EMBARGO Not for publication or broadcast until 3 p.m. EDT (1900 GMT) Wednesday, June 25, 1997 YW)RLI) DE\TEL( )PMENORT [1 EN IlT 1997 aC˘S 1'3 D- a. - E LE T . U-' YE. S EL E CT ED W O RLD DEV E LO PM E NT I ND I CAT ORS5 WORLD DEVELOPMENT REPORT 1 997 T H E S TAT E IN A C H A N G I N G W O R L D PUBLISHED FOR THE WORLD BANK OXFORD UNIVERSITY PRESS Oxford University Press OXFORD NEW YORK TORONTO DELHI BOMBAY CALCUTTA MADRAS KARACHI KUALA LUMPUR SINGAPORE HONG KONG TOKYO NAIROBI DAR ES SALAAM CAPE TOWN MELBOURNE AUCKILAŽEND and associated companies in BERLIN IBADAN © 1997 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. Published by Oxford University Press, Inc. 200 Madison Avenue, New York, N.Y. 10016 Oxford is a registered trademark of Oxford University Press. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Interior design and typesetting by Barton Matheson Willse & Worthington. Manufactured in the United States of America First printing June 1997 This volume is a product of the staff of the World Bank, and the judgments made herein do not necessarily reflect the views of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. ISBN 0-19-521115-4 clothbound ISBN 0-19-521114-6 paperback ISSN 0163-5085 Text printed on recycled paper that conforms to the American Standard for Permanence of Paper for Printed Library Material Z39.48-1984 F O R E W O R D W ORLD DEVELOPMENT REPORT 1997, THE TWENTI- and technical inputs. It is also about the underlying, insti- W eth in this annual series, is devoted to the role and tutional environment: the rules and customs that deter- effectiveness of the state: what the state should do, how it mine how those inputs are used. As this Report shows, should do it, and how it can do it better in a rapidly understanding the role the state plays in this environ- changing world. ment-for example, its ability to enforce the rule of law to These issues are high on the agenda in developing and underpin market transactions-will be essential to mak- industrial countries alike. For many, the lesson of recent ing the state contribute more effectively to development. years has been that the state could not deliver on its The pathways to an effective state are many and varied. promises: transition economies have had to make a wrench- The Report makes no attempt to offer a single recipe for ing shift toward the market economy, and much of state reforms worldwide. It does, however, provide a the developing world has had to face up to the failure of framework for guiding these efforts, in the form of a two- state-dominated development strategies. Even the mixed part strategy: economies of the industrialized world, in response to the failures of government intervention, have opted for a de- * First, focus the state's activities to match its capability. cided shift in the mix in favor of market mechanisms. Many states try to do too much with few resources and Many have felt that the logical end point of all these little capability. Getting governments better focused on reforms was a minimalist state. Such a state would do no the core public activities that are crucial to develop- harm, but neither could it do much good. ment will enhance their effectiveness. The Report explains why this extreme view is at odds * Second, over time, look for ways to improve the state's with the evidence of the world's development success capability by reinvigorating public institutions. The stories, be it the development of today's industrial eco- Report puts particular emphasis on mechanisms that nomies in the nineteenth century or the postwar growth give public officials the incentive to do their jobs better "miracles" of East Asia. Far from supporting a minimalist and to be more flexible, but that also provide restraints approach to the state, these examples have shown that to check arbitrary and corrupt behavior. development requires an effective state, one that plays a catalytic, facilitating role, encouraging and complement- Drawing from examples of successful and unsuccessful ing the activities of private businesses and individuals. states, and of state reform around the world, the Report Certainly, state-dominated development has failed. But so elaborates this two-part strategy and shows how it can be has stateless development-a message that comes through implemented from a number of starting positions. Signif- all too clearly in the agonies of people in collapsed states icantly, although there is an enormous diversity of settings such as Liberia and Somalia. History has repeatedly and contexts, effective states clearly do have some com- shown that good government is not a luxury but a vital mon features. One is in the way government has set rules necessity. Without an effective state, sustainable develop- underpinning private transactions, and civil society more ment, both economic and social, is impossible. broadly. Another is in the way government has played by History and recent experience have also taught us that the rules itself, acting reliably and predictably and con- development is not just about getting the right economic trolling corruption. Building a more effective state to support sustainable the challenge for states is neither to shrink into insignifi- development and the reduction of poverty will not be cance, nor to dominate markets, but to start taking those easy. In any situation many people will have a vested small steps. interest in keeping the state as it is, however costly the results for the well-being of the country as a whole. Over- coming their opposition will take time and political effort. But the Report shows how opportunities for reform can open, and widen, with the help of careful sequencing of reforms and mechanisms to compensate losers. Even in James D. Wolfensohn the worst of situations, very small steps toward a more President effective state can have a large impact on economic and The World Bank social welfare. As we approach the twenty-first century, May 30, 1997 This Report has been prepared by a ream led b! Ajda Chhibber and comprking Simon Conimander. .Alison EBans, Hlrald Fuhr. C-heikh Kanc. Chad Leehor. Brian Levy, Sanjay P'radhan. and Beacrice W'eder. \aluable contriburion, %%crc mide hb lean-Paul am. Ed C arnpos. Hamid Dacoodi. KA'thleen Newland. Kenichi Ohno. Dani RLodri., Su-an Rose-Ackernman. Ascri Suhrke. and Douglis \Webh. The [eim wa, assisted bY Riru Basu. Greg, )-v K,iunko. Uine I eC, C luirdia Sepili-eda. and Adam Nlhchael Smich. Srephanie Flanders wa,i rhe principal editor. The %%ork %a, carried OUt under rhc general direction of rhe late kichael Bruno, L.Yn Squire. and losepph Sngliri. The reamn received useful ad-ice fromni a dislinguished panel of excernal evpern: comprising Mlasahiko Aoki. Eli Bharr. Kwivesi Borch.ehv. Peter Eans. Awul Kohli. Klaus Kinig. Seynmo,ur Miartin LUpset. DOLIsLus North. Emma Rothschild. G raham Scomtt and Vito Tanzi. M\lanv orher, inside and outi:de rhe \VOrld Bank provided helpful commn-ents, w-rore background papers and other conrributions. and participared in consultation meedingS. These conrributors and participants afe listed in the Bibliocgraphical Note. The Inrernartonal Econonites Departmcnt contribluted to thc data appendix and was responsibl- for the Selccct\d World De,elopmentr Indicators T-he production satAt of thc Report included Arnm Brooks. Valerie Chihlhln. Kathrmn Kline Dahl. Joyce Gates. Srephanie G 3erard. leffrevy N. Lecksell. and 1%lichael Treadwa-Y. Rebecca SUgttl served .I execuciVe assisanr to the team,n and Daniel Archlson. Ehliabere de Lima. Mtichael Geller. and Thomrs Zorab as [aff assistants. Maria Amcal ser.ed as administrtice offticer. This Report is dedicated to the memorY of Mlichiel Bruno. Senior \'ice President and Chiet'Economist of the World Banrk fromn 19'!9 to 199u, "%hosc hfe'i work, including his contributions co this and past editions of ll b7rld l *)[t cn Rcrn immcasurible aIdv ancedl our undlerstanding of development. IV C O N T E N T S OVERVIEW .........................................................1................ I PART ONE RETHINKING THE STATE-THE WORLD OVER 1 The Evolving Role of the State .................................................... 19 2 Refocusing on the Effectiveness of the State .......................................... 29 PART TWO MATCHING ROLE TO CAPABILITY 3 Securing the Economic and Social Fundamentals ...................................... 41 4 Fostering Markets: Liberalization, Regulation, and Industrial Policy ......................... 61 PART THREE REINVIGORATING INSTITUTIONAL CAPABILITY 5 Building Institutions for a Capable Public Sector ...................................... 79 6 Restraining Arbitrary State Action and Corruption ..................................... 99 7 Bringing the State Closer to People ................................................ 110 8 Facilitating International Collective Action ........................................... 131 PART FOUR REMOVING OBSTACLES TO CHANGE 9 The Challenge of Initiating and Sustaining Reforms .................................... 145 10 The Agenda for Change ......................................................... 157 Technical Note ......................................................................... 168 Bibliographical Note . ................................................................... 176 Appendix: Selected Indicators on Public Finance ............................................... 195 SELECTED WORLD DEVELOPMENT INDICATORS ................................... 203 BOXES 1 The pathway to a more effective state .................................................... 3 2 Credibility, investment, and growth ..................................................... 5 3 The regional agenda .14 VI VVORLD DEVELOPMENT REPORT 1997 1.1 State and government: Some concepts ............. ......................................... 20 1.2 U.S. government action to support market development: Some examples ............................ 21 1.3 Evolution of the role of the state in India: The past fifty years ..................................... 24 1.4 The economic rationale for state intervention and some definitions ................................. 26 2.1 Building the Internet: A contemporary example of fruitful public-private interaction .31 2.2 Measuring the state-its size, its policies, and its institutional capability .33 3.1 Weaknesses in fundamentals constrain firms the world over .42 3.2 Standing up to crime in Cali, Colombia .44 3.3 Contracting and the judicial system in Brazil .46 3.4 International track records on fiscal deficits and inflation ........................................ 47 3.5 Commitment versus flexibility in the CFA zone ............ ................................... 52 3.6 Private provision of social services: A historical perspective ....................................... 54 3.7 The new Chilean unemployment insurance scheme ........... ................................. 58 3.8 Reducing poverty in Indonesia-how social assistance complements broad-based growth ..... ............ 60 4.1 Mexico's deregulation czar ............................................................... 63 4.2 Six objections to privatization-and how to address them ........................................ 64 4.3 How government supervision averted financial disaster in Malaysia ................................. 67 4.4 Telecommunications regulation in Jamaica ................................................... 70 4.5 Environmental activism in Yokohama, Japan .............. ................................... 71 4.6 Japan's postwar big push in metals industries .............. ................................... 73 5.1 Laying bureaucratic foundations: The Northcote-Trevelyan reforms in the United Kingdom ..... ......... 80 5.2 Australia's mechanisms for transparent, competitive, and results-oriented policymaking ..... ............. 82 5.3 The mushrooming of Bangladesh's government ............ ................................... 86 5.4 Vouchers and school choice .............................................................. 89 5.5 Contracting with NGOs for better schooling in Bolivia ......................................... 90 5.6 Cultivating the best and the brightest: Mandarin versus open systems ............................... 94 5.7 Building worker dedication: Good government in Brazil's Ceara State ............................... 97 6.1 How popular participation improved property rights and dispute resolution in Peru ................... 101 6.2 Urban political machines in the United States and their reform ................................... 105 6.3 Fighting corruption in Uganda .106 6.4 Hong Kong's independent commission against corruption .107 7.1 Public opinion and the state .111 7.2 Managing multiethnic societies in Malaysia and Mauritius .113 7.3 Does social capital matter? .115 7.4 Client surveys to motivate service improvements in India, Uganda, and Nicaragua .118 7.5 Does participation improve project performance? .119 7.6 Pitfalls in intergovernmental relations: The experiences of Brazil and China .......................... 125 7.7 Calculating fiscal equalization grants ............. ......................................... 127 8.1 The World Trade Organization-an international mechanism for bringing credibility to national policy .... 134 8.2 How international agricultural research benefits donors as well ................................... 137 8.3 The challenges of global climate change for international cooperation .............................. 138 8.4 Sharing the burden of environmental protection .............................................. 139 8.5 How large the global peace dividend? .140 CONTENTS VIl 9.1 Weighing the political costs and benefits of reform ............... ............................. 146 9.2 The predatory state under the Duvalier dynasty in Haiti ........... ............................. 149 9.3 Reform under external threat: The Meiji restoration in Japan .................................... 150 9.4 The Moncloa Pacts in Spain ......................................................... 155 9.5 Venezuela's 1989 reform program and its reversal ............................................. 156 10.1 State collapse and beyond in Somalia .159 10.2 The economic underpinnings of conflict: The case of Liberia .160 TEXT FIGURES 1 The state has grown everywhere ........................................................ 2 2 A range of mechanisms can enhance state capability . ............................................. 7 3 Factors associated with corruption ........................................................ 8 4 Higher government employment often means lower government wages ....... ....................... 10 5 Countries with good economic policies and stronger institutional capability grow faster ..... ............. 13 1.1 One world, many more states ........................................................ 21 1.2 Governments the world over have expanded since 1960 ............ ............................. 22 1.3 Transfers and interest payments have grown .................................................. 23 2.1 The state, institutions, and economic outcomes . ............................................... 30 2.2 Good government helps explain the income gap between East Asia and Africa ...... ................... 32 2.3 Reliable institutions make for credible states .................................................. 35 2.4 Perceived credibility and economic performance go hand in hand ........ .......................... 37 3.1 The lawlessness syndrome ........................................................ 43 3.2 Negotiating with government officials can be arduous .43 3.3 Countries are discovering the advantages of the value added tax .48 3.4 Unlike Nigeria, Indonesia managed its recent oil windfall prudently .49 3.5 Well-designed budgetary institutions help avoid large deficits .51 3.6 In Vietnam, the benefits of hospital care are skewed toward the better-off .53 3.7 The balance of private and public education differs enormously worldwide .55 3.8 Pensions and other transfers have crept upward in the industrial countries .57 3.9 Housing subsidies in developing countries mostly fail to reach the needy .59 4.1 Bank crises are all too common and carry enormous fiscal cost .68 5.1 Guinea's policy goals and spending allocations do not add up .84 5.2 Decisionmaking in Ukraine is bogged down by overlapping responsibilities .85 5.3 Most firms rate government services poorly, but some services score higher than others .86 5.4 Three strategies for improving government service delivery .87 5.5 Recruiting and promoting on merit improve bureaucratic capabiliy .92 5.6 Lack of meritocracy and poor pay in the Philippines' civil service have lowered capability .93 5.7 In Africa, as public employment has risen, wages have fallen .............. ........................ 95 6.1 High and unpredictable corruption hurts investment . ......................................... 