I greatly appreciate the honor of being invited to deliver the Brahmananda Memorial
Lecture. I share the immense admiration and respect you all have for his scholarship,
his teaching, and his untiring service for the economics profession and the country.
It is indeed a privilege to give a talk in his memory. And it is a special pleasure
to follow my long-standing friend Lord Desai, who gave the inaugural lecture in
this series. But I must admit that, unlike Meghnad, my knowledge of P. R. Brahmananda
and his work is indirect. During my college days in Mumbai my subjects were mathematics
and physics, so I did not have the benefit of Professor Brahmananda’s teaching.
Some of my work on dual economies connected with his long line of work on wage goods,
but my approach was quite different.
Let me begin with some memories of the time I left India to study abroad. I do so
with a twofold purpose – to show how things have changed, and how they have
not changed.
Although I studied mathematics and physics, I did have one occasion to visit the
Reserve Bank. This was to get permission to buy £50 to take with me when I left
for England. Now the rupee is de facto convertible for current account transactions.
Indian multinationals are major players in making foreign direct investments. Unlike
in Oscar Wilde’s days, schoolchildren are no longer told to omit the chapter on
the fall of the rupee.
During my visits to many government offices to get various documents and permissions
to travel, entry to almost any office required me to give an authorization signature
from C. D. Deshmukh to the chaprasi guarding the door. Mr. Deshmukh had been the
Governor of the Reserve Bank and Union Finance Minister, and in one of these capacities,
his signature appeared on the ten-rupee note. I am sure this practice continues
even now in many government offices. The denomination of the required note has surely
risen many times, and the chaprasis are probably now called the Site Security Officers.
The problem of corruption has become very important in recent thinking on development
policy. For example, the World Bank’s governance web site, http://www.worldbank.org/wbi/governance,
seems to focus almost exclusively on corruption. In the Indian context, observers
like Luce (2007) identify it as a key issue affecting the country’s growth prospects.
But corruption is only a part of the more general issue of economic governance,
and of more general policy questions concerning the design and reform of institutions
of governance. In this lecture I will sketch some of these issues. I will draw on
the research of several others as well as some of my own, and will try to interpret
these findings in the context of India. However, I am handicapped in two respects.
I am primarily an economic theorist and only secondarily a development economist,
and my research, although it draws on my reading of empirical and historical research
about some other countries and times, has not focused on Indian questions. Therefore
my thinking and suggestions must remain very tentative and must be interpreted with
a lot of caution. I hope that some in the audience and the readership will guide
me to related literature, and perhaps also collaborate in modifying and refining
these ideas and their implications for India.
What Is Governance ?
Economic governance comprises many organizations and actions essential for good
functioning of markets, most notably protection of property rights, enforcement
of contracts, and provision of physical and informational infrastructure. In most
modern economies, governments provide these services more or less efficiently, and
modern economics used to take them for granted. But the difficulties encountered
by market-oriented reforms in less-developed countries and former socialist countries
have led economists to take a fresh look at the problems and institutions of governance.
In this lecture I offer a brief and selective look at this research, and attempt
to draw a couple of conclusions that may be relevant to India today.
The importance of secure property rights can hardly be overstated. Without them,
people will not create or improve the assets, physical and intellectual, that are
essential for economic progress. De Soto (2000) builds the argument and marshals
the evidence in a thorough and compelling book. Security of rights improves the
incentives to save and invest. Land and capital can be rented out to others if they
can use it more efficiently, so inefficient internal uses are avoided. And the assets
can be used as collateral to borrow and expand one’s business. Field (2006) has
taken the case even further. Security of property rights not only increases the
supply of capital and efficiency in its allocation; it also increases labor supply.
When titles to land and capital are official and secure, people need not spend time
and effort to guard their rights, so they can put the labor and time to productive
uses. Field’s empirical research on the titling program in Peru finds large and
significant effects: “For the average squatter household, property titles are associated
with a 14% increase in household work hours, a 28% decrease in the probability of
working inside the home, and a 7.5% reduction in the probability of child labor
among single-parent households. Panel estimates … support the cross-section results:
between 1997 and 2000 household labor supply increased an additional 13 hours per
week for squatters in neighborhoods reached by the program.”
