policy reforms and growth performance: what have we …government actions and their design should be...

THIS CHAPTER SYNTHESIZES THE

lessons from the review of expe-rience with policy reform in

macroeconomics, trade, privatization, and finance.As the preceding chapters illustrate, each of theseareas of policy reform is complex and an attempt todraw lessons in any one of them creates vigorousdebate.Nevertheless, three key cross-cutting lessonsseem to emerge:

• Most market-oriented reforms have had positivepayoffs, though their impact on growth was notas large as some of the exorbitant claims madeboth in academic and policy circles.

• Experience shows the importance of creatinginstitutional constraints on the exercise of discre-tion in policy implementation. Institutions andrules should be seen as a means to facilitate thepredictable, credible, and beneficial use of discre-tion, rather than as a substitute for discretion.

• The expectations of the various actors in themarkets play a crucial role in the success or fail-ure of reforms, and their evolution can lead toeither virtuous or vicious circles in the reformprocess.

These lessons are discussed in section 1.Theycreate three suggestions for a way forward, exam-ined in section 2:

• While the basic economic principles behindmost of the reforms of the 1990s were correct,

there was a tendency to believe that they couldonly be implemented in certain ways.Going for-ward, more emphasis is needed on commonprinciples, along with a more pluralisticapproach to implementing those principles.

• Growth strategies, focused on initiating and sus-taining episodes of rapid growth, are the key toreaching much higher levels of income. Suchstrategies focus on attacking the binding con-straints on growth, rather than addressing manyweaknesses simultaneously.

• Creating the institutional conditions for a favor-able climate for investors, both large and small, isessential. Government actions and their designshould be scaled to match the country’s institu-tional capability. “Do no harm” is a wonderfulguide, and the potential for government actionto improve on market outcomes needs to be bal-anced against the ability of existing institutionsto sustain good practices.

1. Cross-Cutting Lessons of the1990s

For each of the three cross-cutting lessons, this sec-tion uses a common organizational structure: itdiagnoses previous successes and failures, reviewsthe conventional wisdom of the 1990s that laybehind the reform efforts, and describes the lessonitself.

Policy Reforms and Growth Performance:What Have We Learned?

253

Chapter 8

• The differences in growth rates across countriesover periods of a decade or more were too largeto be “steady-state” differences, but they alsoseemed too large to be transitional differences inadjusting to efficiency gains.

• Countries’ growth rates change dramatically:some countries have growth rates that propelthem rapidly out of poverty traps while othersgo from rapid growth to stagnation or bust.

Conventional Wisdom in the 1990s: “New Growth” Theory and Large Gains from ReformThis inability of the standard theory of steady-stategrowth to explain the facts perhaps explains the loveaffair of academic and policy-making circles with“new growth theory”models in the 1980s.Advancesin the modeling of noncompetitive equilibria(Romer 1983, 1986) allowed the development of anew set of endogenous growth models in whichnational policies could influence not just the level ofincome but also countries’ steady-state growth rates(Grossman and Helpman 1992;Aghion and Howitt1998).These led to the conventional wisdom of the1990s—that policy reform could affect economicgrowth—but they never made quite clear why thisshould be so. Often, authors did not make clearwhether their growth regressions were intended toidentify differences in steady-state growth or,instead, to identify impacts of policy on the level ofincome. Such lack of clarity pervades discussions ofgrowth. It is useful to dispel this confusion by keep-ing the gains in levels with “growth”as a transitionalphenomenon and gains in “growth” in the steadystate.In the end,the hope was dashed that there werelarge policy-driven gains in steady-state growth.Evenso, this does not imply that policy reform cannotyield large growth gains when it has a large impacton the level of income.

Trade policy reform illustrates this point. Manygrowth regressions related growth in output perperson in the ith country over some period of nyears to the lagged level of output and some indica-tor of trade policy during some period:

E C O N O M I C G ROW T H I N T H E 1 9 9 0 s254

Lesson 1Most market-oriented reforms have had positive payoffs,though their impact on growth was not as large assome of the exorbitant claims. And the benefits ofreform were, in general, predicted correctly bymicroeconomists and sectoral experts, though notby crude applications of the “new growth” theory.

Diagnosis before the 1990s: Conflicting Interpretations of the Relationship of Growth to PolicyUnderstanding the lessons of the 1990s for econo-mists requires a little background on the profes-sional state of play in the early 1980s.At that time,growth theory was still dominated by the Solow-Swann model (Solow 1956, 1971; Swann 1956).According to that model, in the steady-state equi-librium, long-run growth rates are completelyunaffected by national policies. That is, whilenational policies could affect the level of incomethey could not permanently affect the growth rate.1

Meanwhile, the analysis of sectoral reforms—forexample in trade, privatization, or the financial sec-tor—was dominated by microeconomic models inwhich gains resulted from policy reforms but weretypically only small fractions of the gross domesticproduct (GDP).2

This match—of the unresponsiveness of long-run growth rates to national policies in macroeco-nomics, and the apparently small efficiency gainsto be had from sectoral reforms in microeconom-ics—was a stable but increasingly unhappy mar-riage. Stable because these were both very robustfeatures of their respective analytical approaches.Unhappy because by the early 1990s this combi-nation of approaches clearly could not explainsome basic facts about the world, particularly thedeveloping world:

• Since some countries are very rich and othersare very poor, differences in growth rates musthave been sustained and substantial. Indeed, aschapter 2 showed, growth rate differences ofnearly 2 percentage points a year have been sus-tained for more than 100 years.

Figure 8.1 shows the path of annual growthstemming from a hypothetical trade reform thatincreases the sustainable level of output. Let usassume for now that “trade policy” at any point intime can be adequately represented by a singlenumber.The graph shows a hypothetical economygrowing at a steady-state rate of 2 percent a year. Inyear t = 5 there is a permanent improvement intrade policy from TP to TP*. If trade policy raisesthe steady-state growth rate immediately and per-manently by 2 percentage points, the measuredgrowth rate over any five-year period will increasefrom 2 to 4 percent and will remain at that higherlevel. In this case the impact of the trade reform onthe level of output will be infinitely large.

Figure 8.1 also shows the impact of a tradereform that affects only the level of output. In eachcase we assume some dynamics for illustration—that the impact on the level of output takes 10 yearsto be fully felt and that the adjustment from thebaseline to the higher level of output is linear. Inthis case, the reform has an impact on measuredfive-year growth rates that increases as outputadjusts to its new level, and then decreases to zero;that is, the economy returns to its steady-stategrowth path. The graph shows the impact onannual growth rates of a trade reform, using threepossible magnitudes of the cumulative impact ofthe reform on the level of output:5 percent,25 per-cent, and 50 percent (under certain assumptionsabout adjustment dynamics). If the cumulativeimpact of the trade reform on the equilibrium levelof output is only 5 percent, the impacts on meas-ured growth rates are small and disappear quickly,compared to the impact of a 2 percentage pointincrease in steady-state growth rates. In contrast, ifthe cumulative impact of trade reform on the levelof output is 25 percent, over a 10-year horizon theeffect of the reform on the observed growth rate isvirtually indistinguishable from the effect of anincrease in the steady-state growth rate—and onlyover long periods does it become possible to distin-

P O L I C Y R E F O R M S A N D G ROW T H P E R F O R M A N C E : W H AT H AV E W E L E A R N E D ? 255

guish one (an impact on level with transitionalgrowth) from the other (an increase in steady-stategrowth). Finally, if the impact of the trade reformon the equilibrium level of output is as large as 50percent, the impact on observed five-year growthrates is much larger for a reform that “only” affectsthe level than it is for a reform that has a largeimpact on steady-state growth.