103 6.2 Some factors associated with corruption ................................................ 104 7.1 The world has become much more democratic since 1980 . ..................................... 112 7.2 Organizations at the interface of state, markets, and civil society ........... ....................... 116 7.3 Vertical rules and horizontal incentives shape local government's capability .......................... 123 8.1 Many countries are loosening restraints on international capital ................................... 135 VilI WORLD DEVELOPMENT REPORT 1997 8.2 Refugees have been flooding Africa, Asia, and Europe .............. ............................ 141 8.3 Poor policies nullify the effect of aid .................................................... 142 9.1 Older workers will lose from reforming pensions, but the young will gain ....... .................... 147 9.2 Multiple veto points help countries resist pressure to expand welfare ........ ....................... 148 TEXT TABLES 1.1 Functions of the state .................................................... 27 3.1 Social insurance, social assistance, and poverty-targeted programs in developing countries: Characteristics and lessons .................................................... 56 3.2 Implicit pension debt in selected countries ................................................... 57 4.1 Estimates of welfare gains from deregulation in the United States .62 4.2 The variety of regulatory experience .67 5.1 Mechanisms to improve service delivery .88 7.1 Changes in subnational finance in selected countries .121 7.2 Demand and supply characteristics of local and national public goods .122 7.3 Possible tax and expenditure assignments by level of government .................................. 128 7.4 Principles and best practices in grant design .129 7.5 Matching decentralization strategy to government capacity .130 9.1 Alignment of interest groups, political costs, and tactical sequencing of reform by reform type .145 9.2 Estimated efficiency gains from privatizing utilities in Argentina .147 9.3 First- and second-generation reforms .152 Definitions and data notes The countrics included in rgioonal and income Dollar Higures are current U.S. dollars escept groupings used in this Report tecept chowe for rhe ';here orherwise specified. privre sector survc, i are listed in the ClassificatLon of Billiom means 1.0lth million: rV.,/hoi means 1.4100 Econornies tabics at the end of the Selected WVorld billion. Development Indicators. Income classifications are based t,n GNP[' per capita: thresholds t;r income cla.,- The followving abbrev-iations are used: hlfatioianm inthis edition may- be Itbund in the Intro- duction to Selected \\orld Deseloprnent Indicaors. CEE CentraJ and Eastern Europe (nroup averagcs reporced in the ti6ures and tables are CiS Commonnmealth of Independent Stares unw%elihted av%erg,es ot [he countries in the group GDP Gross domestic product except %%here noted co the contrary. GNP Gross national product The use ot the trcri 'countries" to reter to eco- IMF Internationil Mlonetarv Fund nomie' impci n ludg,menc b. thc \W(orld Bank NGO Nongovernmental organization ab,ut the legal or ohecr status of a Teritory. Statiics OECD C)rganizaton for Economic Cooperarion reported tor 'developing countries" include eco- and Developmenr nomies in tramsition trom central planning escept PPP Purchasing power parity w%here notrcd to rhc contrrar,. A ROUND THE GLOBE, THE STATE IS IN THE SPOT- of experience since then is rather different: that the state is A light. Far-reaching developments in the global eco- central to economic and social development, not as a nomy have us revisiting basic questions about government: direct provider of growth but as a partner, catalyst, and what its role should be, what it can and cannot do, and facilitator. how best to do it. What makes for an effective state differs enormously The last fifty years have shown clearly both the benefits across countries at different stages of development. What and the limitations of state action, especially in the pro- works in the Netherlands or New Zealand, say, may not motion of development. Governments have helped to work in Nepal. Even among countries at the same level of deliver substantial improvements in education and health income, differences in size, ethnic makeup, culture, and and reductions in social inequality. But government political systems make every state unique. But this very actions have also led to some very poor outcomes. And diversity enriches this Report's inquiry into why and how even where governments have done a good job in the past, some states do better than others at sustaining develop- many worry that they will not be able to adapt to the ment, eradicating poverty, and responding to change. demands of a globalizing world economy. The new worries and questions about the state's role Rethinking the state-the world over are many and various, but four recent developments have The world is changing, and with it our ideas about the given them particular impetus: state's role in economic and social development. Today's intense focus on the state's role is reminiscent of an earlier * The collapse of command-and-control economies in the era, when the world was emerging from the ravages of former Soviet Union and Central and Eastern Europe World War II, and much of the developing world was just * The fiscal crisis of the welfare state in most of the estab- gaining its independence. Then development seemed a lished industrial countries more easily surmountable-and largely technical-chal- * The important role of the state in the "miracle" eco- lenge. Good advisers and technical experts would formu- nomies of East Asia late good policies, which good governments would then * The collapse of states and the explosion in humanitar- implement for the good of society. State-led intervention ian emergencies in several parts of the world. emphasized market failures and accorded the state a cen- tral role in correcting them. But the institutional assump- This Report shows that the determining factor behind tions implicit in this world view were, as we all realize these contrasting developments is the effectiveness of the today, too simplistic. Flexibility to implement the policies state. An effective state is vital for the provision of the devised by technocrats was accorded pride of place. goods and services-and the rules and institutions-that Accountability through checks and balances was regarded allow markets to flourish and people to lead healthier, as an encumbrance. happier lives. Without it, sustainable development, both In a few countries things have indeed worked out more economic and social, is impossible. Many said much the or less as the technocrats expected. But in many countries same thing fifty years ago, but then they tended to mean outcomes were very different. Governments embarked on that development had to be state-provided. The message fanciful schemes. Private investors, lacking confidence in 2 WORLD DEVELOPMENT REPORT 1997 public policies or in the steadfastness of leaders, held back. veloping world embraced state-dominated development Powerful rulers acted arbitrarily. Corruption became strategies. The result was a tremendous expansion in the endemic. Development faltered, and poverty endured. size and reach of government worldwide. State spending Over the last century the size and scope of government now constitutes almost half of total income in the estab- have expanded enormously, particularly in the industrial lished industrial countries, and around a quarter in devel- countries (Figure 1). The pre-World War II expansion was oping countries. But this very increase in the state's influ- driven by, among other factors, the need to address the ence has also shifted the emphasis from the quantitative to heavy toll on economic and social systems brought on by the qualitative, from the sheer size of the state and the the Great Depression. The postwar confidence in govern- scope of its interventions to its effectiveness in meeting ment bred demands for it to do more. Industrial eco- people's needs. nomies expanded the welfare state, and much of the de- As in the 1940s, today's renewed focus on the state's role has been inspired by dramatic events in the global economy, which have fundamentally changed the environ- igure 1 The state has grown everywhere ment in which states operate. The global integration of economies and the spread of democracy have narrowed the rola; go%ernniert e\perIditure scope for arbitrary and capricious behavior. Taxes, invest- ;pe&nrErU*g, of GDPFi ment rules, and economic policies must be ever more 50 responsive to the parameters of a globalized world econ- omy. Technological change has opened new opportunities 40 for unbundling services and allowing a larger role for mar- kets. These changes have meant new and different roles for 30 government-no longer as sole provider but as facilitator and regulator. States have come under pressure even where Lo _ * - - governments have previously seemed to perform well. Many industrial countries find themselves grappling with a welfare state that has grown unwieldy, and having to make 10 1 d * - - - - - difficult choices about the services and benefits that people should expect government to provide. Markets-domestic 0 l U '- _ - i6C: 9 'n* * and global-and citizens vexed by state weaknesses have 1|:1 come to insist, often through grassroots and other non- OECD countries governmental organizations, on transparency in the con- duct of government, and on other changes to strengthen Centr3r goterr;iene' e-penditire the ability of the state to meet its assigned objectives. ;percenra-e of GDPi The clamor for greater government effectiveness has 5') reached crisis proportions in many developing countries where the state has failed to deliver even such fundamental 40 public goods as property rights, roads, and basic health and education. There a vicious circle has taken hold: people 30 and businesses respond to deteriorating public services by avoiding taxation, which leads to further deterioration in 20 - - - - services. In the former Soviet Union and Central and East- ern Europe it was the state's long-term failure to deliver on :l - | | | - - - - its promises that led, finally, to its overthrow. But the col- lapse of central planning has created problems of its own. O - - 9 1 In the resulting vacuum, citizens are sometimes deprived 196__ 1`1E c1, 0 19 r qs 1i-og: of basic public goods such as law and order. At the limit, Developing countries as in Afghanistan, Liberia, and Somalia, the state has some- times crumbled entirely, leaving individuals and interna- tional agencies trying desperately to pick up the pieces. r. E C-ap f.;r mr. OJEC G 0,ro z our ,r E - fe r --enunlol rI :3 1, 1 go emrineni "clAng iocM' secu' e.rdr,rre- See vie A two-part strategy Techn,r a' icale iH . ot tl. So:-e. Tan-: *n, EtA' e,:i iCtC OECD. vr,ous ,3rIMF : .iriuusv, years a' How can we cut through the maze of questions and pres- sures now facing the world's states? No one-size-fits-all OVERVIEW 3 recipe for an effective state is suggested here. The range of differences amnong states is too enormous, as are their start- Box 1 The pathway to a more effective state ing points. Rather this Report provides a broad framework for addressing the issue of the state's effectiveness world- A more capable sriai c3n bc a more cttec[ive state. wide. It points to a number of ways to narrow the grow- but effecrixcncsn an3d capabilin- ire not the same ing gap between the demands on states and their capabil- ching. GiH-..d' i' applied tio 5r.sc;t. Ehc abilirc ity to meet those demands. Getting societies to accept a to adtldr1ikc and promote ColtecLuc actions effi- redefinition of the state's responsibilities will be one part cientk1-such ns lav and ordcr. public hcalth. and of the solution. This will include strategic selection of the biiia infrastructiire :.IffI V ;C!! i a result * f using collective actions that states will try to promote, coupled rhit capabilit it- mee[t o.ociv'- demmnd t;r thoxe with greater efforts to take the burden off the state, by Aoo2. Ac itre ma!- be capable buE not %eD &ciCe involving citizens and communities in the delivery of core it irs capabilin is fLI urd in socci:rs inerevst. collective goods. The pa[h to a more r-lteci.e staie. Alihoui'll no[ But reducing or diluting the state's role cannot be the lincar. is likelk to be a m-stage pruiC&x. First. [he end of the reform story. Even with more selectivity and 1a[te inwu tocu-I ,eh capbility it ha.s on those tasks greater reliance on the citizenry and on private firms, that it can and should undcrtake. k, it doei rhh. It meeting a broad range of collective needs more effectively crn then tOkLS on buildling additional cadpbiliyr. As will still mean making the state's central institutions work the fiinure illustratc, countries in Zone I pursue a better. For human welfare to be advanced, the state's bi.:,ad ran,- of iaclt;[ies Aii an unitocesedn mannCr capabilitv-defined as the ability to undertake andpromote despi[t litrle state capabilirx. and [heir eftcrMs pr.- e collective actions efficiently-must be increased. ineftecrEic. But courtrics cannot m o%e to Zunc III This basic message translates into a two-part strategy to overnji1t-buildinc capabilir. cAJ:eh time. The path. make every state a more credible, effective partner in its v. a- ii gicater eHc tie nes leads. [rtst to tocusing on country's development: furidanieneal [tasks anid it eriginy the statc limited cap.bilint rlirCLtl'lu partnerlhips with [he buxines, * Matching the state' role to its capability is the first ele- communlin- and cikl socien Zone 11 . Ccountries ment in this strategy. Where state capability is weak, then can nioce gradually to Zonr Ill by strengLhen- how the state intervenes-and where-should be care- ing rheir c.ipahilirv n0.er time. fully assessed. Many states try to do too much with few resources and little capability, and often do more harm than good. A sharper focus on the fundamentals would improve effectiveness (Box 1). But here it is a matter not just of choosing what to do and what not to do- M1re - but of how to do it as well. e. i . * But capability is not destiny. Therefore the second ele- ment of the strategy is to raise state capability by rein- vigorating public institutions. This means designing effective rules and restraints, to check arbitrary state actions and combat entrenched corruption. It means subjecting state institutions to greater competition, to increase their efficiency. It means increasing the perfor- mance of state institutions, improving pay and incen- tives. And it means making the state more responsive to ehe: ,'e people's needs, bringing government closer to the peo- Mlre ple through broader participation and decentralization.. apable Thus, the Report not only directs attention to refocus- Unfotu .