In the Indian context, security of land titles may be the most important issue of
property rights. The controversy regarding land sales in the context of the Special
Economic Zones (SEZ) is a case in point. The merits of the SEZ policy can and should
be debated, but if the debaters raise fears of revocation of rights and benefits
that have been granted through a proper policy process, this uncertainty will deter
investors and merely ensure that the potential benefits will not materialize. At
a more micro level, insecurity of land rights and fragmentation of land arising
from disputes in extended families constitute serious constraints on agricultural
growth.
The relevance of security of contracts may not seem so obvious, but it is equally
important. In most economic transactions that can create economic gains for all
parties, some or all of them can gain an extra private benefit while hurting the
others, by violating the terms of their explicit or implicit agreement. The fear
of such exploitation by the other party may deter each from entering into the agreement
in the first place. This was brilliantly illustrated by Diego Gambetta in his ethnographic
sociological study of the Sicilian Mafia (1993, p. 15). In the course of his interviews,
a cattle breeder told him: “When the butcher comes to buy an animal, he knows that
I want to cheat him [by supplying a low-quality animal]. But I know that he wants
to cheat me [by reneging on payment]. Thus we need … Peppe [the Mafioso] to make
us agree. And we both pay Peppe a commission.” By providing a mechanism of contract
enforcement, Peppe makes it possible for the two to enter into a mutually beneficial
transaction. And he does this with a profit motive, exactly as would any businessperson
providing any service for which others are willing to pay.
This example also demonstrates something else that is an important theme for me:
governance does not have to be provided by the government as a part of its public
services; private parties may do so with other motives. In most countries, even
advanced ones, we find a mixture of the formal legal system and a rich and complex
array of informal social institutions of governance. These mixtures reflect the
country’s level of economic development, and in turn help determine its economic
prospects.
The issue is not the old-style one of “market versus government.” Rather, it is
one of how different kinds of institutions (governmental and non-governmental, formal
and informal, industry-based or community based, singly or in combination) provide
the support that is required for successful economic activity (exchange, production,
asset accumulation, innovation, and so on), and the activity may or may not take
place in conventional markets. I cannot emphasize too strongly the need to get beyond
the old sterile debates and on to issues that really matter.
What forces threaten property rights and contracts? And how can we design and reform
institutions to counter these threat? Let us look at some theoretical concepts and
examples.
Property Rights
If the arm of the government’s law is distant or weak, some people will seize every
opportunity to steal valuable property from others. Of course there are many non-governmental
institutions that attempt to reduce this risk. Parents and schoolteachers strive
to instill in children at an impressionable age the norms of respect for others’
property. Individuals guard their own property and contribute to community policing.
Communities can even evolve their own set of rules of ownership; we have evidence
on this point from some unusual contexts, such as the American wild west (Libecap,
1989) and New England whalers (Ellickson, 1989). Such arrangements succeed to different
extents, because each faces its own limitation of what can be observed and enforced.
In fact even the rules have to be adapted to these limitations; attempting to put
in place an unworkably stringent set of rules would only bring the whole framework
into disrepute.
Thus private theft can flourish when public laws are weak, and private institutions
can cope with it only to a limited extent. However, the biggest threat to property
rights in many countries comes not from private individuals who exploit weakness
of government institutions, but from the government itself and its agents. These
threats need not take the form of outright theft. In fact confiscation or nationalization
without compensation has been relatively rare for the last four decades. 2 The problems
are more likely to be indirect: unexpected and arbitrary increases in tax rates
and imposition of constraints on uses of property and repatriation of profits, and
last-minute hold-ups from officials who demand extra kickbacks or bribes.
I want to emphasize that the big problem is the unexpectedness and arbitrariness
of these actions of the government and its agents. A predictable tax or a predictable
level of corruption will also deter economic activity, but the deterrent effect
of uncertainty is likely to be much bigger .3 Thus Pritchett (2003, p. 148) finds:
“Under a regime that has reasonable institutional stability and is not completely
dysfunctional, a rapidly increasing level of GDP per capita is possible up to semi-industrialization.
… [A]t their best, these types of regimes, while they tolerate high levels of corruption,
also demand some performance such that corruption does not become absolutely disorganized.”