This technical excursion clarifies that over thehorizon of a decade or more the impact of an eco-nomic reform on observed growth rates does notdepend at all on whether the reform raises steady-state growth or “only” raises the long-run level ofoutput with no impact on steady-state growth.What matters is the size of the gain and the speedof adjustment.Over the medium term, if the effectson the level of output are small, the effects onsteady-state growth will also be small, and if theeffects on the level of output are large, the effects ongrowth will be large.

Whether growth regressions in the 1990s wereestimating growth effects or level effects matteredless than how the regressions were interpreted. Inpractice they were widely seen as producing esti-mates of gains from policy reform that were whole

g y y y Trade Polic

Other factors error termt t ni

ti

t ni

t ni

, * *

- - -= - = + +

+ +a l b

Adjustment to new level with exponential decay

Grow

th p

er y

ear

(per

cent

)

Years, reform in year 5

Level increase = 50%

0.09

0.08

0.07

0.06

0.05

0.04

0.03

0.02

0.015 10 15 20 25 300

Level increase = 5%

Level increase = 25%

Steady stategrowth increase = 2%

Base case growth = 2%

FIGURE 8.1

Simulated Impacts of Policy Reform on the Level andGrowth Rate of Output

In particular, from most microeconomic-basedmodels we would expect that the gains would belarger, the larger the initial policy distortion,because the welfare gains from distortions increaseas the square of the distortion. Chapter 5 empha-sized that countries that made very large reductionsin tariffs (Bangladesh, India,Pakistan) achieved largegains in integration, while those that made smallerreductions in tariffs achieved smaller gains. Simi-larly, chapter 4 showed that the potential gains fromtaming hyperinflation are much larger than thepotential gains from reducing inflation from moremoderate levels. And in the financial sector, thegains from interest rate liberalization depend on theseverity of the initial financial repression: thus forcountries with very negative real interest rates, lib-eralization should produce large gains, while forcountries with moderate financial repression thegains would be more modest.

These relationships would also lead one toexpect large gains in countries that are very poorwhen reforms begin, since many of these countriesare much less productive than they could be if theyhad good policies and institutions.The very fastgrowth achieved by countries such as China, India,and Vietnam is consistent with the view thatreform can have enormous effects on the level ofoutput, which in turn lead to rapid growth in thecourse of transition to the new higher levels ofequilibrium output.

That said, the claims that policy reforms wouldraise growth rates permanently, or by as much as 1or 2 percentage points a year, were almost certainlyexaggerated.The disappointment with the returnsto policy reform stems partly from the fact thatregressions have suggested that some policy vari-ables, such as budget deficits, outward orientation,and privatization, are associated with economicgrowth. If such an empirical association represents astable,uniform,causal relationship between the pol-icy variable and growth, it is puzzling if, at least onaverage, the relationship does not hold for policyreforms. However, the magnitudes of the impact ofthe policy variables on immediate growth rateswere never very clear.


orders of magnitude larger than the microeconomicestimates of those gains.The example of trade liber-alization again illustrates this point.The originalmicroeconomic (“Harberger triangle”) estimates ofthe welfare gains were on the order of 1 to 5 per-cent of GDP for an ambitious reform of tariffs frommoderately high levels.With moderate adjustmentspeeds, such a reform would increase growth ratestemporarily by not more than half a percent a year.Even when models introduced general equilibriumeffects and plausible links from trade reform to pro-ductivity improvements, the apparent gains fromtrade reform were too small to cause sustainedgrowth increases of more than 1 percent a year,overa period as long as a decade. By contrast, it was fre-quently claimed that growth regressions, such asthose of Sachs and Warner (1995), supported theview that trade liberalization could raise the rate ofeconomic growth by 2 percent a year over a 30-year horizon.This implies a rise of 80 percent in thelevel of output. Even if trade policy reform were toraise the economic growth rate by only 1 percent ayear, sustaining these effects for a very longperiod—as implied by the very small adjustmentcoefficients—would produce gains of as much as 50percent of GDP.

Interpreting the “aggregate” and “growthregression” evidence concerning the impacts oftrade policy on output is nearly impossible, becauseeven though many studies take growth as the vari-able to be explained, the interpretation of the mag-nitude of the resulting coefficient depends entirelyon how the dynamics of the regression are speci-fied: the same reported coefficient on a variable rep-resenting trade policy could imply either a small oran infinitely large effect on the level of output.

Lesson of the 1990s: Policy Reform ProducedMixed, and Modest, GainsThe 1990s showed that the long-run impact onoutput3 of most policy reform actions in the areasconsidered—macro, trade, privatization, financialliberalization—was positive and roughly as large asclaimed by microeconomic or general equilibriumstudies.

To sum up, the gains from more effectively andefficiently provided infrastructure services will notbe infinite but they are important, as are the gainsfrom better allocation of financial resources.4

Finally, not everything that is called “market-friendly” reform will work to increase output.Thedetails do matter and it is perfectly possible to makelarge and costly mistakes, as attested by some of theexamples in this volume.

Lesson 2Institutional limits are needed on the exercise of discretionin policy implementation. Government discretion can-not be squeezed out of policy making, and the pres-ence of government discretion implies the need fora solid institutional foundation to control it. Creat-ing effective institutions that will play this roledepends not just on technocratic design, but also onan underlying “shared mental model”(North 1990).

DefinitionsFor purposes of this discussion we define “policy,”“organization,”and “institutions”to mean very spe-cific things.

A policy is a mapping from states of the world toactions.That is, a policy is not a single action but thedescription of a process that produces a sequence ofpolicy actions.The policy actions may be contingenton facts: for example if a country has a fiscal policyof running a cyclically adjusted surplus of 1 percentof GDP, this requires a budget (policy action) that istailored to the state of the business cycle (fact).

To implement a policy, translating it into prac-tice, requires an organization of policy making.

The direct organization of policy makingincludes the following:

• The organization that has authority to take pol-icy action;

• The range of feasible policy actions;

• The process to be followed in taking policyactions;

• The objectives of the policy;


• A model that determines the relevant facts (orstates of the world); and

• Some indication of the policy mapping fromfacts to actions, given the objectives and themodel.These policy mappings can take one ofthree archetypical forms: objectives with discre-tion, conditional rules, and unconditional rules.