- -- LsahIe ing the state's role, but also shows how countries might begin a process of rebuilding the state's capability. Matching role to capability do and what not to do is critical. But this also involves Matching role to capability is not a simple message of dis- choosing how to do things-how to deliver basic ser- mantling the state. In some areas much greater focus is vices, provide infrastructure, regulate the economy-and badly needed to improve effectiveness: choosing what to not just whether to do them at all. The choices here are 4 VWORLD DEVELOPMENT REPORT 1 997 many and must be tailored to the circumstances of each graphic areas. Marginalized from public discussion and country. excluded from the broader economy and society, such groups are fertile ground for violence and instability, as The first job of states: Getting the undamentals right many parts of the world are increasingly learning. Five fundamental tasks lie at the core of every govern- Public policies and programs must aim not merely to ment's mission, without which sustainable, shared, deliver growth but to ensure that the benefits of market- poverty-reducing development is impossible: led growth are shared, particularly through investments in basic education and health. They must also ensure that * Establishing a foundation of law people are protected against material and personal insecu- * Maintaining a nondistortionary policy environment, rity. Where poverty and economic marginalization stem including macroeconomic stability from ethnic and social differences, policies must be care- * Investing in basic social services and infrastructure fully crafted to manage these differences, as Malaysia and * Protecting the vulnerable Mauritius have done. * Protecting the environment. Government regulation is not the only answer to pollu- tion. An expanding toolkit of innovative and flexible Although the importance of these fundamentals has long incentives is now available to get polluters to clean up their been widely accepted, some new insights are emerging as to act. Although there is no substitute for meaningful regula- the appropriate mix of market and government activities in tory frameworks and information about the environment, achieving them. Most important, we now see that markets these new tools, which rely on persuasion, social pressure, and governments are complementary: the state is essential and market forces to help push for improved environmen- for putting in place the appropriate institutional founda- tal performance, can often succeed where regulation can- tions for markets. And government's credibility-the pre- not. Countries are using some of these tools, with promis- dictability of its rules and policies and the consistency with ing results, in four areas: which they are applied-can be as important for attracting private investment as the content of those rules and policies. * Harnessing the power of public opinion A survey, specially commissioned for this Report, of * Making regulation more flexible domestic entrepreneurs (formal and informal) in sixty- * Applying self-regulatory mechanisms nine countries confirms what was already known anecdo- * Choosing effective market-based instruments. tally: that many countries lack the basic institutional foundations for market development (Box 2). High levels Going beyond the basics: The state need not be the of crime and personal violence and an unpredictable judi- sole provider ciary combine to produce what this Report defines as the There is a growing recognition that in many countries "lawlessness syndrome." Weak and arbitrary state institu- monopoly public providers of infrastructure, social services, tions often compound the problem with unpredictable, and other goods and services are unlikely to do a good job. inconsistent behavior. Far from assisting the growth of At the same time, technological and organizational innova- markets, such actions squander the state's credibility and tions have created new opportunities for competitive, pri- hurt market development. vate providers in activities hitherto confined to the public To make development stable and sustainable, the state sector. To take advantage of these new opportunities-and has to keep its eye on the social fundamentals. Lawlessness better allocate scarce public capability-governments are is often related to a sense of marginalization: indeed, beginning to separate the financing of infrastructure and breaking the law can seem the only way for the marginal- services from its delivery, and to unbundle the competitive ized to get their voices heard. Public policies can ensure segments of utility markets from the monopoly segments. that growth is shared and that it contributes to reducing Reformers are also moving to separate programs of social poverty and inequality, but only if governments put the insurance, designed to address the problems of health and social fundamentals high on their list of priorities. employment insecurity for all, from programs of social Too often, policies and programs divert resources and assistance, intended to help only the poorest in society. services from the people who need them most. The polit- COPING WITH HOUSEHOLD INSECURITY. It is now well ical clout of the more affluent in society sometimes leads established that the state can help households cope with governments to spend many times more on rich and mid- certain risks to their economic security: it can insure against dle-class students in universities than on basic education destitution in old age through pensions, against devastating for the majority and scholarships for the less well off. In illness through health insurance, and against job loss rnany regions poverty and inequality are often biased through unemployment insurance. But the idea that the against ethnic minorities or women, or disfavored geo- state alone must carry this burden is changing. Even in OVERVIEW 5 Box 2 Credibility, investment, and growth A sur.ey otf loAl entrepreneUr in s'i_x-n-in countrxen rliabdlitr of thc invtitutonUal irame.. & nornalized showvs thar mrany sLtes are pert rniing their core lun,- herc to [he high-inc.rnc O)ECD councric) a per- rio-ns poo.-rlI: rhc- are failing to ensure Law% and ordcr. Ci\c db privare erireprceInLrs-1se cail it credibilmn. pr.1aecl property. :-rid apply rule' anild policic; pre- The other rt-wo panels siiov. thar. OIce differencnC in iII- dictabilv. In% esirs Li.- nor consider suCh stiaes crediblt, coume and edluclaton and policy dmitortions ha-ve [ten anld rowrh and inmesrmcn suter as a consejquCrLe. conrr ied t;r therc i scrong Lorrelnori bterX%eeen Firmc wkere aked to rank each If se%eral Indicarors c01,nrrice crcditllh% ricing rid chcir recourd ot gross rh in a scale from onc (ec;trcme problemi cc fOi: (10 prrob- trid in'esrment. l-hc credibility raling- are based on lcmri. Aiefaging che ar!n%%ers. as rhe I-ft panel dues fir investors perceptionis. Bt it is thesc percepci.:ns char Cach world region. yi elds in v-erall indicator ov tlie dcterminc in%et[inent bchavior. rro.w:ili ot GOP rer: :3nita ip eieni pe :,eari Credibility index .2.' i Hi-gh-isnconi OECD = 1.0 I r- Ut. - - - 03.8 Level of crediblity U(G r i' C tinlreint tperc:enrage o1 COP' Is - - O.; 11 I-8 5. 12 H,gh, --iu,slh M.-idie CEE L,;t.n Su!:r I WWCOrrE 3r,d E;-r an-1 q;s;stl;;..- oECE, -Jh pNhM jr-, ilr; .L...a O _ P! : '' s -.a Hog. r,; oMuni L Level of credibility rI-te The cr'dtdilitd ride: ldE i tanipsl i-. A .f rra, 'e' ac' att *- .3tre ,-,, eajer.cs or, F,r,-,f Ea,:L r. b.j ( T,%(. Vi,l1 p3,-eis rr,e aserage f r a rup iAt-;neiS TlieiiSilS are taSec or reris;ris irte peC-I 149.-J- I CD .. ,wlfl r..; cntre; I,31 in.estrner,t iclell Tvir,rue csurlr,es, on tie o.re. corqrdir .rg iri:.oii A.i.:rliAri 3r,1 rcit(, di ra[. ttu- i i nI ,r- ciesir I I ar-i .la l Easr 3nd [irNrth Afri.ca are each. repieSvrite r, crnl. tie ecr.rc.ne3 av.i:e, v:r-rio s1ail r ci,:al uI: n*'g c1i' a r irt pr,k are -e rsr so', *:xcndu.-te-j fer rri, Pecon. a3'.j Ers,ner.. rions c ar, pseler r%acwe',jril p-r many industrial countries the welfare state is being re- Innovative solutions that involve businesses, labor, house- formed. Emerging economies from Brazil to China will be holds, and community groups are needed to achieve greater unable to afford even pared-down versions of the European security at lower cost. This is especially important for those system, especially with their rapidly aging populations. developing countries not yet locked into costly solutions. 6 VW'ORLD DEVELOPMENT REPORT 1997 EFFECTIVE REGULATION. Well-designed regulatory sys- Experience has shown that the way privatization is tems can help societies influence market outcomes for managed is terribly important to the end result. The key public ends. Regulation can help protect consumers, work- factors are transparency of process, winning the acquies- ers, and the environment. It can foster competition and in- cence of employees, generating broad-based ownership, novation while constraining the abuse of monopoly power. and instituting the appropriate regulatory reform. Where Thanks to regulatory reforms initiated in the early 1980s, privatization has been managed carefully, it is already Chile's telecommunications industry has enjoyed sustained showing positive results: in Chile, for example, and the private investment, increasing service quality and com- Czech Republic. Its importance in the strategy to foster petition, and declining prices. By contrast, until some markets may vary, but for many developing countries recent reform initiatives, dysfunctional regulation led the seeking to scale back an overextended state, privatization Philippine telecommunications industry-long privately must be kept on the front burner. A carefully managed owned-to underinvest. The result was poor and often privatization process brings very positive economic and high-priced service, imposing a high cost on citizens and fiscal benefits. other firms. Making the best use of the new options emerg- ing for private provision of infrastructure and social ser- Knowing the state's limits vices will also rely, often, on a good regulatory framework. The key to predictable and consistent implementation of INDUSTRIAL POLICY. When markets are underdevel- policy is a good fit between the state's institutional capa- oped, the state can sometimes reduce coordination prob- bilities and its actions. In well-developed states, adminis- lems and gaps in information and encourage market devel- trative capability is normally strong, and institutionalized opment. Many of today's oldest industrial economies used checks and balances restrain arbitrary action, even as they various mechanisms to spur the growth of markets in their provide government organizations the flexibility to pursue early stages of development. More recently, Japan, the their mandates. By contrast, states with weaker institu- Republic of Korea, and other countries in East Asia used a tions may need to err on the side of less flexibility and variety of mechanisms for market enhancement, in addi- more restraint. This can be done in two ways: tion to securing the economic, social, and institutional fun- damentals. Sometimes these interventions were quite elab- a Through self-restricting rules, which precisely specify the orate: the highly strategic use of subsidies, for example. content of policy and lock it into mechanisms that are Other times they were less intrusive, taking the form of costly to reverse. Regional common-currency arrange- export promotion and special infrastructure incentives. But ments, such as the CFA currency zone in francophone the ability to choose wisely among these interventions and Africa or quasi currency boards as in Argentina, are use them effectively is critical; ill-considered trade, credit, examples of such mechanisms in the field of monetary and industrial policies can and have cost countries dearly. policy. "Take-or-pay" contracts with independent power Many developing countries pursued ill-thought-out activ- producers serve a similar function in utilities regulation. ist industrial policies, with poor results. Countries that a Through working in partnership with firms and citi- have pursued an activist industrial policy successfully could zens. In industrial policy, for example, states can foster not have done so without strong institutional capability. private-to-private collaboration. In financial regulation MANAGING PRIVATIZATION. Carefully designed regula- they can give bankers an incentive to operate prudently. tions and other active government initiatives can enhance And in environmental regulation they can use the the growth of markets. But in many countries this can spread of information to encourage "bottom-up" citi- take time, as private initiative is held hostage to a legacy of zen initiatives. antagonistic state-market relations. And poorly perform- ing state enterprises are often a big drain on the state's Countries in transition face a special challenge: not finances. Privatization provides an obvious solution. In only are roles changing as a result of the adoption of general it is easier to sell off state assets once a supportive market-based systems; so are capabilities. Some transition environment for private sector development is in place. countries retain inherent capabilities in the form of quali- Economies such as China, Korea, and Taiwan (China) fied people and usable equipment, but they are not orga- have therefore opted not to give top priority to privatiza- nized to perform in their new roles. Sometimes islands of tion, but to allow the private sector to develop around the excellence are found in countries where overall effective- state sector. This option, however, may not be available ness has suffered. The task of improving effectiveness here where the fiscal burden is very high, and where the pres- is in some ways easier and in some ways more difficult: ence of poorly performing state enterprises impedes easier because capability does not start from a low base, much-needed overall restructuring of the economy. more difficult because rebuilding capability means chang- OVERVIEW 7 ing attitudes. Reform is not a matter of simply assigning that distort incentives and ultimately lead to poor out- people new responsibilities. comes. Three basic incentive mechanisms can be used, in a variety of settings, to combat these deeper problems and Reinvigorating state institutions imrv caablit Fgr ) improve capabilty (Figure 2): Acknowledging the state's existing, possibly meager capa- bilities does not mean accepting them for all time. The * Effective rules and restraints second key task of state reform is to reinvigorate the state's * Greater competitive pressure institutional capability, by providing incentives for public * Increased citizen voice and partnership. officials to perform better while keeping arbitrary action in check. Effective rules and restraints Countries struggle to build the institutions for an Over the long term, building accountability generally calls effective public sector. One reason the task is so difficult for formal mechanisms of restraint, anchored in core state is political. Strong interests may develop, for example, to institutions. Power can be divided, whether among the maintain an inequitable and inefficient status quo, judicial, legislative, and executive branches of government whereas those who lose out from this arrangement may be or among central, provincial, and local authorities. The unable to exert effective pressure for change. broader the separation of powers, the greater the number But the problem of continued ineffectiveness, or of of veto points that can check arbitrary state action. But corruption, is not entirely political. Often politicians and multiple veto points are a double-edged sword: they can other public officials have strong incentives and a sincere make it as hard to change the harmful rules as the benefi- interest in improving public sector performance. But cial ones. managing a public bureaucracy is a complex business that In many developing countries legislative and judicial does not lend itself to clear, unambiguous solutions. In oversight of the executive is weak. The setting of goals and fact, building institutions for an effective public sector the links to the policies needed to achieve them are some- requires addressing a host of underlying behavioral factors times diffuse, legislatures suffer from limited information Figure 2 A range of mechanisms can enhance state capability - - . NiMerit-Dasea - , /;~~~~~~~m ->> ffitment /- , ' Cxprornotiosl - Voice and F partnership . , , i 8 WORLD DEVELOPMENT REPORT 1997 and capability, and judicial independence is compro- guarantees from international agencies, can serve as a mised. An independent judiciary is vital to ensure that the short-term substitute. legislative and executive authorities remain fully account- A major thrust of any effective strategy to reinvigorate able under the law, and to interpret and enforce the terms the public sector will be to reduce the opportunities for of a constitution. Writing laws is the easy part; they need corruption by cutting back on discretionary authority. to be enforced if a country is to enjoy the benefits of a Policies that lower controls on foreign trade, remove entry credible rule of law. These institutions of restraint take barriers for private industry, and privatize state firms in a time to establish themselves, but international commit- way that ensures competition-all of these will fight cor- inent mechanisms such as international adjudication, or ruption (Figure 3). Such reforms should not be half- Figure 3 Factors associated with corruption InrLe. .rf crrUiJpi,)n In,Lep ol corruI)tiol 5 2 1 11Il LO;:.- koi'4e,:i,urr Hl'&i Lct. *.leoiun Higri Policy distortion index Predictability, of judiciary index Ir,ae of c:rruLQtcr1 inde of corruprIcr .3 3 ;y I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~I Low Nit.1-Meiuml High Lov. Meiun i- Hign Merit-based recruitment index Ratio of civil service wages to manufacturing wages rlori- E3,:r, r,. iene I rre wo; w i a r,''jr oi c-unre. e . S ree r ,r Te:.i r1cre F.r del;,- wr l. 1,r,r.i:r,. :1 t'e ,os . ,i-igr-r aiues or the corruLpir, c,r -i-.e o 1C r n,it tcmirnpErl .r aV 1 i 5 lldiiT 10, Tne Dtl-ir r inDuet Tne rIp lfi preni b; :r or. J Cpic ,ciaat,n foi r,,rr, ne r,d n ii ;;a Je.iw, - :c.ri,iec iJi ne 1%84-'3 ui: the r.- oo ,anconcr no,en. nd ic i,;r ii e *:'ri,ruralo ndA,, The tP r,giit panel iC t3[d s.e o An .,ere- ;,on, -,r,r odr; n trol rr,nA-nre ,rd.Cii. :.Ui. rai .leeloprng ;;-unlr,es rdurr,r 1i99e TF, D.