Note the qualification “up to semi-industrialization.” Progress beyond this point
requires much more: “The policies required to initiate a transition from low-income
equilibrium to a state of rapid growth may be quite different from those required
to re-ignite growth in a middle-income country” (Rodrik 2003, p. 17). Therefore
it may be especially important for India to curtail corruption if it is to ensure
progress beyond its current stage of development.
How can people ensure that their government and its agents respect property rights?
Waiting for the government to eliminate corruption may be futile. But the most that
any one person whose rights are violated can do is not deal with that official or
agency again, at worst by withdrawing from that form of economic activity. He cannot
on his own persuade his friends to do participate in a boycott on his behalf; they
have too much to gain by going along with the system, and the official can always
promise them better treatment. Therefore individuals can do little; collective action
is needed. Greif, North and Weingast (1994) show how merchant guilds in medieval
Europe performed this function to keep monarchs from expropriating foreigners trading
in their realms. Perhaps confederations of industries in modern economies can perform
similar functions. Any one firm or industry may be tempted to get along and comply
with demands of corrupt officials and agencies to secure a favorable treatment for
itself; at a minimum, any one firm or industry may feel itself helpless to resist.
But all firms and industries should recognize that such practices hurt them all
in the long run. Therefore they should be willing to organize and collectively commit
all their members to resist these pressures. They can enforce that commitment using
the threat that other members would refuse to trade with anyone who complied and
gave bribes. If this can be done in conjunction with generating adverse media publicity
about corrupt officials, which again organized industry groups can do better than
can individuals, the effect is likely to be reinforced.
The research concerning property rights and corruption has yielded some useful conceptual
distinctions and implications. The first is the distinction between de jure and
de facto effectiveness of governance. The distinction is most vividly seen by contrasting
China and Russia. China, at least until recently, had very little formal legal protection
of property rights, especially those of foreign investors. However, in practice
it has been able to deliver sufficient security to continue to attract large foreign
investments. Russia has a much better legal framework on paper, but reality seems
much worse. What explains the difference? Qian (2003) and Rodrik (2004) emphasize
the role of the Township and Village Enterprises (TVEs) in China. This system turned
local official into owners and residual claimants, giving them the incentives to
make efficient decisions; if they were corrupt they would be stealing from themselves.
But insider privatization in Russia had exactly the same aim (Shleifer and Treisman,
2000, pp. 31-2), and did not work so well.
McMillan (2003, p. 100) offers a different explanation: “High officials in Deng
Xiaoping’s government understood enough about economics to recognize that growth
requires markets and markets require assured property rights. The Communist Party
had retained its highly disciplined organization and so was able to prevent self-seeking
behavior by low-level officials.” The top level in Yeltsin’s Russia may have had
the same understanding, but presumably lacked the disciplined organization. If this
explanation has some validity, the intentions and authority of the top levels of
government are an important determinant of whether corruption and violation of property
rights can be effectively controlled.
The top level of government, even if itself well-intentioned, needs sufficiently
drastic punishments at its disposal to keep the lower and middle-level agents in
check. This may be more difficult in a democracy than in an authoritarian regime.
But even a harsh authoritarian or dictatorial regime can have troubles with its
agents. Stalin had, and used, punishments as drastic as one could imagine, and yet
could not get his officials to perform efficiently. What went wrong? Gregory and
Harrison (2005) argue that Stalin’s harsh incentives did not work well because his
methods for detecting shirking were arbitrary, imprecise, and themselves open to
corruption. People found that they ran almost the same risk of being denounced and
punished when they worked hard as when they shirked or cheated. Therefore they did
not have the incentive to work hard after all. An accurate detection procedure is
important for the success of any incentive scheme, including an anti-corruption
one.
The second finding I want to highlight is the distinction between organized versus
disorganized, or unified versus non-cooperative, corruption. Shleifer and Vishny
(1998, Chapter 5) emphasize this aspect. If a project needs nineteen permits issued
by nineteen separate licensing and regulatory agencies, each of them can try to
extract as much as they can from the applicant, not taking into account the fact
that the implied tax levied by each of them discourages the activity and thereby
reduces the take of all the others. If all nineteen permits are in the hands of
one agency, it will recognize this interdependence and therefore will impose a lower
tax, that is, engage in less corruption.4 This argues for the creation of “one-stop”
licensing and regulation authorities for each kind of economic activity. Many U.S.
states, and some countries like Virgin Islands, have adopted such streamlined procedures
for business licensing. India enacted a similar agency, the Foreign Investment Implementation
Authority (FIIA) in 1999. But I have not been able to find any independent studies
of how well it works in practice. There are good arguments for ensuring its effectiveness,
and establishing similar agencies for domestic investors as well. A key issue in
India is how well one-stop authorities can coordinate all the licensing requirements
of the multiple levels of governments in India: central, state, and local. Unless
this can be done, multiple governments will continue to require multiple stops,
to the detriment of investment and growth.