The background institutions of policy makingare the legal and political environment into whichthe direct institutions are embedded. The back-ground institutions include not just governmentalorganization of checks and balances on the discre-tion of organizations and on the governmentitself—but also rules such as the freedom of thepress and the ability of citizens to organize.

Figure 8.2 illustrates these basics.The organiza-tion responsible for implementation is the agent, towhich the principal delegates the power to takepolicy actions. If for simplicity we imagine theorganization as a single agent,5 we can imagine apositive model of policy actions.One such model isthat the organization will take policy actions thatmaximize its own objective function subject to theconstraints and incentives it faces. In this sense thenotional policy (proposed objectives, model, rele-vant facts, and proposed mapping) and the back-ground institutions are what establish the incentivesand constraints on the maximization problem ofthe agency.

Table 8.1 gives examples of how these descrip-tive terms fit into a specific area, such as monetarypolicy, as a component of macroeconomic policy.Each of the policy areas discussed in the previouschapters, from trade to financial sector regulation,can be understood using this same vocabulary.

Diagnosis before the 1990s: Government Discretion Is the ProblemUp to the 1990s, a prominent diagnosis of develop-ment experience had two components. First, policymappings were seen to consist mainly of multipleobjectives with discretion. Hence in macroeco-nomic, trade, financial, infrastructure, and regulatorypolicy the organizations with direct responsibility

• Multiple objectives led to ineffective actions.

• Policy actions were politicized in a way that sac-rificed effectiveness for political expediency.

• Public officials had inadequate incentives to bedynamic or to innovate.

• Corruption was rampant.

Conventional Wisdom in the 1990s: Create Market-Friendly Conditions by Reducingor Eliminating Government DiscretionGiven that the diagnosis was “too much discretion,”the conventional-wisdom goal of the 1990s was toreduce public sector discretion as much and as fastas possible. Reformers pursued this goal in threeways (table 8.3):

• First, reducing the scope of government activi-ties that required discretion, by removing thegovernment from direction over production (bydivesting the public sector of productive assets),and by eliminating unnecessary regulations.

• Second, in whatever regulatory or policy activityremained under the government, reducing gov-ernment discretion, by pursuing rules-based for-mulas for decision making based on clear“objective” criteria and by granting autonomyto regulatory agencies.

• Third, making binding international commit-ments that limited the scope of domestic discre-tionary action, for example multilateral orregional international trade agreements, andagreements limiting exchange rate flexibility.

Lesson of the 1990s: Proper Exercise of Discretion in Policy Implementation Is KeyThe attempts to reduce government discretion hadtwo phases: a rationalization phase followed by anoptimization phase.

The rationalization phase, which happenedmainly in the 1980s, was needed and beneficial. Iteliminated accretions of actions, regulations, anddecisions that had often resulted in policies thatserved nobody’s best interests.6 Examples included


for policy actions were often given multiple(unclear) objectives, while at the same time theywere given control over a wide range of policyactions. Second, while discretion was seen to beused well in some times and places, it was also seento be misused, in a variety of ways (table 8.2):

• Inadequate information led to wrong decisions.

• Technical capacity was insufficient to take cor-rect decisions.

Backgroundinstitutions

Relevant “states of the world”

(empirically contingent facts that are relevant to the desirability of various policy actions—S)

Organization

(The organizations or agencies legally authorized totake actions)

Policy actions (The outcome of all of this is

the actual sequence of decisionsand policy actions taken)

Background institutions ofpolicymaking

AdministrativeJudicial

Political

(Executive, Legislative)

Impact of policy action on actions of relevant agents

Outcomes

Free press

Model(description of how policy actions lead to outcomes—M)

Notional policy:• objectives with discretion• conditional rules (a mapping from “states of the world” to “policy actions”

• unconditional rules (always do policy action a)

ASPM

:

Citizen organizing capability

Feasible policyactions(The set of actions that the policymaking organizationcan take)

FIGURE 8.2

The Elements of Policy Action


TABLE 8.1

Sectoral Example of Direct and Background Institutions of Policymaking

Examples from monetary policyObjectives with Conditional rule— Unconditional rule—

Item Definition discretion inflation targeting Unconditional rule no discretion(free banking)

Feasible A legally authorized Money supply Money supply Money supply Nonepolicy action act by a public

sector authority“Model” Specification of Money lowers interest

causal chain from rates, stimulates policy action to outputoutcome

Relevant state Relevant facts for State of the business Prices None Noneof the world the application cycle

of policyPolicy mapping A model-informed Increase money when Always increase Match outstanding

mapping from states output temporarily low money supply obligations to of the world to by k percent foreign assetspolicy actions

Direct Public sector Central bank Central bank Central bank Currency boardorganization of organization policymaking authorized to act

Indirect Formal and informal Procedures for administrative appealinstitutions of checks on policy- Courtspolicymaking making decisions Executive

LegislatureMedia

Interest groups

Source: Author’s elaboration.

reducing the variability and capriciousness of tariffrates, closing down and consolidating many special-purpose and money-losing financial intermediaries,and selling off assets in competitive industries.

By the 1990s, reforms were moving into theoptimization phase. These “second generation”reforms (Naim 1995, 1999) constituted a move toconditional rules governing the actions of a widerange of policy makers—monetary authorities, reg-ulators of banks and utilities, and private contrac-tors providing public services. In essence, many ofthe reforms were shaped by the view that institu-tions should play the role of eliminating discretionwherever possible, rather than facilitating effectivedecision making.The reforms had to grapple withthe question of how core government responsibili-ties were to be carried out. In a number of sectorsthere is a core of public responsibility that govern-

ments cannot avoid. For example, while there is nocompelling reason for government to own andoperate commercial or investment banks, govern-ment does have a core, unavoidable responsibilityand interest in the soundness of the banking sector.And while there is no compelling reason why gov-ernment should run an electricity company, gov-ernment does have a core, unavoidableresponsibility and interest in the soundness of theelectricity grid.

The attempts to reduce government discretionby imposing rules-based policies had much lessimpact than was hoped. In retrospect, there weretwo reasons why.