-n; ,ru tJTcr ri. ;n ,s b, 3ed rjn a reEresQ*n LcrL,n latr wi, t r i, * de.eiorirn courir-E dIrc 1.7,C-- Tr,e r,otcOn) ri2it p;nel ,s r,e.a or,r s, imrr,le orrC3lCr, for rment, cclr ,. mee l,*ori ,.nre' ,r . rc l.,ie I rilO c i ti-e eil. 1I((,.T d ,e,3ie 3-e me.3r,s. Soure ............. r|il Ear,L starT clIulatOtrs OVERVIEW 9 hearted: reforms that open opportunities for private entry effectively and retain their competence even when all into closed sectors of the economy, but leave that entry to other institutions have declined. These agencies work well the discretion of public officials rather than establish open for all the reasons listed above. They are less subject to and competitive processes, also create enormous scope for political interference. They have limited but clear objec- corruption. Formal checks and balances can also help re- tives. They are given adequate resources and training. And duce official corruption, but they are seldom enough. their staff are usually better paid than their counterparts in Reforming the civil service, restraining political patron- other parts of government. age, and improving civil service pay have also been shown Cross-country evidence reveals that bureaucracies with to reduce corruption by giving public officials more more competitive, merit-based recruitment and promo- incentive to play by the rules. tion practices and better pay are more capable. In several Where corruption is deeply entrenched, more dramatic countries (Kenya, the Philippines) political appointments efforts will be needed to uproot it. These efforts should be run quite deep, whereas countries such as Korea have ben- focused on better monitoring of official action-both by efited from reliance on highly competitive recruitment formal institutions and by individual citizens-and pun- and a promotion system that explicitly rewards merit. ishment of wrongdoing in the courts. In Hong Kong Ongoing reforms in the Philippines are examining these (China, as of July 1, 1997), an independent commission issues in an effort to improve bureaucratic capability. By against corruption is one successful example of such an and large, countries in which broader checks and balances approach. Likewise, recent reforms in Uganda have incor- are weak need to rely more heavily on more transparent porated several elements of the anticorruption strategy and competitive systems. The experience of certain high- outlined here, with some encouraging results. The same performing East Asian economies also shows that meri- mechanisms could be applied around the globe: corrup- tocracy and long-term career rewards help build an esprit tion, despite claims to the contrary, is not culture specific. de corps, or a shared commitment to collective goals. This Reducing it will require a multipronged approach, which reduces the transactions costs of enforcing internal con- must include the private sector and civil society more straints and builds internal partnerships and loyalty. broadly. The briber has as much responsibiity as the In many countries civil servants' wages have eroded as bribed; effective penalties on domestic and international a result of expanding public employment at lower skill business must be part of the solution. levels and fiscal constraints on the total wage bill (Figure 4). The result has been a significant compression of the Subjecting the state to more competition salary structure and highly uncompetitive pay for senior Governments can improve their capability and effective- officials, making it difficult to recruit and retain capable ness by introducing much greater competition in a variety staff. Some countries, such as Uganda, are undertaking of areas: in hiring and promotion, in policymaking, and far-reaching reforms to reduce overstaffing dramatically, in the way services are delivered. increase average pay, and decompress the salary structure. BOOSTING COMPETITION WITHIN THE CIVIL SERVICE. But in many countries these problems have yet to be Whether making policy, delivering services, or adminis- addressed. tering contracts, a capable, motivated staff is the lifeblood MORE COMPETITION IN THE PROVISION OF PUBLIC of an effective state. Civil servants can be motivated to GOODS AND SERVICES. In many developing countries ser- perform effectively through a combination of mechanisms vices are delivered badly or not at all. Politicians often to encourage internal competition: intervene in the day-to-day operations of public agencies, and managers have limited flexibility. There is limited * A recruitment system based on merit, not favoritism accountability for results. And in many countries the pub- * A merit-based internal promotion system lic sector has assumed a monopoly in delivery, eliminating * Adequate compensation. pressures for better performance. Building an effective public sector in these circum- Starting in the nineteenth century, all of today's estab- stances will mean opening up core government institu- lished industrial countries used these principles to build tions, to improve incentives in areas that the public sector modern professional bureaucracies. More recently these has long monopolized. Dozens of countries through- principles have been applied in many countries in East out the Americas, Europe, and Asia have capitalized on Asia, which have transformed weak, corrupt, patronage- changes in technology and introduced competition in based bureaucracies into reasonably well functioning sys- telecommunications and electric power generation. This tems. But many developing countries do not even need to has resulted in lower unit costs and a rapid expansion of look overseas or to history for role models: they exist at service. Competition is also being enhanced by contract- home. Central banks, for example, often continue to work ing out services through competitive bids and auctions. 1D WORLD DEVELOPMENT REPORT 1997 ing public managers more flexibility will merely increase Figure 4 Higher government employment arbitrariness and corruption with no commensurate im- often means lower government wages provement in performance. And writing and enforcing contracts, particularly for complex outputs, require special- as ;, n,ulr,e ofriu~I GGP~ra Da iier M~... 3 k'1ized skills that are scarce in many developing countries. as n1LJITIe ot GDP ritr p These countries need first to strengthen rule-based compli- 12 I ance and financial accountability (as Argentina and Bolivia have done) within the public sector, provide greater clarity Ic' 6 of purpose and task, and introduce performance measure- ment (as in Colombia, Mexico, and Uganda). As output * 1@ measurement and ex post controls on inputs are strength- \ @ ened, agencies can be provided more flexibility in exchange for their greater accountability for results. Bringing the state closer to people \S e * * Governments are more effective when they listen to busi- J. _ 8 49 -nesses and citizens and work in partnership with them in :: *.: deciding and implementing policy. Where governments 2 * * i p > * @ lack mechanisms to listen, they are not responsive to peo- P . r. e* ~ ple's interests, especially those of minorities and the poor, i *e * @ who usually strain to get their voices heard in the corridors 1' of power. And even the best-intentioned government is unlikely to meet collective needs efficiently if it does not Gc%einn,e er,; ,oIo,mnwernt as a srnare know what many of those needs are. C;T portulatoDn pe-rcenti GMNG PEOPLE A VOICE. Partnership involves bringing the voice of the poor and of marginalized groups into the ! cli tj.si .;r.. I:. ,,r.i.,.-,. ,r..gu''rl, ii id *evs;c'. .iIC*t', 3jlrlr~ * 3(101jv ie lrl . -.r l tie'r, .9i Z.$. Fl. Te.ichn,r,Il very center of the policymaking process. In many countries, Nour' Ec.v- ,; - C 5p-rs mi d T.), 1n-J. Jn1 M),jl cri;eto voice is distributed as unequally as income. Greater infor- rt-rg.l.,., r:,r.r mation and transparency are vital for informed public debate and for increasing popular trust and confidence in the state-whether in discussing expenditure priorities, This is a significant trend in industrial countries (the designing social assistance programs, or managing forests United Kingdom, Victoria State in Australia), but such and other resources. Client surveys (in India, Nicaragua, mechanisms are also being used to improve efficiency in and Tanzania) and citizen charters (in Malaysia) are pro- developing countries (for example, that of road mainte- viding new options for making voices heard. nance in Brazil). Faced wvith weak administrative capac- The best-established mechanism for giving citizens ity, some countries (Bolivia, Uganda) are also contracting voice is the ballot box. In 1974 only thirty-nine coun- out the delivery of social services to nongovernmental tries-one in every four worldwide-were independent organizations. democracies. Today, 117 countries-nearly two of every There is a growing trend to set up focused, perfor- three-use open elections to choose their leaders. But mance-based public agencies with more clarity of purpose periodic voting does not always mean the state is more and greater managerial accountability for outputs or out- responsive. Other mechanisms are needed to ensure that comes. New Zealand provides the most dramatic example the concerns of minorities and the poor are reflected in among the high-income countries. It broke up its con- public policies. Getting genuine intermediary organiza- glomerate ministries into focused business units, headed tions represented on policymaking councils is an impor- by chief executives on fixed-term, output-based contracts tant first step in articulating citizen interests in public with the authority to hire and fire and to bargain col- policymaking. Even more effective in local and provincial lectively. Singapore has long followed a broadly similar government, these organizations have recently become approach with its performance-based statutory boards. very active in developing countries-especially where the Other developing countries are following suit, with state has performed poorly and where such organizations Jamaica, for example, establishing executive agencies are not suppressed. along the lines of the British model. BROADENING PARTICIPATION. Evidence is mounting But countries with inadequate controls and weak capac- that government programs work better when they seek the ity need to proceed with caution. For these countries, giv- participation of potential users, and when they tap the OVERVIEW 1 community's reservoir of social capital rather than work ment. The challenge is to find the right division of labor against it. The benefits show up in smoother implemen- between the center and the other tiers of government. tation, greater sustainability, and better feedback to gov- ernment agencies. Higher returns from water-borne sani- Strategic options for reform tation systems in Recife, Brazil; housing schemes for the Building a more responsive state requires working on poor in Port Elizabeth, South Africa; forest management mechanisms that increase openness and transparency, efforts in Gujarat State, India; and health care in Khar- increase incentives for participation in public affairs, and toum, Sudan, are all testament to the power of partner- where appropriate, lessen the distance between govern- ship-the participation of local people. This is in contrast ment and the citizens and communities it is intended to with top-down approaches, which often fail. serve. This yields four broad imperatives for policymakers: In successful countries policymaking has been embed- ded in consultative processes, which provide civil society, * Where appropriate, ensure broad-based public discus- labor unions, and private firms opportunities for input sion of key policy directions and priorities. At a mini- and oversight. In East Asia public-private deliberation mum this includes making available information in the councils-such as Korea's monthly export promotion public interest and establishing consultative mecha- meetings, Thailand's National Joint Public and Private nisms-such as deliberation councils and citizen com- Consultative Committee, and the Malaysian Business mittees-to gather the views and make known the pref- Council-have provided mechanisms for feedback, infor- erences of affected groups. mation sharing, and coordination. * Encourage, where feasible, the direct participation of DEVOLVING POWER, CAREFULLY. The typical developing users and other beneficiaries in the design, implementa- country has a more centralized government than the typical tion, and monitoring of local public goods and services. industrial country. But with some significant exceptions, * Where decentralization is considered desirable, adopt a the past thirty years have seen a small shift in public spend- carefully staged and/or sectoral approach in priority ing power in developing countries from the national to areas. Introduce strong monitoring mechanisms and lower levels. The industrial economies have seen an oppo- make sure sound intergovernmental rules are in place to site trend, with spending power moving to the center. Nei- restrain arbitrary action at the central and the local level. ther of these observations, of course, takes into account the * At the local level, focus on mechanisms-and hori- decentralization implicit in recent market reforms, which zontal incentives in government's relations with the have clearly reduced the direct power and resources of cen- rest of the community-that build accountability and tral government in a broad range of countries. competition. Decentralization is bringing many benefits in China, India, much of Latin America, and many other parts of Of course, a strategy of more openness and greater the world. It can improve the quality of government and decentralization has its dangers. The more numerous the the representation of local business and citizens' interests. opportunities for participation, the greater the demands And competition among provinces, cities, and localities that will be made on the state. This can increase the risk can spur the development of more-effective policies and of capture by vocal interest groups, or of gridlock. Bring- programs. But there are three big pitfalls to watch out for: ing government closer to some people must not result in taking it even further away from others. Equally, without * Rising inequality. The gap between regions can widen- clear-cut rules to impose restraints on different tiers of an issue of considerable concern in China, Russia, and government, and incentives to encourage local account- Brazil. Labor mobility provides a partial solution, but it ability, the crisis of governance that afflicts many central- is seldom easy, especially in ethnically diverse countries ized governments will simply be passed down to lower where migrants are not always welcome. levels. But there are some safe ways to start the ball rolling, * Macroeconomic instability. Governments can lose con- including the use of communication and consensus build- trol of macroeconomic policy if local and regional fiscal ing to render reform intelligible to citizens and firms and indiscipline leads to frequent bailouts from the center, enhance its chances of success. as occurred in Brazil. * Risk of local capture. A serious danger is that of local Beyond national borders: Facilitating global governments falling under the sway of special interests, collective action leading to misuse of resources and of the coercive Globalization is a threat to weak or capriciously governed power of the state. states. But it also opens the way for effective, disciplined states to foster development and economic well-being, These dangers show, once again, how central govern- and it sharpens the need for effective international coop- ment will always play a vital role in sustaining develop- eration in pursuit of global collective action. 