workersand minimize impediments to economicrestructuring.

Both the design of external trade policyand the workings of internal product mar-



kets reflect patterns of influence. Remov-ing biases and ensuring access to all needto be complemented by measures to expandskills, infrastructure, and safety nets toachieve genuine access and to manage losses(especially horizontal inequities). Impru-dent macroeconomic policy is typicallyinequitable: high inflation hurts those leastcapable of managing its consequences, and

financial crises are particularly pernicious,because the powerful can benefit or bebailed out at the expense of the rest of soci-ety. Prudent macroeconomic management,backed by strong countercyclical policy andindependence in policy design is an ally,not a foe, of greater equity. We now turn topolicies that can help level the global play-ing field.



markets and the macroeconomy 9 - world bank

Documents