First, the risk that the public sector will abuse itsdiscretion is a necessary consequence of themonopoly nature of state power over the means ofcoercion. If performance is poor because the public


TABLE 8.2

Examples of Misuse of Discretion

Examples of ways in which Motivation for policymaking discretionary

Policy area public sector engagement power was misused Negative consequences of discretion

Macro Control of the money supply

Maintenance of system of Central banks forced to “print Money creation, high and variable inflationexternal payments money” to finance deficits Lack of fiscal discipline led to high debts(exchange rate) through high seigniorage Mismatch of monetary and exchange rate policy

Overvalued exchange rates led to overvaluation with periodic crises and maintained with preferential “maxi” devaluationsaccess to foreign exchange for government and parastatals

Trade Revenue mobilization, Firms lobbied to obtain protection Industries, once protected, never grew up from industrial promotion, for politicians “pet” projects “infant” statuscontrol of trade balance Bribery in customs to evade Discretionary controls over imports led to “rent

trade restrictions seeking” in the creation and allocation of importrestrictions

Privatization Supply of infrastructure Governments used firms for Underpricing and lack of autonomous control over and regulation patronage (for example, adequate cash flow led to underinvestment in

placement of executives) maintenancePlacement of facilities was Multiple and unclear objectives (no “bottom line”)

politically motivated led to productive inefficiencies and technological Outright corruption in the stagnation

placement of contractsFinancial sector Private sector capital Allocation of credit to Large losses for banks

markets could not politically preferred activities Low deposit rates (often negative in real terms)provide long-term credit Rollover of debt for favored High borrowing rates for nonpreferred borrowers

borrowers (for instance, Capital did not flow to new, promising industriesparastatals)

Selective enforcement of repayment obligations


TABLE 8.3

Efforts to Limit the Discretion of the Government[or: Government Discretion]

Reduce the scope of “Rules not discretion” government activity with “independent” regulation Binding international agreements

Macroeconomic Dollarization, currency boards, Monetary unionsinflation targeting, independent central banks

Trade Elimination of barriers to trade Moving to uniform tariffs; eliminating Bilateral (NAFTA), regional (EU, nontariff barriers in favor of tariffs Mercosur), multilateral (WTO)

Privatization/ Privatization Using contracts as a means of engaging regulation with private sector providers

Financial sector Privatization of state-owned banks; Adopting supervisory standards Allowing entry of foreign banksliberalization elimination of regulations (for example, Basel).


[Definetableacronymshere in anote ifyou wish.]

sector has incentives to abuse discretion (whetherby failing to respond to problems,making mistakes,capricious enforcement and corruption,or outrightpredation), it is unlikely to be sharply improved byreforms that limit the scope of government. Policyconditionality cannot be effective except in thoserare cases in which the policy action is unequivocaland compliance is easily observed. Easterly (2000)provides an insightful analysis of attempts to limitfiscal deficits through the application of rules. Sup-pose, as is not unusual, that a government wants tooverspend—specifically, to bring expenses into thepresent and to push the generation of revenues intothe future, hence reducing net public assets.Thensuppose some outside agency wants the country tolimit its fiscal deficit to a level lower than the gov-ernment wants.Will a “policy” change that limitsthe fiscal deficit to some specified amount staunchthe reduction in net assets? No.The governmentcan reduce net public assets in hundreds of waysthat do not increase the recorded fiscal deficit.7Thisability exposes the mirage of so-called rules-basedpolicies, because by the time one has a means toprevent all the tricks by which a simple rule such as“no fiscal deficits” can be subverted, one actuallyhas the institutional conditions in place for goodexpenditure management.

The second reason why attempts to reduce gov-ernment discretion by imposing rules-based poli-cies had less impact than hoped for is that thedifference between “rules” and “discretion” provedmuch murkier than supposed.The first round ofthe rules-versus-discretion debate generallyignored the key difference between conditional andunconditional rules.

The 1990s brought home that if incentivesremain unchanged, and there are no backgroundinstitutions to check the findings of fact, the use ofconditional rules can produce exactly the same pol-icy actions as the use of discretion. Conceptually,and often in practice, the process of policy actionswith conditional rules can be divided into twostages: a findings-of-fact stage and a policy actionstage; as noted above, the findings of fact dictate thepolicy action (or narrow range of actions). The


scope for exercising discretion can then be pushedback from the policy action stage to the findings-of-fact stage.

A telling example comes from Indonesia’sattempt to create bankruptcy courts. In the wakeof the financial crisis, many observers felt that thelack of a credible judiciary was limiting creditors’ability to enforce their contracts or even to forcedebtors to negotiate resettlements. Because judicialreform is a slow process, a new bankruptcy law waspassed that attempted to remove all discretion fromthe courts in bankruptcy cases.The only role left tothe courts was to declare a debtor bankrupt,8 andafter the judicial declaration of bankruptcy allfuture jurisdiction passed to the group of creditors.The result was that in the first few high-profilebankruptcy cases the judges did not declare bank-ruptcy because they found that a “legal” debt didnot exist. Instead they used various criteria to showthat otherwise apparently ironclad debt contractsdid not in fact constitute debt.The new law hadnot changed anyone’s incentives.There were nocredible checks on the courts’ findings and hencethe exact same result—lack of a credible creditorthreat of bankruptcy—was reached even in the faceof determined attempts to remove discretion fromthe legal process.

This conceptual framing may help us to under-stand several elements of the experience of the1990s:

• Why the success of reforms differed so widelyacross countries, and the significance of new evi-dence about the importance of institutions overpolicies;

• The evolution of concerns from policy reformto governance and institutions;

• The mixed popularity of growth reforms andimportance of perceptions in the success ofreform; and

• The evolution toward policy recommendationsdesigned to fit specific institutional capabilities,as opposed to the application of universal bestpractices.

intensive reforms—financial sector regulation, andregulation of privatized infrastructure—in the1990s. Not surprisingly, therefore, some reformsworked well and were widely popular, someworked well and were unpopular (such as the pri-vatization of water utilities in Argentina), and someworked badly with recriminations all around (forexample the first round of Mexican toll roads).

Evolution of concerns from policy reform to governanceand institutions. Current discussions about theinvestment climate differ from 1991 discussions of“market-friendly”policies.The recognition today isthat, except for a very few macroeconomic policiesthat can be executed with the stroke of a pen andeasily observed, policies are meaningless unless theyare backed by controls that make the policy actorssufficiently accountable.

Take the example of replacing the public provi-sion of an infrastructure service with private provi-sion by a contractor.The public agency responsiblefor awarding the contract must announce the win-ning bidder.Most of the second generation reformsin infrastructure dealt with extremely complex ser-vices, for which the evaluation of bids inevitablyinvolves some discretion (one does not merely wantto choose the lowest bidder without prequalifica-tion, consideration of the full range of servicesincluded in the contract, and so forth).But the nec-essary discretion that is created by complexity canlead to inefficiency, malfeasance, or corruption.Thesame is true with the transition from concern withfiscal discipline to a broader concern with budget-ary institutions.While it is easy to place conditions(either via rules or outside agencies) that governeasily observable policy variables such as the fiscaldeficit, it is impossible to mandate that publicmonies be well spent. Similarly, sensible regulationof banks requires the use of considerable judgment.Because of the importance of trust between bor-rowers and lenders, especially in environments inwhich the formal mechanisms of contract enforce-ment are weak, close continuing relationshipsbetween banks and firms tend to be the norm.From a regulator’s perspective this makes it difficultto distinguish between a perfectly rational business


We discuss each of these elements in turn.Intercountry differences in the success of reform. Why

did the success of reforms differ so widely acrosscountries? The answer may lie in the combinationof a country’s initial level of income and its institu-tional capability to implement complex reforms.