12 VORLD DEVELOPMENT REPORT 1997 Embracing exterizal competition how state policies (and international assistance) help The state still defines the policies and rules for those manage nascent conflict is needed in designing eco- within its jurisdiction, but global events and international nomic and social policy. agreements are increasingly affecting its choices. People * Promoting global economic stability. Concern has been are now more mobile, more educated, and better in- growing about the potentially destabilizing effects of formed about conditions elsewhere. And involvement in large and rapid flows of portfolio capital, particularly the global economy tightens constraints on arbitrary state when a crisis in one country can spill over into other action, reduces the state's ability to tax capital, and brings markets. A variety of international mechanisms have much closer financial market scrutiny of monetary and been suggested to guard against such problems, and the fiscal policies. International Monetary Fund has recently created a "Globalization" is not yet truly global-it has yet to new facility to help members cope with sudden finan- touch a large chunk of the world economy. Roughly half cial crises. But prudent and responsive economic poli- of the developing world's people have been left out of the cies at home will be countries' best protection. Grow- much-discussed rise in the volume of international trade ing international labor mobility is also raising a host of and capital flows since the early 1980s. Governments' hes- issues requiring international collective action. itance to open up to the world economy is partly under- * Protecting the environment. Urgent global environmen- standable. Joining the global economy, like devolving tal issues include climate change, loss of biodiversity, power from the center, carries risks as well as opportuni- and protection of international waters. International ties. For example, it can make countries more vulnerable collective action can help through better coordination, to external price shocks or to large, destabilizing shifts in greater public awareness, more effective technological capital flows. This makes the state's role all the more crit- transfer, and better national and local practices. ical, both in handling such shocks and in helping people Progress has been slow, however, raising the worry that and firms grasp the opportunities of the global market- it will take a major environmental catastrophe to goad place. But the difficulties should not be exaggerated, par- countries into concerted action. ticularly when laid against the risks of being left out of the * Fostering basic research and the production of knowledge. globalization process altogether. Now being revitalized to meet renewed challenges in The cost of not opening up will be a widening gap in food production, the Consultative Group on Interna- living standards between those countries that have inte- tional Agricultural Research has shown how technology grated and those that remain outside. For lagging coun- can be developed and disseminated through interna- tries the route to higher incomes will lie in pursuing tional collective action. Similar consultative mecha- sound domestic policies and building the capability of the nisms need to be developed to tackle other pressing state. Integration gives powerful support to such poli- research problems in the domains of environmental cies-and increases the benefits from them-but it can- protection and health. not substitute for them. In that sense, globalization begins * Making international development assistance more effec- at home. But multilateral institutions such as the World tive. To become more effective, foreign aid needs to be Trade Organization have an important role to play in pro- tied more closely to the policies of the recipient coun- viding countries with the incentive to make the leap. tries. A high priority for aid agencies is to systemati- cally channel resources to poor countries with good Promotingglobal collective action policies and a strong commitment to institutional rein- Global integration also gives rise to demands for states to vigoration. cooperate to combat international threats such as global warming. Economic, cultural, and other differences be- Removing obstacles to state reform tween countries can make such cooperation difficult- The history of state reform in today's established indus- even, at times, impossible. But stronger cooperation is trial countries offers hope-and gives pause-to today's clearly needed for at least five major concerns that tran- developing countries. Until the last century many of the scend national borders: problems that now appear to have reduced the effective- ness of the state in the developing world were in plain * Managing regional crises. The threat of nuclear war evidence in Europe, North America, and Japan. But the between the superpowers has given way to a mush- problems were addressed, and modern states with profes- rooming of smaller conflicts, entailing costly problems sional systems emerged. This gives us hope. But it also of refugee relief and rehabilitation. No solid interna- gives us pause, because institutional strengthening rakes tional framework exists for managing these conflicts or time. The reforms of the Meiji restoration, which helping avoid them. A more integrated assessment of launched Japan onto the path of development, took al- OVERVIEW 13 most twenty-five years to take root. A more capable state can be built, but the process will be slow and will require Figure 5 Countries with good economic immense political commitment. It is urgent to act now. policies and stronger institutional capability Over the past fifteen years many governments have grow faster responded to internal and external pressure by launching far-reaching reforms to improve their performance. Typi- Giohlt ir. GECP cally, changes in macroeconomic policy-dealing with .rr apira percer.- exchange rates, fiscal policy, and trade policy-have come fastest. These reforms have political implications but do not require the overhaul of institutions. They can be . ..-.. undertaken quickly, often through decree, by a small group of competent technocrats. All it takes is the politi- 2.0 cal decision to make the change. . But other state reforms, dealing with regulation, social services, finance, infrastructure, and public works, cannot be accomplished so rapidly because they involve changing institutional structures established for different purposes, r:,.sI to fit different rules of the game. This kind of institutional _ reform involves wrenching changes in the way govern- ment agencies think and act, and often a complete over- High c :rII:4 -- haul of long-established systems of patronage and corrup- LO.¶ cap'b'-i " High OC;1uT. tion. But such change is absolutely essential if the distortion capability of the state is ever to improve. The two to- gether-good policies and more capable state institutions to implement them-produce much faster economic R&uir e . or, rŽr2Wrje ujirierel ire Iron,. development (Figure 5). n.'urir-1 ana icer.ar:r, r c.I r rtie pec.:i It*'-- Comprehensive reform along these lines will take a . :currr,r,r.ir.Or . rCtrici IC great deal of time and effort in many developing coun- L..t.;Jn.1 prre, tries, and the agenda varies considerably from region to region (Box 3). Reform will also encounter considerable political opposition. But reformers can make a good start by strengthening central agencies for strategic policy for- Neighbors, too, can be a powerful motivator for change. mulation, introducing more transparency and competi- There is a clear domino effect at work in the wave of tion, hiving off activities and agencies with easily specified reform sweeping East Asia, Latin America, and much of outputs, seeking more feedback from users about the Eastern Europe and the former Soviet Union. The threat delivery of services, and working with labor unions on of being left behind can goad countries to improve the programs that will enable workers to seek security in functioning of their bureaucracies. But research has yet to change rather than seek security against change. explain why some countries respond to crises and others do not. Why, for example, does popular tolerance of infla- When do reforms occur? tion seem to be much lower in Asia than in parts of Latin Deep distributional conflicts and constraints embedded in America? And why can some countries endure a long state institutions are at the heart of the explanation for so period of economic decline before responding, while oth- many countries' failure to reform. But they are not im- ers take action much sooner? mutable. Ultimately, change comes when the incentives Often the analysis of winners and losers yields a predic- to throw out the old policies and old institutional arrange- tion of when-or at least whether-reforms will be ments become stronger than the incentives to keep them. undertaken. Reforms have little appeal if the winners can- An economic crisis or an external threat, or the arrival of not compensate the losers. Even when the potential gains a new government with fewer vested interests in the old are enough to allow for compensation, reform can be system, may provide the impetus for reform. But reform hard to achieve because the gains are spread over many can be delayed if those in power stick with outdated poli- people, whereas the losers, although smaller in number, are cies because it is in their (or their allies') interest to do so. powerful and articulate. A further problem is that the ben- And the delay can sometimes be painfully long, as in Haiti efits are often realized in the future, whereas the losses are under the Duvaliers, or Zaire today. immediate. Yet sometimes conditions have deteriorated so 14 WORLD DEVELOPMENT REPO3RT 1997 Box 3 The regional agenda The key fearurcs and challenges ofimprvox ing the effec- * The job of reorienting Ehe stare ow-urd the task of' ci%cne~s of chc s>arc in Ehe various developing regions sreering. nor rowing" is far fronm complete in C-n- ire summarized below. These are uf rnecessinr broad rr.7i ind Eaterph Europe. But miost countries have generalizations. and e3ch reition includei several coun- made progress and are on thc wa to impruving tries %%hose c\perienrtcs are ven different. capabdirv and accountability. * Lo%is tare capabiliny in manv' countries of the Corn- * MaInv countrries in S:di,,ai'.ut,' are suffering z111Mvea,rl' ot hdale,iident hraires is a serious and from a criii of srtaehood-i criis of capabilir%. An mounting obstacle ro furthir progress in mosr areas urgent priority Is to rebuild siate effecdi%eness of economic and social policv. Reotienjicnrt of the thrIcuCh an overhaul 1f public instirutions. reas,er- starc is srill at an early stage. and a host of ievere [ion ot the rule *.f law,. and credible checlk on abuse problemns ha%-e emerged tronm a general lack of ac- of State po:wrcf. W\-here [he links between rhe itate. counrabdiir and transparenc.% [hc private vc,cor. and ci'il society are tragile and * In Lari7n _4menca, deccntralization of powver and of underdeveloped. impro',ing the ddiven- of public spending. coupled with democratization. has dra- and collective ser'ice; wilII require closer parrner- marica-ltv transformed the local polliical landscape. in ships with the pri ate ccr;or and civil sociery. v.har soine have called a -quiet revolution." A new * The capability o*t [he s[tae in most L-.7i Jsiddi cOwl- model of go-,ernmenE is emerging in the region. But tries cannot be considercd i problem. But stares' greater emphasis is also needed on reform of the legal abiltit to change in response to the new challenges swstem, the civil erv ice. and social policies. tacing the rcgion ' ill pla a critcical role in their cn - a In the .1hiadl/ E.asrad dNort Ah-.4 unemplovmenr is tinued eco:>nuiic su;ccss. LV fiar the 'rearest economic and social problenm and * The main iue in Soirt! .4.ia is o\trregulation. both makelos goernment dov. nsizing especial1y difficult. Be- a cause and in eltect ot bloated public employment cause the political and social diffilcuhics of reform are and the surest route to corruprion. RC9Ld.it0rv sim- considerable, alrhough not insurmountable, a promis- plifca,i1in0 and public enterprise reform. and lhe ing approach might be to begin decencralizing selected resultnvg cc.nrracrionf the rok othe state. will be services, and focus on refiarming staEc enrerprises, comple\ and politically difticultl. while preparing the ground for wider-ranging reforms. far that the winners far outnumber the losers. Then reform fected by reform (which may not always be the poorest in can produce immediate economic and political gains. society) can help secure their support. Although compen- sation may be costly in the short run, it will pay off in the How can reforms be sustained? long run. Deep-seated differences and mutual suspicions Reform-oriented political leaders and elites can speed re- among groups can also delay reform. There are no quick form by making decisions that widen people's options, fixes for removing age-old enmities, but social pacts, such articulate the benefits clearly, and ensure that policies as Spain's Moncloa Pacts and Benin's National Economic are more inclusive. In recent years farsighted political Conference, can help. leaders have transformed the options for their people International agencies can encourage and help sustain through decisive reform. They were successful because reform in four ways. First, they can provide important they made the benefits of change clear to all, and built technical advice on what to do and what not to do. This coalitions that gave greater voice to often-silent beneficia- assistance is often invaluable, especially for smaller states ries. They also succeeded-and this is crucial-because that lack the resources to handle all the technical issues they spelled out a longer-term vision for their society, internally. But it must be complemented by local ex- allowing people to see beyond the immediate pain of pertise, to adapt reforms to local conditions and institu- adjustment. Effective leaders give their people a sense of tions. The World Trade Organization plays a major role owning the reforms-a sense that reform is not something in trade reform, the World Health Organization on health imposed from without. issues, and the International Labour Organisation on Reforming the state requires cooperation from all labor legislation and employment policy. Second, interna- groups in society. Compensation of groups adversely af- tional agencies can provide a wealth of cross-country OVERVIEW 15 experience on a wide range of issues. Often staffed by peo- Instances of state collapse are both extreme and ple from all over the world, they can bring in experts from unique, but they are growing. As the Report elaborates, different backgrounds. Third, the financial assistance no simple generalizations about their causes or effects can these agencies provide can help countries endure the early, be made, nor, for that matter, are there any easy solutions painful period of reform until the benefits kick in. Fourth, to their reconstruction; each case brings its own challenges they can provide a mechanism for countries to make for countries, their neighbors, and the international sys- external commitments, making it more difficult to back- tem, The consequences, however, are almost uniformly track on reforms. If the history of development assistance borne by ordinary people, illustrating once again how teaches anything, however, it is that external support can fundamental an effective, responsive state is to the long- achieve little where the domestic will to reform is lacking. term health and wealth of society. The quest for a more effective state even in the estab- Goodssity govdern lopmentisnotalut is a vital lished industrial countries suggests that the returns to in- cremental improvements are high. This is especially true The approach of the twenty-first century brings great in countries where the effectiveness of the state is low. promise of change and reason for hope. In a world of Over time, even the smallest increases in the capability of dizzying changes in markets, civil societies, and global the state have been shown to make a vast difference to forces, the state is under pressure to become more effec- the quality of people's lives, not least because reforms tive, but it is not yet adapting rapidly enough to keep tend to produce their own virtuous circle. Small improve- pace. Not surprisingly, there is no unique model for ments in the state's effectiveness lead to higher standards change, and reforms will often come slowly because they of living, in turn paving the way for more reforms and fur- involve a fundamental rethinking of the roles of institu- ther development. tions and the interactions between citizens and govern- A tour of the world's economies in 1997 would turn ment. But the issues raised in this Report are now an inte- up countless examples of these virtuous circles in action. gral part of the rethinking of the state in many parts of the But it would provide equally plentiful evidence of the world and are on the agenda of the international organi- reverse: countries and regions caught in vicious cycles of zations that assist them. poverty and underdevelopment set in train by the chronic People living with ineffective states have long suffered ineffectiveness of the state. Such cycles can all too easily the consequences in terms of postponed growth and social lead to social violence, crime, corruption, and instability, development. But an even bigger cost may now threaten all of which undermine the state's capacity to support states that postpone reforms: political and social unrest development-or even to function at all. The crucial chal- and, in some cases, disintegration, exacting a tremendous lenge facing states is to take those steps, both small and toll on stability, productive capacity, and human life. large, toward better government that set economies on the The enormous cost of state collapse has naturally turned upward path, using the two-part framework suggested in attention to prevention as a preferable and potentially this Report. Reform of state institutions is long, difficult, less costly course of action-but there are no shortcuts. and politically sensitive. But if we now have a better sense Once the spiral into collapse has occurred, there are no of the size of the reform challenge, we are also much more quick