A related issue is the effect of competition. Shleifer and Vishny point out that
in the United States no one has to bribe anyone to obtain a passport. There are
multiple offices and multiple windows where one can apply for a passport; if one
official asks for a bribe, the applicant can simply go to another. Competition between
these officials lowers the “price,” in fact all the way to zero. Can the same be
done with “one-stop” agencies? What if there are multiple agencies of this kind,
each of them authorized to provide all the clearances an investor needs, so they
are forced to compete with one another?
Finally, consider a country that is introducing a modern and formal system of titling
as De Soto and others would recommend. They are not doing this with a complete clean
slate. Most societies without formal legal titling have some traditional system
of rights, determined by tribal chiefs or village elders or heads of extended families,
and enforced by these traditional authorities using various systems of social norms
and sanctions. These rights may not work perfectly, but they exist, and will interact
with the formal rights that are being introduced. If this interaction is dysfunctional,
the formal rights may not work as western advisers would wish. Ensminger (1997)
found just such a problem with land rights in Kenya. The traditional system guaranteed
shares (usufruct rights) to various members of the extended family of the purported
owner. This made it infeasible to use the land as collateral in a loan application
from a formal sector bank, thereby defeating one of the most important advantages
of titling offered by De Soto.
Kranton and Swami (1999) found that the introduction of civil courts in colonial
India interacted adversely with agricultural credit markets in just this way. Competition
among lenders increased. But traditionally lenders used to reduce risk for farmers
by subsidizing their investments in times of crises; they could no longer do so
because the courts enforced only simple debt contracts, not complex contingent risk-sharing
ones. The overall outcome was a worsening of social welfare. These examples bring
out the importance of ensuring that new formal systems relate synergistically, not
adversely, with the informal and traditional systems.
Contract Enforcement
The courts in 1990s Italy may not have been perfect, but they were surely fairly
competent in matters of simple contracts like that for the sale of an animal by
Gambetta’s cattle breeder to the butcher. Then why was the pair relying on Peppe
for enforcement? The answer is that they were trading in a clandestine slaughtering
market, to avoid the tax levied on officially registered traders in the formal one.
In such cases the private enforcement can be socially harmful even if it “works.”
If the government disrupted the mafia, the traders may shift to the formal market,
which may supply other useful things like an assurance of quality to the ultimate
consumers. But if failures of the state’s formal legal system are the reason for
the emergence of private enforcement, then that may be a good “second-best.”
More generally, whether a formal or an informal system of contract enforcement,
or some mixture, will work best depends on the relative costs and benefits of the
two in particular contexts.5 The potential advantages of a formal system are evident.
Such a system has universal coverage in the country; one party to the contract cannot
back out of it claiming to be outside its jurisdiction. The rules of the system
are set out in its laws and precedents, and therefore are known to all participants
(or should be so known). And compliance with the system is ultimately secured by
the government’s coercive powers. 6
By contrast, informal systems must rely more on voluntary participation of the members
of a more limited group or community. Usually the only way to secure such participation
is to exclude those who misbehave from benefits of continued membership. In some
associations of traders in an industry, this can work well. Bernstein (1992, 2001)
has studied diamond and cotton traders’ associations in the United States. She finds
that their arbitration procedures have drastic punishments at their disposal. They
can basically drive a persistent miscreant out of business; moreover, since the
members also mix socially, they can ostracize not only miscreants but also their
families. However, such drastic punishments are not invoked readily or quickly.
Contrary to the theory of repeated games where the best tacit cooperation is sustained
by inflicting the most severe feasible punishment upon any deviation, milder penalties
are tried first and are escalated only if misbehavior persists.