Many of the biggest successes of the 1990s wereachieved by countries that were much less produc-tive than they could be with good policies and insti-tutions, so that modest reforms whoseimplementation was not institutionally demandingwere able to produce large gains in expected futureincome.Examples are China’s liberalization of agri-culture and India’s dismantling of very high tradebarriers.9

The varied experience of the transition coun-tries illustrates the difficulty of achieving the rightmix between declared policies and institutionalcapability. A viable financial sector that channelsresources to productive investments is key to a mar-ket economy. Reform efforts in this directionsometimes had acceptable results—for instance inHungary. In Albania, by contrast, financial sectorliberalization with essentially no government con-trol led to a giant Ponzi scheme,10 and after a briefbubble, to massive losses that forced the govern-ment out of power. In some countries of EasternEurope, privatization worked reasonably well. Inothers, privatization was achieved rapidly but it wasfollowed by a shake-out, because the institutionalcapability for regulating the basics of corporate gov-ernance did not exist.Another group of East Euro-pean countries pursued a so-called policy ofprivatization without any credible central authority,any mechanisms of public sector accountability orcorporate governance, or any means of legalenforcement of contracts.This concentrated assetsin the hands of those who were able to operate insuch an environment.

Latin America’s experience was mixed. By andlarge, the countries of the region began with a baseof better policies and more advanced institutions,offering less “low hanging fruit” for reformers thanin Asian and transition countries.Most Latin Amer-ican countries had to grapple with institutionally

decision to carry a long-term customer over a dif-ficult spot by rolling over loans and a bank’s unwill-ingness to realize and write off bad debts. Theregulator’s problem in observing the “true” factsabout any given loan is of course compoundedwhen a regulatory agency is held accountable forthousands of such decisions made every day.

The mixed popularity of growth reforms and impor-tance of perceptions.Analyzing the institutional con-ditions for policy implementation may also help toexplain why many market-oriented reforms—even those for which there is evidence of success—have not been altogether popular. In LatinAmerica, for example, bringing more marketforces into the provision of infrastructure hasimproved the quality of services and expandedtheir coverage, but prices have risen and “privatiza-tion” is widely unpopular.A possible explanation isthat a lack of public confidence in the regulatoryinstitutions means that the public may perceivedeals as fixed or corrupt and price increases as sim-ply leading to high and unjustified profits for firms,which have regulators “in their pockets.”This is ahard problem to deal with.

The evolution toward policy recommendationsdesigned to fit institutional capability. Suppose thatsome goods have dynamic externalities, so thatgreater domestic production of these goods raises acountry’s overall output, and that other goods donot, so that their protection and greater domesticproduction cause overall output to be lower.11

Assuming that tariff rates can change relative prices,a possible tariff policy would be to place a high tar-iff on the good with dynamic externalities and no


tariff on the growth-reducing good.This policy is aconditional rule that depends on distinguishingwhich good is which. In practice, however, this dis-tinction might be difficult to draw and to verify.Now suppose that producers of the growth-reduc-ing good offer a larger bribe than producers of thegrowth-enhancing good.

In such a situation the optimal policy dependsentirely on the institutions of policy making. If wedefine good tariff policy institutions as those pro-viding institutional conditions in which the condi-tional rule, “high tariffs on growth-promotinggoods,” will be applied correctly, with good institu-tions the best policy to choose is a conditional rule.But the institutions of tariff policy could be weak.They might lack the technical capacity necessary toassess which goods are growth-promoting andwhich are not. Or, if they were faced with discre-tion or a conditional rule, their findings of factmight be susceptible to political influence or out-right bribery. If the direct and indirect institutionsof policy making are weak, the optimal policy is anunconditional rule of uniform tariffs, and perhapseven zero tariffs (table 8.4).

More generally, if it is perceived that corruptionis the central problem in public sector action, thetendency will be to force all discretion out of pol-icy implementation—for example by removing thegovernment from bank regulation.Good regulationis better than no regulation. But no regulation isbetter than bad regulation, and where mechanismsare not available to control the discretion that isinherent in attempts to implement reasonable poli-cies,“no regulation”may be the appropriate choice.

TABLE 8.4

Example of the Dependence of Appropriate Policy on Institutional Conditions

“Bad” institutions “Good” institutions

Differentiated tariffs (either Can lead to lobbying, rent seeking, corruption, Can allow trade policy instruments to promote discretion or “conditional and mistakes and result in complex, nascent industries with possible dynamic rules”) distorting tariffs with no positive effects externalities

Uniform tariffs Forgoes possible benefits of differentiation, but avoids losses from rent seekingBetter policy Uniform/precommitment Differentiation


Diagnosis before the 1990s: Policies Had PutToo Much Faith in Government as the Driver ofGrowthAs detailed above, the key explanation for the slow-down in growth in the late 1970s and early 1980swas that policy makers had simply been wrong intheir attempt to extend the scope of governmentaction beyond the government’s implementationcapacity.

Conventional Wisdom in the 1990s: Fixing Policies Would Ignite GrowthThe conventional wisdom of the 1990s was thatfixing policies would ignite growth.The belief wasthreefold:

• Get the policies right and investors will respond.

• Bold action upfront signals the seriousness ofreform.

• Signaling to the market requires ambitiousreform agendas.

Lesson of the 1990s: Expectations Are CentralNot only does the investment climate need toimprove, but also investors (small and large, domes-tic and foreign) need to believe that the improve-ment in investment climate is here to stay. The1990s emphasized that expectations are central notonly as regards stabilization during crises, but also asregards the supply response to policy reform.Wediscuss these two aspects in turn.

Crisis management. Restoring expectations isoften the single most important factor in turningaround a crisis.

To restore credibility [after a crisis] you haveto show that your word is your bond… [I]tis crucial to choose targets that can be andare met.This is more important than issuingunrealistic projections...

—Kemal Dervis, in World Bank (2005b)

Our strategy at the Central Bank was basedon the view that, given the lack of reference


Similarly, if the central problem is that privateinvestors fear predation by the state, strong precon-ditions to prevent predation are needed—even iftheir introduction sacrifices otherwise desirableregulations or actions.

The debate today is no longer about whether“the market” or “the state” is always superior, nor isit about “the proper role of the state” in theabstract.12 As theorists, most prominently JosephStiglitz, have shown, one can always create a theo-retical model in which state action can improve onthe free market outcome—if the state action is per-fect.But, as Pigou pointed out nearly a century ago,the real choices are not between the best the econ-omist can imagine and “the market.”The choice isbetween the market such as it is and what will actu-ally happen if a given policy is adopted—which inturn depends on the actual policy decisions thatwill be taken, which in turn depend on the qualityof institutions for controlling the discretion used inpolicy implementation.13

This discussion points forward to the problemsaddressed in chapters 9 and 10. If the key problemis policy implementation, and the key problem withimplementation is to create the conditions for theeffective exercise of government discretion, theorganizations of the public sector are vitally impor-tant (chapter 9) and so are the background institu-tions of policy making, especially the ways in whichcitizens are able to monitor the performance ofgovernment (chapter 10).