fixes. aware of the costs of leaving things as they are. I I ET :1 1V F E STATE- TH ORLD OV R THROUGHOUT HISTORY, NOTIONS OF THE STATE'S ROLE HAVE SHIFTED DRAMAT- ically. For much of this century people looked to government to do more-in some cases a great deal more. But during the past fifteen years the pendulum has been swzinging again, forcing the world to look at government from a range of conflicting perspectives. The end of the Cold War and the collapse of command-and-control economies, the fiscal crises of welfare states, the dra- matic success of some East Asian countries in accelerating economic growth and reducing poverty, and the crisis of failed states in parts of Africa and else- where-all of these have challenged existing conceptions of the state's place in the world and its potential contribution to human welfare. Governments are also having to respond to the rapid diffusion of technol- ogy, growing demographic pressures, increased environmental concerns, greater global integration of markets, and a shift to more democratic forms of govern- ment. And amid all these pressures remain the formidable-and persistent- challenges of reducing poverty and fostering sustainable development. It is not surprising, then, that countries are again putting the state under scrutiny, asking what government's role ought to be and, critically, how that role should be played. This Report explores why and how some states have 18 WORLD DEVELOPMENT REPORT 1997 been more effective than others at playing a catalytic and sustainable role in economic development and the eradication of poverty. This part of the Report provides a broad historical and conceptual introduction to the issues (in Chap- ter 1) and examines the empirical evidence of the impact of state policies and institutions on development (in Chapter 2). It conveys three principal messages: * Development-economic, social, and sustainable-without an effective state is impossible. It is increasingly recognized that an effective state-not a min- imal one-is central to economic and social development, but more as part- ner and facilitator than as director. States should work to complement mar- kets, not replace them. * A rich body of evidence shows the importance of good economic policies (including the promotion of macroeconomic stability), well-developed human capital, and openness to the world economy for broad-based, sustainable growth and the reduction of poverty. But as our understanding of the ingredients of development improves, a deeper set of questions emerges: why have some societies pursued these actions with greater success than others, and how, precisely, did the state contribute to these differing outcomes? * The historical record suggests the importance of building on the relative strengths of the market, the state, and civil society to improve the state's effectiveness. This suggests a two-part strategy of matching the role of the state to its capability, and then improving that capability. These are the sub- ject, respectively, of Parts Two and Three. THE EVOLVING ROLE OF THE STATE A CENTURY AGO, A CANADIAN FARMER AND AN recall Thomas Hobbes' insight, in his 1651 treatise A Ivorian probably felt little connection with their Leviathan, that life without an effective state to preserve governments, and none at all to each other. Government order is "solitary, poor, nasty, brutish and short." affected their lives only to the extent that it provided a This Report aims to show how every state, regardless of handful of classic public goods, such as law and order and its point of departure, can improve its effectiveness and basic infrastructure, and collected taxes from them. move ever further away from this doomsday scenario. Today the state has expanded dramatically-and the Toward that end, this chapter begins with a reminder of world has shrunk. The same farmers' descendants send how we got here. Surveying the history of the state from their children to government-run schools, receive medical its early beginnings, it shows how notions of the state's treatment from publicly supported clinics, rely on an role have evolved to produce, in both industrial and devel- array of publicly provided services, and may benefit from oping countries, a dramatic expansion of the state and, government price controls on the seed and fertilizer they more recently, a change of emphasis from the quantity of buy, or the wheat or coffee they sell. These later genera- government to the quality. The chapter then lays out a tions of Canadians and Ivorians are therefore likely to be simple framework for rethinking the state, introducing a much more concerned than their ancestors were about the two-part strategy for greater state effectiveness that the effectiveness of government and the checks and balances rest of the Report explores. The message is that the state on its decisions. And they are likely to be much more can rise to the challenges it faces, but only by, first, match- aware of how their own government's performance com- ing what it tries to do to what it can do, and second, pares with others'. Vastly expanded communications, working to increase the number of things it can do capa- trade and investment, radio and television, friends and rel- bly by reinvigorating public institutions. atives traveling to foreign lands as tourists or migrant Where the state began laborers-all of these give Canadians and Ivorians today a much better idea of how the government services they From earliest times human beings have banded together receive measure up to those in other countries. The state's into larger associations, starting with household and kin- behavior, and the consequences of that behavior, are being ship groups and extending through to the modern state. scrutinized like never before. For states to exist, individuals and groups have to cede This scrutiny might lead to better government. But if authority in key areas, such as defense, to a public agency. states are unable to respond constructively to the chal- That agency has to possess coercive power over all other lenges they face, the result could simply be further erosion organizational forms within a designated territory. of the state's credibility, as the gap between what the state States have come in all shapes and sizes, depending can do, and what people ask it to do, widens even further. on a mix of factors including culture, natural endow- The terminal phase of this process is visible in the recent ments, opportunities for trade, and distribution of power. agonies of Angola, Somalia, and Zaire. The state collapses The ancient Athenian state, for example, was under- from within, leaving citizens bereft of even the most basic pinned by slavery and colonial spoils. Further east, elabo- conditions of a stable existence: law and security, trust in rate state structures were built from early times on the contracts, and a sound medium of exchange. These crises basis of state ownership of land or, in Mughal India and 20 WORLD DEVELOPMENT REPORT 1997 Box 1.1 State and government: Some concepts Star,. in i, -. Lder: ncfl,. rcfcr to a set ofinltittions that otoftices. which is inftrc rnarro' in conception. and the poo;risi the irczaib of legirinine ecoerciLn. cxercised over relationship between -oxeronietit and die ro-erned. ai defined territry ind itc populanion. reterred to as soi- The first classification is hLsed on the relatLriiship be- cr-. The sate ni oLYlpoli?es rulemrakingv withi its tt,rri- B-tcen rhe executive arid he iegislarure. In a ar/ram.'ru- ton!- through (he mediumofa orgrnized go)ernment. r. 'J ^-syem the eCulies continuance in ottice de- The term <. r:enersr s oten ued ddiffeTenv- in dif pend un is nimaintaining the support of the legislarure. tervnt Cvm.nexts. Ir can refer to (he proces, of gvernning. Mlembers of the executi1Veare commonhx also members Et! the e.ercie of pow%er. Ir can also refer to the exisence Of the leislaruurc. AF primne minister may% be the most oLf (hat proccss. tr : condiri. in of ordered rulc. U G - poertful meniber of tlhe xecutiie . but importnt deci- ernmint oftren iamn the peopIe -ho till the posilions sio %% ichin the execunste are usually made collectivelv of authority in a state. Final!. the term mjv refer ro the by a grup Of ministers. In a ,rel'"-ialh ssvtem the manner, mrthod or svitem oft ,'..vetiny in a scxiety: ito executiv-e pos.ition i independent of the le,islature. the struclUre and arrangemenr of offices and how rhes% Member o.f the execurive are nor normailk also mem- rela[e to thc ;.no. rned. \Xhile leeping these disrinction betrs of rhe lcgs larue. and ultimate. deci;sionmaking in mlind. we alis u'ce h, tcrm nstarr and .pr 'n7ic nrccl- aurhorir- within the cxcuruiC lies w% ith one person. the loquiallY and somctimes inte rehhaneably-As the.- are presilent. otren used in discussio -n and % ririne around the v.orld The s co:nd la sstlcaticon concentrate, on rhe distri- Giwernment iS 7 normallv rec,arded is consisting of bution of power between lekels Of government. In a three distincr sets of pox%crs. each u ith its asskgned ui'ia sti[arct all authoriry to make laws,is tested in one role. tne ir the i /r..h lC. iFhosc ro.le is to mriake the supreme Ie;isladrure whose jurisdiction ce rets the w,.hole law%. The srCund i the :./ rsoniferiles referred countns-. Local le4islaiures ma exist. but onlyv with the It as the o emirnrenCt . Nthich is rcsponesible tilr in- suffterance of the national legislature. In a fi-eie.d stare. plemenring the hix. The third i; rhe vmi˝ .i whpch is o 1oC11 Icgislatlres are ruiranteed at least a measure of respons,ible foi interpreting and apIl-ying the law. lutonoimous decisionmal ing authority. In a rxfinbt/era- Classificatiuns otf govcriiment are mans but have no's, a g1roup ct soserelin statrs combine [ir specified tended ro oncenttrHe on El';o critcrij: [he arrang cmtent purpoies. but ecih s[.te retamini its sovcreignr-. imperial China, highly developed systems of administra- of the public and private spheres have not. Whether in tion and tax collection. The combination of public own- Niccolo Machiavelli's The Prince, Kautiliya's Arthashastra, ership of land and a complex bureaucracy long impeded Confucius' writings, or Ibn Khaldoun's The Muqad- the emergence of modern, market-based economies in dimah, the discussion has revolved around the mutual these regions. rights and obligations of states and citizens. Almost all Yet despite this diversity of origins, states over time came these traditions have included a role for the state in pro- to acquire several common and defining features world- viding basic public goods (although the weight accorded wide. Modern states have a consolidated territory and pop- to public, as opposed to private, goals has varied consid- ulation, and within these they play a centralizing and coor- erably). Using public resources to provide critical public dinating role. Sovereign authority commonly encompasses goods and to raise private productivity is nothing new. separate judicial, legislative, and executive functions (Box Beyond these minimal functions, however, there has 1.1). Since the eighteenth century, through conquest and been much less agreement on the appropriate role of the colonization, nation-states have incorporated most of the state in promoting development. Seventeenth-century world into their own mutually exclusive territories. As em- mercantilists saw a major role for the state in guiding pires disintegrated and minority groups established claims trade. Not until Adam Smith wrote The Wealth ofNations to statehood, the number of nations increased sharply. in the late eighteenth century was it generally recognized Membership in the United Nations jumped from 50 inde- that the market was the best instrument for realizing pendent countries in 1945 to 185 in 1996 (Figure 1.1). growth and improving welfare. The state, on this view, was best held to certain core functions-providing public Modest beginnings goods such as defense, ensuring the security of persons The configuration of states has varied widely across conti- and property, educating the citizenry, and enforcing con- nents and centuries, but arguments over the proper roles tracts-deemed essential for the market to flourish. THE EVOLVING ROLLE OF THE STATE 21 Figure 1.1 One world, many more states Box 1.2 U.S. government action to support market development: Some examples rauniber of UniteO Nations member coLintries 200 TThe Uinited eiaies iS the country ch.ar prrduced and believes in rhe dictum thar That go\ernnmnt is So b|cst that ,o%erns lebrs. %VhLrcas in manv parts ot 160 16he orld the role the .o'ernncnt has evol. d I s-l g Yradtialld. the LUlniied Staie;s v, a foundcd on a rex-- 140) oluton. Thc triincr, of the Ccn-[nrunion e-:plicltk 12. aslked. What should be the role of the goeri-emcni.n 1I0 ! tc e\en in the l United siacev. where l.lis,e!-tairc :ind distrusM utf Z0%rnnmeilt are central to, the ['ram- 100J,, rin; cd rhtire >ae role in .Socien. g-eperninent action -o - ha. otncii proxe.d critical to. the grwtuTh and de%el- 5prneri: of market[s Ftur ev.inple: 6 0 _Fhe oloail telecomniunicarions inrdustry ha's irs 40 roori in U1.. go\r-vrnimcnt wupport tor [he tirst 20 Tele.gaph line becteen \\Wahington and Balti- more in ihe earlv 1 8-Sio. 0 _ The enorinotus increainc atgricultural producti- 1945 19419 1959 1969 1979 1989 1996 it in che ninereenth and mtentierh .enruries cani ic tfracd Co the tfeeralb, supporced progranm ot t1oi,t Dai. B ae c,s . :.t fh-,f., otI lei' f S C research and e-\rension ier.ices daring tfrom the Miorrill Acct of 1i.;. * The Norih,xest 0rdinanc;s ot i l-.6 a-nd 1-S- c-!n-mitnl thed ie ernnlenr. ro upportin- e.dUca- lion, and tc de\ oting the rec cnues from the iale cf But even then, state intervention went on to play a cecrtan lands to thar purpoe. And in 1863 the vital, catalytic role in the development and growth of mar- tcder di go-ernnienr helped erhIi h the publit kets in Europe, Japan, and North America. In the United Lrnih ersin- sv iiem. States, where state involvement in the economy has histor- * In 1863. i nthe rndst of the Ci. il \ af. the Con- ically been more limited than in Europe or Japan, govern- gress recognizcd [he need for a na[ional tin.inial ment was instrumental in constructing the first telegraph ,vsnm andi pasied rhc Nartional Banking Act. line, which spurred development of the telecommunica- esirblfshin_ the firsc ndtiemnu ide bank suoperi- tions industry, and in agricultural research and extension, sorv igenc\. In later years tht joncrnmlent circ- which stimulated productivity gains (Box 1.2). arcd the Federal Rescr-e S\ ,rem t[hei U.S. cenrrai In the nineteenth century the state's role in redistribut- hanki a. %vell ai a serie; Of pLIb1ic financial inter- ing income was still quite limited. Redistribution in medlirici. Europe came mainly through private charity and other * The interstate hi.ah.x., n-.seri aind tfedcral support voluntary action. Tax systems were usually restricted to fur che esitblishincr ot railroad.. are caseN of vital customs, excise, monopoly, and commodity taxes. Income public m nol%enemnt in transport intrasirucrurc taxation, which had been introduced in France and Britain th.u hclped the de'.elopnrent o: markets in the by the end of the eighteenth century, was not a major Linited S[ares. source of revenue. The first faint stirrings of the modern welfare state were seen in Germany, at the end of the nine- teenth century, where Chancellor Otto von Bismarck in- troduced the first nationwide systems of social insurance. the Russian Revolution of 1917, which led to the aboli- tion there of most private property and put the state in The expanding state in industrial countries c . . control, through central planning, of all economic activ- States remained small by modern standards until well into ity. The second was the Great Depression of the 1 930s, this century. A series of dramatic events in the aftermath which caused such economic devastation in the noncom- of World War I marked the turning point. The first was munist world that states were spurred to experiment with 2Z WORLD DEVELOPMENT REPORT 1997 countercyclical policies to restore economic activity. The half decades between 1960 and 1995, governments in the third event, unleashed by World War II, was the rapid industrial countries swelled to twice their starting size breakup of European empires. That geopolitical change- (Figure 1.2), with much of the expansion driven by as well as the clamor for social insurance in the industrial increases in transfers and subsidies. economies-ushered in fifty years of policy debate focused Indeed, by the early 1990s it was fair to say that most around a more activist role for government. industrial-country governments spent more time moving The postwar paradigm coalesced around three basic money around the economy in the form of transfers and themes, all of which commanded broad, if not uniform, subsidies than they spent providing traditional public agreement. This three-pillared consensus remained largely goods. Spending on defense and on law and order had undisturbed until the first oil price shock of 1973. First was shrunk to some 10 percent of general-government outlays, the need to provide welfare benefits to those suffering from while over half of all tax revenues were transferred to indi- transitory loss of income or other deprivation. Second was vidual beneficiaries (Figure 1.3). Demographics accounted the desirability of a mixed public-private economy, which for some of the shift, as aging populations forced an would often mean nationalizing a range of strategic indus- increase in outlays for pensions and health care. But tries. Third was the need for a coordinated macroeconomic national preferences also made a difference. Thus, from a policy, on the grounds that the market alone could not point of rough equivalence in 1960, the Swedish state deliver stable macroeconomic outcomes that were consis- grew to nearly twice the size of that in the United States rent with individuals' objectives. In time, the goals of by 1995, in terms of both spending as a share of income macroeconomic policy were made explicit: full employ- and public employment as a share of the population. ment, price stability, and balance of payments equilibrium. States thus took on new roles and expanded existing . .. And in developing countries ones. By mid-century the range of tasks performed by Governments in developing countries were also reaching public institutions included not only wider provision of into new areas. They, too, grew dramatically in the second infrastructure and utilities, but also much more extensive half of the twentieth century (Figure 1.2). Initially, much support for education and health care. In the three-and-a- of the growth came from state and nation building after Figure 1.2 Govemments the world over have expanded since 1960 C-W.ras l(,overfnlnent s&ri-rinp ipeic&raage of GODPi 30 4;)~~~~~ I 15' 1'':- 7 DECC-19 All deltoc,,-iri St'-Sar,;,3r East Asia anre Soifhi ASa Lbr AfliefiC5 Mi,odle East 3nor ,cunr,ti is ,,tvra Pacm,-i ind Car,til.ear, ,lorth AFrica r .:.i. LEi ar .i r i,,,:r,l C;;Ta f E;t ai,g rl.