An informal system in a limited community can have advantages over formal legal
systems. Many of these pertain to information. In an industry-based arbitration
system, the judges are expert insiders who can interpret and evaluate the evidence
more accurately than can the “general practitioner” judges of state courts.7 Such
communities also have good gossip networks; therefore they can spread the word quickly
when someone reneges on a contractual obligation, thereby destroying his reputation
in the whole community of traders. However, these advantages are eroded if the group
becomes too large or its scope expands beyond a narrow range of expertise.
Given this balance of considerations, it is not surprising that formal and informal
systems coexist and interact, even in advanced economies. Many contracts in the
United States specify that disputes will be settled by arbitration. And even without
such explicit stipulation, disputes are often resolved by negotiation between the
parties. Going to the court is often the last resort; some estimates are that only
10% of disputes end up in courts.
The need for alternative institutions for resolving contractual disputes is even
more pressing in India, where one estimate puts the backlog of court cases at over
300 years. Of course good lawyers can cut through this, but the other side can also
hire a good lawyer, and the fear of high costs of litigation can be a powerful deterrent
on business.
Of course improvements in the state’s formal system of contract enforcement are
also badly needed. Informal systems, with their reliance on group or community-based
networks of information flow and sanctions on miscreants, are inherently limited
in their scope. As India’s economy expands and integrates both nationwide and internationally,
more and more transactions must occur among strangers who do not belong to the same
network, and formal institutions become increasingly important for providing good
external governance.
Reforms of formal institutions of contract enforcement, as in the case of property
rights institutions, should try to build synergistically upon the traditional informal
ones. Theoretical considerations and practical experience alike suggest that industry-based
arbitration and formal courts interact well together. A division of labor can emerge
where insiders use their expertise to interpret the facts and take into account
various customs and practices in contracts to arrive at a decision, for example
who owes what damages and to whom, and then the courts can stand ready to enforce
this verdict, backed by the state’s powers of coercion. If the industry-based arbitration
forum had to enforce its own decision, it would have to rely on the repeated game
mechanism, and this typically involves some loss of efficiency. The combination
of expert decision-making and court enforcement can achieve the best of both worlds.
In matters of governance of contracts between nationals and foreigners, the latter
often fear that domestic courts will be biased against them. Various international
forums of arbitration are available, each based on a different legal tradition,
and such contracts often stipulate that any disputes will be adjudicated in a designated
forum. Unlike industry-based dispute resolution institutions, these international
forums usually do not have expertise in the specific matter at hand. They can be
slow, costly, and even somewhat arbitrary; almost their only merit is their perceived
lack of bias. If Indian courts or Indian industry-based institutions can develop
a credible reputation for not favoring their own nationals, they will have an immense
advantage when it comes to entering into contracts with foreigners, in particular
in attracting foreign investment. Indeed, this may be a key to success as India
integrates with the world economy and attempts to obtain gains from globalization.
Collective Action
I have ventured to make several suggestions on how the institutions of economic
governance can be improved. These suggestions were mostly based on well known case
studies in other countries and at other times. Therefore some of my suggestions
may prove to be impractical in the Indian context. But let me continue and make
some further suggestions on how the reforms can be made to work.
Most importantly, I think that waiting for the political process to institute the
needed reforms “top down” would be a mistake. During my youth in India four or five
decades ago, I saw that people relied too much on the government to do everything,
but “maa baap sarkar” often disappointed these expectations. The experience of the
last two decades has hopefully shown Indians what individuals given freedom of enterprise
can achieve by way of industrial progress; the same can be done, given a little
additional dose of collective action, for institutional reform.
Even in Western countries, such reforms were often launched by visionary social
entrepreneurs, and only later adopted by wider business communities or officialdom.
Even something as basic as periodic publication of companies’ audited accounts was
initiated privately by J. P. Morgan when he started Federal Steel with Elbert Gary
in 1898, because they believed that “corporations issuing publicly traded securities
had to account for their financial performance” (Strouse 2000, p. 398). Later this
principle was taken over and implemented in legislation by the progressive movement
under Theodore Roosevelt. And recently the CEO of Aflac, an insurance company, has
voluntarily allowed the shareholders a vote on his compensation; this may also spread.