Lesson 3Expectations play a crucial role in the success of policyreform. And political and social legitimacy and con-tinuity are important in promoting expectations ofa more stable investment climate.

If the gains from policy reform are to be real-ized, individuals and firms must believe that if theyinvest in response to the opportunities created bythe policy reforms, they will reap the gains of theirinvestment. Investment is always about the future,and about the future there are no certainties, onlybeliefs and expectations.

for the correct exchange rate, exchange rateexpectations had to be stabilized for the bankto develop a market for its sterilization instru-ments. Otherwise, the interest rate needed toinduce significant demand for the new instru-ments would reach unreasonable levels. Inother words,an interest rate defense and activeforeign exchange market intervention werecomplementary rather than substitute poli-cies.These three policies were popularly char-acterized as a Central Bank attempt toincrease demand for domestic assets—and inthis way stop the bank run and the currencyrun—by inducing greed to overcome panic.The bank’s main consideration was that greed(interest rate policy) cannot overcome panicunless panic is also reduced by controllingchaotic conditions in the foreign exchangemarket through active intervention.

—Mario Blejer, in World Bank (2005b)

There is disagreement on two big issues.Thefirst is that of the proper scope of a reform programin the midst of the stabilization of a financial crisis.One view is that the reform should be limited andfeasible,because an overambitious reform can back-fire by creating expectations that cannot be met.The other is that the reform should be big, broad,and aggressive, because that convinces the marketsthat the government is serious about reform. But ifin fact the big broad and aggressive measures are adhoc and not institutionalized, there is a risk thatmeeting the targets will not create confidence,while missing them will create damage.This is par-ticularly true of implementation-intensive reformsincorporated into crisis stabilization packages.

The second big issue is whether expectationscan be positively affected by tying a government’shands. For example, in the early 1990s there was aview that countries should move to either fixed orcompletely flexible exchange rates to show evi-dence of the complete removal of government dis-cretion. But since the Argentina crisis, someobservers believe that removing discretion by creat-ing mechanisms that impose large penalties may


itself undermine expectations.Velasco and Neut(2003) argues that if the world is uncertain andthere are situations in which the lack of discretionwill cause large losses, a precommitment device canactually make things worse.

Achieving a supply response. The supply responseto any given policy action depends on how crediblythat policy action signals a sustained rise in the levelof income. Many of the benefits of trade liberaliza-tion, privatization and/or deregulation, and finan-cial sector reform depend on the responses ofprivate investors.The gains come with new exportindustries, new expansions of industry, improve-ments in efficiency and productivity (which oftenrequire investments), and new activities. Smallreforms may have big impacts if they are seen asharbingers of future reforms, while large reformsmay have little impact if investors perceive theresults as temporary.14 Though the supply responseto a policy reform is limited by credibility, largersupply responses make for greater support for con-tinuing the policy, creating a virtuous circle inwhich successful reform leads to continued reform.

Many problems may interpose themselvesbetween policy reform and the faster growth it isdesigned to achieve (table 8.5).

The first possibility, which has received a greatdeal of attention, is that policy actions may or maynot signal policy reform. For example, if the budgetdeficit is cut from 5 percent to 2 percent, does thissignal macro-stability or merely reluctant compli-ance with external pressures? Certainly expecta-tions about future macroeconomic stability willdiffer dramatically depending on which of the twois perceived to be the case. Conventional wisdomholds that part of the reason why policy condition-ality had a disappointing impact on growth was thatthe conditioned changes in policy actions did notchange investors’ expectations about the long run.As a result, the 1990s saw a growing emphasis onthe ownership of reforms as key to a successfulinvestment and supply response.Without owner-ship, current policy actions may not signal futurepolicy actions and hence do not create a powerfulinvestment response.

of reversal alone can block an investment response,given that the only profit rate at which investorswould be willing to risk their capital in new invest-ments is one at which governments cannot resistpublic pressure to lower prices. Hence the risk ofpolicy reversal can itself create a self-fulfillingprophecy of failure.

These dilemmas explain the continuing searchfor mechanisms with which to signal a govern-ment’s commitment to the irreversibility ofreforms.The temptation has been to argue that thelack of a supply response meant that reforms had tobe pushed harder, faster, and deeper. But this is notnecessarily so. If the problem is that the reforms arenot expected to be sustained because they are tooaggressive, pushing them harder might furtherundermine expectations of their sustainability.Tosum up, acknowledging the importance of expecta-tions does not imply that either big bang or gradu-alism is the right approach to policy reform, but itis a reminder that excessively ambitious reforms thatare delayed in implementation can hinder the for-mation of positive expectations.


Even if a policy shift is owned by the currentgovernment, the shift may not change expectationsif it appears likely to be reversed by either the cur-rent or a future government. And even if investorsbelieve that current policy actions signal a true shiftin policy, and even if they do not expect the policyto be reversed, the fact that new policies often callfor new organizations and direct institutions of pol-icy making implies that investor confidence may bedifficult to build.

This can create a particularly difficult dynamic,particularly in the interaction between governmentand providers of infrastructure. This dynamic isthat—even if investors would invest at existing prof-its/prices if they were confident these prices wouldpersist—they fear the government may renege onits commitment to price regulations and attempt tosqueeze their profits in the future. If that is so,investors will be willing to invest only at a large riskpremium over and above profitability. But—partic-ularly in a weak political and institutional climate—the likelihood that a government will renege ishigher, the higher the ex post profitability.The risk

TABLE 8.5

Policy Reform and Growth: Sources of Differential Impacts

Possible slips between policy action Question Effect and growth/output response

By how much does a policy action raise growth?

Does policy action change • Policy action conditionedanticipated policy? • Policy action unsustainable (either economically or

politically)• Policy actions not institutionalized

Do changes in trajectory of policy • Changes in returns not largechange the trajectory of distributions • Policy is “wrong”of profitability?

Do changes in trajectory of profitability • Expected profitability higher but uncertainty raise desired capital stocks? higher (and investors not risk neutral)

• Policy changes lower profitability in the short run (adjustment costs) but raise it in the long ru

• ComplementaritiesDo changes in desired capital stock(s) • Financial system does not accommodatelead to investment responses? • Other aspects of investment climate unfavorable to

investment

Source: Pritchett 2003a.

∂∂

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2. The Way Forward

Taking on board the lessons of the 1990s, what isthe way forward? Three guidelines are discussed inwhat follows:

• Accept that there are many ways to implementcommon principles.

• Pursue growth strategies—not just stabilizationor the avoidance of problems.

• Create the institutional conditions for a favor-able investment climate.

Common Principles—And Many Ways toImplement ThemPerhaps the most important and difficult lesson ofthe 1990s is that there is no one right way toachieve development.

The 1990s have not proved mainstream econo-mists wrong; indeed the basic principles of eco-nomics have proved remarkably resilient. Incountries such as Poland, the Czech Republic, andthe Slovak Republic where the introduction ofincentives proved feasible, they have workedremarkably well. In China and Vietnam, the intro-duction of stronger incentives has led to the mostrapid poverty reductions in history.