-,rli, Afrin:; f;r 1Ž6C -.i4 ;rl, ,na,anlirie ioc.r.: tIrF :*;|1.i, - i i / ari r it.0 . E: rl- .3 ,1 THE EVOLVING ROLE OF THE STATE 23 Figure 1.3 Transfers and interest payments have grown Ccq,nposirion o,f cenrroi go.ernmrent. speridrn; iperrerrtece ;'t Crirjl, *40 Ir,.: i.3i_rtnr 20 I E'a Dale 9r,e4iEr. kt;.tl,e 9ir reh r;l,^:9T9l. ,;r,:9 ii IF ,*.ar..'j] .9 ii1; the collapse of colonialism. The ups and downs in in- the state a central role in correcting them. Centralized ternational commodity markets also had an impact. planning, corrective interventions in resource allocation, Resource-rich economies such as Mexico, Nigeria, and and a heavy state hand in infant-industry development Venezuela tended to use the revenue bonanzas from the were part and parcel of this strategy. Economic national- oil price rises of the 1970s and other commodity booms ism was added to the mix, to be promoted through state to expand their public sectors, sometimes with reckless enterprises and encouragement of the indigenous private abandon. Oil-importing countries, under the imperative sector. By the 1960s states had become involved in virtu- of fiscal austerity, were less able to expand their spending. ally every aspect of the economy, administering prices and Perhaps more significant than these forces has been the increasingly regulating labor, foreign exchange, and finan- shift in thinking about the role of the state over the past cial markets. fifty years. Most developing countries in Asia, the Middle By the 1970s the costs of this strategy were coming East, and Africa came out of the colonial period with a home to roost. The oil price shocks were a last gasp for strong belief in state-dominated economic development, state expansion. For the oil exporters they created a The state would mobilize resources and people and direct bonanza, which many threw into even greater expansion them toward rapid growth and the eradication of social of state programs. As long as resources were flowing in, injustice. State control of the economy, following the the institutional weaknesses stayed hidden. The oil- example of the Soviet Union, was central to this strategy. importing countries, for their part, got caught on a tread- (How it was followed in one country, India, is described mill of heavy borrowing of recycled petrodollars to keep in Box 1.3.) Many Latin American, Middle Eastern, and the state growing. The costs of this development strategy African countries also followed this postwar pattern of were suddenly exposed when the debt crisis hit in the state-dominated, import-substituting industrialization. 1980s and oil prices plunged. This belief was reinforced by the popularity of state The collapse of the Soviet Union-by then no longer activism worldwide. The Great Depression was seen as a an attractive model-sounded the death knell for a devel- failure of capitalism and markets, while state interven- opmental era. Suddenly, government failure, including tions-the Marshall Plan, Keynesian demand manage- the failure of publicly owned firms, seemed everywhere ment, and the welfare state-seemed to record one success glaringly evident. Governments began to adopt policies after another. The new interventionist credo had its coun- designed to reduce the scope of the state's interven- terpart in the development strategy of the day, adopted by tion in the economy. States curbed their involvement in many developing countries at independence, which em- production, prices, and trade. Market-friendly strategies phasized the prevalence of market failures and accorded took hold in large parts of the developing world. The 24 WORLD DEVELOPMENT REPORT 1997 Box 1.3 Evolution of the role of the state in India: The past fifty years When India became independent in 1947, income per menu schemes, but only a small fraction of the rising capita had been stagnating for half a century, and mod- subsidies actually reached the poor. Competition ern industrv was minimal. berween political parties drove subsidies up at every ThJe Nehru vear), 194/7-6'. India's first prime min- election. The resulting large fiscal deficits (8.4 percent isrer, Jawaharlal Nehru, saw industrialization as the key of GDP in 1985) contributed to a rising current to alleviating povertv, and a powerful state with a account deficit. India's foreign exchange reserves were planned economv as essential if the countrv was to virtually exhausted by mid-1991, when a new govern- industrialize rapidlv, accelerate public saving and in- ment headed by Narasimha Rao came to power. vestment, and reduce the role of foreign trade anid The reformiphase. 1991 to thepre3ent. Rising interest achieve self-sufficiencv. Unlike many East Asian coun- pavments on India's foreign debr meant that neither tries, which used state intervention to build strong pri- the central government nor the state governments vate sector industries, India opted for stace control over could continue to finance both subsidies and heavy key industries. Believing the potential of agriculture public investment. The former won out, and the gov- and exports to be limited, Indian governments taxed ernment began to woo private and foreign investment. agriculture bv skewing the terms of trade against it and Thus, impending bankruptcy drove the reform process emphasizing import substitution. Theyr saw technical and changed the state's role from that of principal education as viral for industrialization. investor to that of facilitator of entrepreneurship. This Ga7ibi hatao, 1966-g7. Under Prime Minister shift was expected to free up government finances for Indira Gandhi, rvo major shifts cook place in the role more social spending. but in practice the fiscal crunch of the state. First, the neglect of agriculture was re- prevented a significant increase. versed through state activism in subsidizing new seeds Rao's government abolished most industrial and and fertilizers, agricultural credit, and rural electrifica- import licensing, devalued the rupee, diastically re- tnon. The green revolution took off, and by the mid- duced import tariffs, liberalized the financial sector 1970s India was self-sufficient in grain. The second and foreign investment, and allowed private invest- shift was the tightening of state control over every ment in areas previouslv reserved for the government. aspect of the economy. Under the slogan of garibi T'he new coalition governiment that came to power hatao ("abolish poverty"), banks were nationalized, in 1996 has by and large sustained these reforms. trade was increasingly restlicted, price controls were And the 1997 budget takes very positive steps in thar imposed on a wide range of products, and foreign direction. investmenr was squeezed. The state achieved a stran- Thus the old national consensus on socialism has glehold on the economv. Yet growth of gross domestic given way over the course of a few years to a new product (GDP) failed to accelerate, remaining during consensus on liberalization. But formidable challenges this period at 3.5 percent a vear. remain. Most parties agree on the need for reform, The Jpendmng boom and risingfiscal deficits, 1977-91. vet no parrt) is eager to retrench surplus labor, close Between 19'77 and 1991, most stiingent controls on unviable factories, or reduce subsidies. The reforms imports and indusTrial licensing were gradually relaxed, so far are a positive step but must be extended stimulating industrial growth. The government and accelerated if India is to catch up with the East expanded antipoverry schemes, especially rural employ- Asian tigers. pendulum had swung from the state-dominated develop- health, and infrastructure as often as-or more than- ment model of the 1960s and 1970s to the minimalist they cut low-priority programs, bloated civil service rolls, state of the 1980s. and money-losing enterprises. Cuts came primarily in cap- As often happens with such radical shifts in perspective, ital budgets and, in Africa, in operating and maintenance countries sometimes tended to overshoot the mark. Efforts outlays, further reducing the efficiency of investment. The to rebalance government spending and borrowing were result, seen most starkly in Africa, the former Soviet uncoordinated, and the good was as often cut as the bad. Union, and even parts of Latin America, was neglect of the To meet their interest obligations, countries mired in debt state's vital functions, threatening social welfare and erod- squeezed critically important programs in education, ing the foundations for market development. THE EVOLVING ROLE OF THE STATE 25 The consequences of an overzealous rejection of gov- power can help resolve problems of collective action that ernment have shifted attention from the sterile debate of would otherwise reduce the social benefits of insurance state versus market to a more fundamental crisis in state markets, or prevent mutually complementary private effectiveness. In some countries the crisis has led to out- investments from being made, to take just two examples. right collapse of the state. In others the erosion of the state's At the same time, however, the state confronts unique capability has led nongovernmental and people's organiza- challenges both in clarifying its objectives and in ensuring tions-civil society more broadly-to try to take its place. that its employees pursue them. First, even though elec- In their embrace of markets and rejection of state activism, tions and other political mechanisms help mediate many have wondered whether the market and civil society between citizens and the state, citizens' mandates can could ultimately supplant the state. But the lesson of a half- remain vague-and powerful special interests continually century's thinking and rethinking of the state's role in try to direct the focus of government in their favor. Sec- development is more nuanced. State-dominated develop- ond, monitoring performance is difficult in many govern- ment has failed, but so will stateless development. Devel- ment activities such as primary education, environmental opment without an effective state is impossible. protection, and preventive health care. This can make it hard to set standards or put other mechanisms in place to Rethinking the state: A frameworkrr ensure accountability. Both problems can lead to state A central difficulty in redefining the state's role is that the bureaucracies being granted enormous room for discre- ground beneath governments' feet is always changing. If tion. When that happens, state officials at all levels may we consider how global economic and social forces have pursue their own agendas rather than the society's. Haiti changed prevailing notions of the state, it is clear that it under the Duvaliers provides a vivid example of where the retains a distinctive role in providing the public goods that use of arbitrary public power for personal profit, rather promote economic and social development. And market than for the social good, can lead. failures continue to offer powerful economic arguments In many countries the voluntary sector has stepped in for state intervention (Box 1.4). But changes in technol- to address some of the gaps in collective goods and ser- ogy are transforming the nature of market failure: in infra- vices left by market and by government failure. The vol- structure, for example, technology has created new scope untary sector brings its own strengths to the table, but also for competition in telecommunications and electric power its own weaknesses. It does a lot of good in increasing generation. And many of the most successful examples of public awareness, voicing citizens' concerns, and deliver- development, recent and historical, entail states working ing services. Local self-help organizations are sometimes in partnership with markets to correct their failures, not the preferred providers of local public goods and services, replacing them. because of their closeness to local concerns. But their con- Equity also remains a central concern of the state. New cern is often for certain religious or ethnic groups and not evidence, especially from East Asia, shows that the famil- society as a whole, their accountability is limited, and iar tradeoff between growth and equity is not inevitable, as their resources are often constrained. The challenge, then, was once thought. Appropriately designed policies in basic for the state is to build on the relative strengths of private education and health care can reduce poverty and increase markets and the voluntary sector while taking into equity while promoting economic growth. Neglecting account and improving its own institutional capability. these social fundamentals of development can be fatal. But All these considerations point to a two-part strategy to the mere fact of market failure, and other problems of improve the state's ability to enhance economic and social inequality and insecurity, does not mean that only the welfare. The first task is to match the state's role to its state can-or should-resolve these problems. The state's existing capability-to establish the institutional rules and coercive authority within its boundaries gives it unique norms that will enable the state to provide collective goods strengths in seeking to address these concerns, but also and services efficiently. The second is to reinvigorate the unique weaknesses. Governments must keep a firm eye on state's capability through rules, partnerships, and compet- both in deciding whether, and how, to respond. itive pressures outside and within the state. The state's unique strengths are its powers to tax, to prohibit, to punish, and to require participation. The Matching role to capability: What states do and state's power to tax enables it to finance the provision of how they do it public goods. Its power to prohibit and punish enables it Part Two of this Report discusses the first part of the strat- to protect personal safety and property rights. And its egy: matching the state's role to its capability, to improve power to require participation enables it to minimize free the effectiveness and efficiency of public resource use. It riding: those who would reap the benefits of public goods advocates ways in which states can provide the fundamen- can be made to pay their share of the costs. The same tals for development, especially where capability is low 26 WORLD DEVELOPMENT REPORT 1997 Box 1.4 The economic rationale for state intervention and some definitions Market failure and the concern for equity provide the crease prices and profits. Governments have addressed economic rationale for government interventioni. But this problem by regulating private monopolists or there is no guarantee that any such incervention will providing the good or service themselves. Changes in benefit sociertv. Government failure may be as com- technolog, have created new scope for competition in mon as market failure. The challenge is to see that the services once considered natural monopolies, such as political process and institutional structures get the telecommunications and power generation. incentives right, so thar their interventions actually incomplertenmarkets and imnperfcror aymmet-k infor- improve social welfare. martion are pervasive problems and can result in ineffi- Markeet fdhlure refers to the set of conditions under cient outcomes. Markets are incomplete whenever which a market economy fails to allocate resources eflf- they fail to provide a good or service even though the ciendy. Thcie are many sources of market failure and cost would be less than what individuals are willing to manv degrees of failte. The implications for the role pay. Imperfect information on the part of consumers of the state and rhe form of public intervention can be can lead to systematic unldervaluation of some ser- quite different in each case. ,ices, such as primary education or preventive health Puiblic good. are goods that arc non>ival (consump- care. Asymmetry of information-when suppliers tion by one user does not reduce the supply available know more than consumers, or vice versa-can lead to for others) and none.