Perhaps one or more business pioneers in India will likewise realize that good governance
is good business because the credible guarantee of contract fulfillment attracts
more serious contractual partners. Then they can, in groups or in some cases even
singly, take actions to improve governance. Institutional investors can similarly
play a major role in improving corporate governance; in the US it is said that the
California public employees’ pension fund CALPERS has been more important than the
Sarbanes-Oxley act in this way. Corporate governance in India may be even worse
than in the United States, and the improvements in this matter will emerge as an
extremely important issue as the economy grows and shareholding becomes more widespread.
In dealing with corruption, shining light on corrupt activities and exposing them
to fresh air may be the most important starting point. In this respect India has
the great benefit of a free press; no government and no media mogul should be allowed
to depreciate this asset. The Right to Information Act can have major beneficial
effects by removing information asymmetries and improving accountability. Public
interest litigation and “people’s courts” can also serve a useful role, although
sometimes such institutions can act for very small and single-issue interest groups
and thereby become an obstacle to much-needed economic progress. Here India’s democratic
tradition may hurt.
On the whole I believe that bottom-up and organically generated reforms will work
better than imposed top-down ones. This finds support in many case studies conducted
by Ostrom (1990) and her students. They find that local information, locally designed
incentives, and local enforcement by norms and sanctions, all help explain the success
of many successful instances of collective action. In India, there is scope for
improving the provision of many public goods by greater decentralization and harnessing
local initiatives. But one should not expect perfection; some recent research on
public projects in Africa finds that local elites can also become corrupt and siphon
away a large proportion of the gains intended for the general population.
Finally, I think that the process of designing institutional reforms offers a good
opportunity for fruitful collaboration between academic economists and businesspeople.
Many academic economists used to dislike or disdain businesspeople and prefer a
statist solution to economic problems. This is much less true in western countries
these days, but the tendency may be more persistent in India. I hope even they will
regard the task of improving the institutions of economic governance in a favorable
light, seeing it as a way of constraining the opportunistic behavior of businesspeople.9
Many of them will also be attracted by the idea of a bottom-up rather than a top-down
reform. There is a wealth of academic studies, theoretical and empirical, of the
evolution, performance, and limitations of such institutions. Businesspeople have
a clear perception of the specific governance needs of their industries. The two
can combine their brains and energies to adapt the lessons of these studies to the
Indian situations, and contribute to creating a better environment for continued
rapid economic progress of the country.
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1 This is a draft of the P. R. Brahmananda Memorial Lecture to be delivered at the
Reserve Bank of India, Mumbai, on June 28, 2007. The actual material delivered may
differ slightly from this text. I thank Meghnad Desai and Vijay Kelkar for their
perceptive comments and suggestions on a previous draft.
2 But such seizures may be on the rise again, from recent populist governments in
some countries and the expansion of the use of eminent domain in the United States
and elsewhere.
3 Even more generally than in the context of corruption, the stability of policies
can be extremely important for promoting investment. Uncertainty creates an “option
value” of waiting, and thereby acts as a powerful deterrent on investment; see Dixit
and Pindyck (1994).
4 The economics jargon for the higher total burden of corruption imposed by multiple
authorities acting together is “double marginalization,” and its cause is the “negative
externality” that these authorities exert on each other. If they act collectively,
they will internalize this externality.
5 The following paragraphs give a very brief and selective discussion of this. For
more detailed analyses, see Dixit (2004) and Greif (2006).
6 These coercive powers ultimately depend on other people's willingness to exercise
them - judges to hand down punishment, and the police or the prison authorities
to carry them out. Laws and regimes that tried to be more coercive than their citizens
were willing to tolerate have fallen into disrepute and collapsed. See Mailath,
Morris and Postlewaite (2001) for a discussion and game-theoretic analysis of this.
7 The latter can have the benefit of expert testimony, but experts can have their
own biases which the judges must somehow figure out and take into account.
8 In the jargon of game theory, the outcome is a second-best, subject to dynamic
incentive compatibility constraints.
9 I have argued that even businesspeople, when they regard their whole conduct of
future business, recognize the benefit of establishing a system that curbs opportunism
and promotes respect for property rights and contracts. More generally, this is
true of all “moral hazard” problems: people agree on the ex ante desirability of
reducing such “hazardous” behavior, even though they are tempted ex post to engage
in it.
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