What was wrong, and never should have beenpart of economics,was the belief that the first prin-ciples of economics had to be implemented in aparticular way (Rodrik 2002).This point can beillustrated with regard to four economic principles:

• Expectations about future claims. Investors needcertainty that they will reap the gains of theirinvestment. But this stability of expectations canbe sought in a variety of ways. For example, dofavorable investor expectations depend on prop-erty rights? Do property rights rest on the samedefinition of property and the same means ofenforcing those rights as have developed in someparticular industrial country? Experience withland titling has shown that, in some cases, hold-ing the title to land increases a farmer’s incen-


tives, but in other cases the existing informal sys-tems have provided adequate security. One wayof providing property rights is through a well-functioning legal system, but many countriesachieved decades of rapid growth with very lit-tle legal certainty, when stability was embodiedin the political system.

• Openness. The principle of openness to ideas,trade, and investments with the rest of the worldneed not entail free trade.There are many waysof engaging productively in international mar-kets. Even the four East Asian Tigers, all famedfor being outward oriented, differed widely inthe extent to which their governments inter-vened in the economy and in international trade.While Hong Kong (China), as a trading center,was always open, the Republic of Korea openedits markets to imports only quite late in itsgrowth process.While some economies invitedforeign investors,Korea had very little direct for-eign investment.

• Competition. The principle that competitionfrom alternative suppliers promotes productiveefficiency does not dictate that competition hasto take any particular form. China’s experiencewith township and village enterprises, whichwere not private enterprises in the usual sensebut created effective competition, is instructive(see box 6.1 in chapter 6).

• Macroeconomic stability. The view that this or thatparticular arrangement is needed in order tocreate macroeconomic stability is belied by thediversity of experience of countries that triedthe same thing, and the similarity of experienceof countries that tried different things.

To conclude this discussion of the differentmodalities for implementing common principles, itshould be emphasized that “one size does not fitall” should not be interpreted as “anything goes.”Avast array of policies in the world are not funda-mentally sound, and are not heterodox implemen-tations of sound orthodox principles. A vast array

In any developing country, nearly everything isfar from ideal.The 1990s have shown that to achieverapid growth, countries do not need to get every-thing right but they do need to get the right thingsright. Identifying those right things is the purpose ofdevising a growth strategy,which is a coherent set ofactions designed to initiate and sustain rapid growth.

Devising a growth strategy requires a clear diag-nosis of the obstacles to growth—in particular, thebinding constraints, which will vary widelydepending on countries’ initial conditions.To illus-trate, figure 8.3 from Hausmann, Rodrik, andVelasco (2004) maps the possible explanations ofslow growth in a country in which the slow growthis associated with low rates of investment and entre-preneurship.15 The figure emphasizes that startingfrom fundamental principles can lead one’s searchfor binding constraints in many directions. Forexample, starting from the condition that profitabil-ity must exceed the cost of investment, perhaps thecost of capital is too high; perhaps investors fearmacroeconomic instability; perhaps too few prof-itable opportunities are discovered;or perhaps infra-structure deficits raise costs.


restrict competition in order to protect existingowners (private and public), and create investoruncertainty through arbitrary and capriciousbehavior by state officials.What is needed is not lesseconomics but more and better economics, to iden-tify the exact set of policies and institutionalchanges needed to address binding constraints ongrowth, based on first principles in each instance.

Growth StrategiesIf policy reform, while beneficial, does not explainthe bulk of the variation in growth performanceacross countries and time, something else must. Asdiscussed in chapter 2, recent research has empha-sized that there are large numbers of extendedepisodes of rapid growth—some sustained andsome not. How these growth episodes are initiatedand sustained is a key question.While “policies,” asrepresented by standard growth-regression meas-ures,do increase the likelihood of a growth episode,they are far from sufficient to explain growth.Andwhat causes the start of a sustained episode of rapidgrowth is not well understood.

Low p Low a Low k

Low paf’ (k, k, l, g) High r

Low l Low g

Too little bankcompetition,high spreadsPoor human capital,

rigid labor marketLack of R&D, low entrepreneurialrents, too little “self-discovery”

Insufficient infrastructure,high transport costs,

low tax base

Multiple equilibria,spillovers, coordination

failure

Macro risk:financial orfiscal crisis

Micro risk:property rights,corruption, taxes

Country risk still too high,FDI conditionsunattractive

Bad internationalfinance

Bad localfinance

Profitability condition: paf (k, k, l, g) = r

FIGURE 8.3

Diagnosing the Problem of Low Levels of Investment and Entrepreneurship

Source: Hausmann, Rodrik, and Velasco 2004.

Note: FDI stands for foreign direct investment; R&D stands for research and development.

One problem, particularly with strategies thatinvolve donors, is that governments face pressure toact on all fronts simultaneously. In creating an all-encompassing document such as a poverty reduc-tion strategy paper it is very easy to justify anythingas being important to growth—from low humancapital, poor health conditions, judicial insecurity,weak infrastructure, a weak civil service, to stagnantinvestments in agriculture.Thus too often a pro-posed strategy becomes a menu, not a meal.To besure, all of these problems will at some stage need tobe addressed. But identifying the binding con-straints on growth and focusing on them is theessence of strategy.

Institutional Conditions for a FavorableInvestment ClimateFor investors, the launch of any new public policyinitiative raises the question, How will policyactions evolve with this new policy? For govern-ments and societies at large, a key question goingforward is, How does one develop the institutionsof policy that reliably lead to the (mostly) positiveuse of discretion in policy implementation?16

First, continuity in the background institutionsof policy making is conducive to success in pursu-ing individual reforms. One of the problems withthe transition in Eastern Europe and former SovietUnion countries is that investment depends onexpectations of policy implementation, that policyimplementation depends on background institu-tions, and that when institutions are in flux no onecan say with certainty what will happen.The factthat Indonesia has had much more difficulty thanKorea and Thailand in restoring growth after crisisis almost certainly because Indonesia’s backgroundinstitutions have shifted, so that no one can predictquite where they will lead, while those of Koreaand Thailand have not. Often shifts in backgroundinstitutions are seismic political events beyond thecontrol of any policy maker. But experience doessuggest that new governments that are in the midstof an institutional shift should consider it a priorityto establish credibility around a few key areas, rather


than undertaking a broad array of new policy ini-tiatives whose success may depend on expectations.

Second, if the key problem is that credible back-ground institutions that can limit predation by thestate, such as an independent judiciary or electoralaccountability, do not exist and the governmentcannot make a credible commitment to resistpredatory behavior, it is possible that no amount ofinstitutional reform will sufficiently reassureinvestors.Acemoglu, Johnson, and Robinson (2001)have argued strongly that what is meant by “institu-tional quality” is not the state’s ability to regulatetransactions between individuals, but rather a coun-try’s ability to limit the state’s temptation to expro-priate. Since economic elites often benefit fromcontrolling the state and existing institutions (Hell-man, Jones, and Kaufmann 2000;Acemoglu, John-son, and Robinson 2001), there may be littleinternal impetus for reform, precisely when it isneeded most.

Third, the capability of the direct organizationof policy making is often a key issue in debatesabout reform. For example, should one privatizewhen there is no regulator? Should banks be liber-alized while prudential regulation is weak? Particu-larly with the large fiscal losses in the financial sectorin the 1990s, should reforms have been more grad-ual, with greater attention paid to prudential regu-lation? In some cases “the use of all deliberatespeed” is hard to distinguish from “never.”Anotherschool of thought argues that capacity only devel-ops in response to need,and so if one delays the pri-vatization of utilities until one has developed anadequate regulatory capability one might delay for-ever. Indeed, it is hard to build experience in regu-lation if there is nothing to regulate.17

A fourth area of debate about creating favorableexpectations is the tension between attempting toreassure specific investors and improving the overallinvestment climate. Some would argue that sincethe costs of investment are so high, and improve-ment in organizations and institutions is so slow, thebest way to attract investment in the short run is tonurture individual investors, either on a deal-by-deal basis or in special regimes (such as for foreign

4. Many proponents of the efficiency case for the welfaregains from trade (as opposed to the “growth”arguments)are strong supporters of free trade. Jagdish Bhagwati fre-quently points out that there was never any theoreticalsupport for growth-regression-based claims on behalf oftrade liberalization—but that theory and evidence onthe microeconomic level provide all the support oneneeds.

5. Of course, in reality each organization will have its own“principal-agent” problems.

6. For instance, in trade policy an original policy would beset, restrictions would be added, and then exceptionsgranted, and then new categories created, and thenother new restrictions added. Many countries hadreached the point where few people actually knew whatthe trade regulations were (in many cases, even customsofficials did not possess fully up-to-date copies of thetariff code) and where, taken as a set of interventions,the trade policy was “irrational.” Similar accretions—taking over firms that had gone bankrupt here, makinga firm a parastatal in order to obtain official financingthere—often led to government ownership of a varietyof businesses and activities for which there was nocoherent rationale.

7. Suppose that to meet the fiscal deficit target the gov-ernment simply lengthens payments to suppliers.Thisdoes not change net public assets. One could imaginethen putting limits on both the cash fiscal deficit and thepayment of suppliers. A government could then deferspending on the maintenance of public assets, causingpotentially the same (or an even larger) reduction in thevalue of net assets while meeting the same target for thefiscal deficit plus payables. One could then set condi-tions that specify a cash deficit target, a limit on payables,and a limit on the reductions in maintenance. But thereare still many other ways to reduce net public assets—for example freezing the nominal wages of public sectorworkers at lower than sustainable levels, or underfund-ing future pension obligations, or authorizing expendi-tures (such as guarantees of lending) that create aquasi-fiscal obligation.

8. The new law attempted to remove every vestige of judi-cial discretion by declaring that if any creditor peti-tioned for a bankruptcy and a debtor was more than acertain number of days overdue on a contractual pay-ment, the judge must declare bankruptcy.

9. For instance, in the early 1990s tariffs in India were fourto five times as high as in most Latin American coun-tries.

10. A Ponzi scheme refers to any investment that pays offinitial investors unsustainably large returns not out ofactual returns from investment but from flows of fundsfrom new investors.These depend on rapid growth in


investors).The latter approach, bypassing the weak-nesses in the overall investment climate, is attractivebecause initiating a new industry or endeavor oftenrequires attracting a large investor. Certainly thisapproach has been made to work, but it has dan-gers. Complex special deals can be conspicuouslyopaque and a perfect vehicle for corruption.Partic-ularly when their negotiated terms are contested,special deals can undermine the perception of socialand political legitimacy of a government’s overallpolicy approach (the deal with Enron in the Indianstate of Maharashtra and the water deal in the Boli-vian city of Cochabamba are examples).Particularlyin infrastructure, the renegotiation of individualdeals has proven be an enormous challenge (WorldBank 2004e). Finally, cutting deals for specificinvestors or specific classes of investors can under-mine the pressures for systemic improvement for allinvestors. De Soto (2005, forthcoming) is eloquenton the fact that most Latin American investors existoutside the scope of the formal legal economy.

Notes

1. This feature, “Solow invariance” (Hall 1999), is robustand driven by basic features of these models.

2. The classic example (perhaps because it was there thatthe theory had been the most clearly worked out) wasthe calculation of the welfare losses that resulted fromthe differences between international and domesticprices induced by border restrictions on trade, such as atariff.The standard analysis showed that a tariff raisedprices, which benefited producers and hurt consumers,but that the efficiency losses from “too little” consump-tion caused an overall net social loss.Graphically this lossof consumer surplus was a triangle—in fact the estimatesof the losses from price distortions were known as Har-berger triangles (after Arnold Harberger 1971).The “par-tial equilibrium” estimates suggested that a move fromthe current level of restrictions to completely free tradewould produce welfare gains on the order of 1 to 5 per-cent of GDP.These small estimates implied that the tem-porary “growth” effects caused by the transition fromlower to higher levels of (properly measured) outputfrom efficiency-improving reforms were quite limited.

3. That is, .∂∂ ∞

yA*

new investors, but in the end not every investor can bepaid the promised high returns.

11. This would be the case, for example, for a good that isan input into many other goods and is produced by adomestic monopoly.

12. No one can look at the experience of Singapore or theRepublic of Korea (and earlier Japan) without beingconvinced that purposive government action to pro-mote rapid development can succeed. Conversely, noone can review the tragic experience in many Africancountries and believe that purposive government action(at least ostensibly) to promote rapid development can-not fail.

13. Comparing industrial countries with poorer countries,it is noticeable that government action is much morepervasive in industrial countries—tax rates are higher,and regulation is pervasive—and that the exercise ofdiscretion is explicit, and that much of the infrastruc-ture is owned and operated by the public sector.A fre-quent practice has been to attempt to transplant moreor less wholesale the policies of industrial countries—including the direct institutions of policy making—without adequate consideration for whether thetransplants could survive in entirely different condi-


tions. For example, every industrial country regulatesbanks. But can banks be successfully regulated withoutan effective legal system that can enforce creditor rights?Without a strong tradition of an autonomous civil ser-vice that can resist political pressures? Without effectivelegislative oversight? Without transparency and anaggressive free press? Without a police force that canprotect impartially against threats of violence?

14. These observations are part of the same overall story asthe first two common lessons in this chapter—the ques-tion of large- versus small-level effects and the impor-tance of institutional quality for successful policyimplementation.

15. If investment were high and growth slow, a differentdiagnostic would be appropriate.

16. This is the main question in chapter 9, which reviewsefforts in the 1990s on several fronts.

17. Countries with parastatal firms had decades in whichthey could have created regulatory capability—but theydid not do so, in part because it was not perceived asnecessary. Similarly with financial sector regulation:developing the capability for “arm’s length” regulationwhen the government embraces the entire sector isconceivable, but difficult.

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