%chidible (users cannot be pre- excessive or supplier-induced demand, for example in vented from consuming the good). These characteris- the provision of medical care. Problems of adverse tics Inake it infeasible to charge for the consumption of selection and moral hazard can lead to the failure of public goods. and therefore private suppliers will lack insurance markets. Adverse .election occurs when buyers the incentive to supply them. Nationial public goods, of a service tend to impose higher-than-average costs on such as defense, benefit an entire country; local public the service provider, or when sellers are able to exclude goods, such as rural roads, benefit a smaller area. P7i- such high-cost customers. Health insurance provides vate goods are those that are both rival and excludable, an example: those who are more likely to need care are common1iproperity goods are nonexcludable but rival (an more likely to buy insurance, and more likely to be example is groundwater irrigation), and club goods are turned down by insurers. Moral hazrd is present when nonrival but excludable (examples are interutban high- persons carrying insurance have an incentive to cause or ways and toll roads). allow the insured-against event to happen. An example Externalities arise when the actions of one person or is the tendency of health care consumers to seek, as well firm hurt or benefit others without that person or as provideis to provide, more treatment than they need firm paying or receiving compensarion. Pollution is an when a third parry, the insurer, is paying most of the example of a negative externalitr, which imposes tin- cost. Governments have sought to address these prob- compensated costs on society; the broader benefit to lems by ensuring widespread coverage and holding society at large of a literate population is a positive ex- down costs. 'They have done this by either regulating tcrtnahzly of primarv education. Governments can curb private insurance, financing or mandating social insur- negative and promote positive externalities through ance, or providing health care themselves. regulation, taxation or subsidy, or outright provision. Eqiuitv may prompt state intervention even in the A natural monopoly occurs when the unit cost of absence of market failure. Competitive markets may providing a good or service to an additional user distributte income in soci.llv unacceptable ways. Persons declines over a wide range of output. reducing or elim- with few assets may be left with insufficient resources to inating the scope tor competition. But left to operate achieve acceptable living standards. Government action freelv, monopoly providers can restrict output to in- may be required to protect the vulnerable. (Chapter 3). Chapter 4 looks at more demanding state from activities that will not be undertaken at all without functions, such as regulation and industrial policy, and state intervention to activities in which the state plays an shows how getting the right fit between roles and capabili- activist role in coordinating markets or redistributing assets: ties is vital for improving the state's effectiveness. Table 1.1 presents a framework for thinking about these issues. It * Countries with low state capability need to focus first on classifies the functions of government along a continuum, basic functions: the provision of pure public goods such THE EVOLVING ROLE OF THE STATE 27 Table 1.1 Functions of the state Addressing market failure Improving equity Minimal functions Intermediate Activist functions as property rights, macroeconomic stability, control of olies. The design of regulation needs to fit the capabil- infectious diseases, safe water, roads, and protection of ity of state regulatory agencies and the sophistication of the destitute. In many countries the state is not even pro- markets, and give greater emphasis to personal respon- viding these. Recent reforms have emphasized economic sibility. fundamentals. But social and institutional (including * Although the state still has a central role in ensuring the legal) fundamentals are equally important to avoid social provision of basic services-education, health, infra- disruption and ensure sustained development. structure-it is not obvious that the state must be the * Going beyond these basic services are the intermediate only provider, or a provider at all. The state's choices functions, such as management of externalities (pollu- about provision, financing, and regulation of these ser- tion, for example), regulation of monopolies, and the vices must build on the relative strengths of markets, provision of social insurance (pensions, unemployment civil society, and state agencies. benefits). Here, too, the government cannot choose * In protecting the vulnerable, countries need to distin- whether, but only how best to intervene, and govern- guish more clearly between insurance and assistance. ment can work in partnership with markets and civil Insurance, against cyclical unemployment for example, society to ensure that these public goods are provided. aims to help smooth households' income and con- * States with strong capability can take on more-activist sumption through a market economy's inevitable ups functions, dealing with the problem of missing markets and downs. Assistance, such as food-for-work programs by helping coordination. East Asia's experience has or bread subsidies, seeks to provide some minimum renewed interest in the state's role in promoting mar- level of support to the poorest in society. kets through active industrial and financial policy. Reinvigorating the states capability Matching role to capability involves not only what the Reinvigorating the state's capability-the second, equally state does but also how it does it. Rethinking the state also vital part of the reform strategy-is the subject of Part means exploring alternative instruments, existing or new, Three. Its theme is that such improvements are possible that can enhance state effectiveness. For example: only if the incentives under which states and state institu- tions operate are changed. Improving capability is not * In most modern economies the state's regulatory role is easy. The modest successes, and many failures, of techni- now broader and more complex than ever before, cov- cal assistance efforts over the decades underscore that it is ering such areas as the environment and the financial a matter of changing the incentives that determine behav- sector, as well as more traditional areas such as monop- ior as much as it is one of training and resources. The key 28 VVORLD DEVELOPMENT REPORT 1997 is to find rules and norms that create incentives for state A remote, imperious state, whose deliberations are not agencies and officials to act in the collective interest, while transparent, is much more likely to fall into the downward restraining arbitrary action. This can be achieved through: spiral of arbitrary rule and decreasing effectiveness. Chap- ter 7 looks at the benefits of making government reach a Rules and restraints. Mechanisms for enforcing the rule out to people and grant them a greater role in deciding of law, such as an independent judiciary, are critical and implementing policy. And it shows how, carefully foundations for sustainable development. Along with pursued, decentralization-the transfer of powers and appropriate separation of powers and the presence of resources to lower levels of government-can support this watchdog bodies, they also restrain arbitrary behavior. effort. Finally, Chapter 8 provides a reminder that collec- O Competitive pressure. Competitive pressure can come tive action increasingly involves looking across national from within the state bureaucracy, through recruitment borders. The chapter examines the various ways in which of civil servants on the basis of merit. It can come from national governments can and must cooperate to meet the domestic private sector, through contracting out demands that, although felt at home, can only be for services and allowing private providers to compete addressed effectively at the international level. directly with public agencies. Or it can come from the international marketplace through trade and thrStrategic options: Initiating and sustaining reforms international marketplace, through trade and through the influence of global bond markets on fiscal decisions. This two-part strategy for improving state effectiveness H Voice andl partnership. The means to achieve trans- is far easier said than accomplished. The difficult job for parency and openness in modern society are many and reformers will be not only devising the right kind of varied-business councils, interaction groups, and con- reforms but combating the deep-seated opposition of sumer groups, to name a few. Institutional working those with a vested interest in the old ways. Matching arrangements with community groups can contribute role to capability means shedding some roles, including to greater state effectiveness by giving citizens a greater some that benefit powerful constituencies. Proponents of voice in the formulation of government's policies. And a more capable state will quickly discover that it is in partnerships between levels of government and with many people's interest to keep it weak. Nevertheless, international bodies can help in the provision of local politicians have an incentive to undertake reforms if they and global public goods. result in net gains to important constituencies. Windows of opportunity occasionally open in response to crisis or All three mechanisms are a recurrent theme of Part external threat, and effective political leadership is skilled Three, which starts (in Chapter 5) by looking at the basic at devising strategies for building consensus or compen- building blocks of a more effective public sector. The sating losers. emphasis there is on rules and forms of competition to Part Four explores the challenge of initiating and sus- enhance the three basics: policymaking, service delivery, taining reforms of the state (Chapter 9). Its central argu- and the lifeblood of the public sector, the civil service. But ment is that constraints on reform are largely political and history tells us that rebuilding public trust in govern- institutional. Hence fundamental institutional reform is ment-and therefore its capability-will involve putting likely to be long term, but reform opportunities arise, or restraints on arbitrary action. These issues are taken up in can be created, and these must be seized. Finally, Chapter Chapter 6, which analyzes the checks and balances in the 10 lays out the prospects for change and the reform constitutional structure of the state and the best ways to agenda for each developing region. The message is that control arbitrary behavior and corruption. reform will be difficult and must be tailored to its cir- A third layer, which supports the other two, is efforts cumstances, but the special challenge of collapsed states to open up the government and make it more responsive. provides a salutary reminder of the risks of failure. REFOCUSING ON THE EFFECTIVENESS OF THE STATE Men are powerless to secure the fitture; institutions alone fix the destinies of nations. -Napoleon I, Imperial snance (une 7, 1815) F IFTY YEARS AGO, WORLD WAR II HAD ENDED AND edge and ideas and increases the speed with which they are reconstruction was under way in much of Europe, absorbed, disseminated, and used. Since the 1980s the the Soviet Union, and Japan. Many developing countries focus has shifted to the role of sound policies in explain- were starting to emerge from colonialism, and the future ing why countries accumulate human and physical capital seemed full of promise. The difficulties of economic de- at different rates. This, in turn, has led to yet another shift velopment were not yet haunting us. Improving people's of focus, to the quality of a country's institutions. New, lives looked so achievable, a simple matter of applying the more complex questions have emerged. What institu- right ideas, technical expertise, and resources. And so it tional arrangements best allow markets to flourish? What proved-in some cases. But in others progress was mea- is the role of the state both as a direct agent (mostly in the ger. Despite five decades of effort, enormous disparities provision of services) and as a shaper of the institutional remain in the quality of life of people around the world. context in which markets function? How do policies and Indeed, by some measures the gap between rich and poor institutions interact in development? has widened. The answers to these questions are central to our Explanations for these huge international differences in understanding of the deeper sources of differences in living standards have changed over the years. For cen- development outcomes-and of why the response to eco- turies, access to natural resources-land and minerals- nomic reform often varies so widely from one country to was considered the prerequisite for development. Much of another. They help explain, for example, why investment Africa, Asia, and the Americas was colonized to acquire and economic activity have revived more strongly follow- these resources, and countries went to war over them. ing the embrace of the market in Poland than in Russia. Gradually, however, the thinking changed, and physical They also help explain why many countries in Africa and capital-machines and equipment-was held to be the Latin America have yet to see much of the improvement key to development. "Industrialized" became synonymous in the quality of life they were promised when they with "developed." But around the middle of this century embarked on their economic reforms a decade ago. economic theorists realized that even this was too simplis- The state has much to do with whether countries tic. Embodied in machines and equipment was technol- adopt the institutional arrangements under which markets ogy-knowledge and ideas. But no one could explain in can flourish. Not only is the state the arbiter of rules; simple terms why technology developed better and faster through its own economic activity it shapes the environ- in some parts of the world than others. ment for business and the rest of the economy. For good Other factors, such as human capital, have since at- or ill, the state sets the tone. tracted much attention as possible solutions to the puzzle. This chapter makes the empirical case for shifting the Investment in human capital both leads to new knowl- focus of our thinking about development toward the 30 WNORLD DEVELOPMENT REPORT 1997 quality of a country's institutions and the capability of the explain much of the difference between countries in state-for bringing institutions into the mainstream of rates of return on development projects. our dialogue about development. That case is supported The state, institutions, and economic outcomes by three new sets of findings: What does the state do? For one thing, it sets the formal * First, panel data analyzed for this Report, covering rules-laws and regulations-that are part and parcel of a thirty years and ninety-four industrial and developing country's institutional environment (Figure 2.1). These countries, show that policies and institutional capabil- formal rules, along with the informal rules of the broader ity matter for economic growth and for other indicators society, are the institutions that mediate human behavior. of the quality of life, such as infant mortality. But the state is not merely a referee, making and enforc- * Second, and taking the analysis a step further, are the ing the rules from the sidelines; it is also a player, indeed results of a survey, specially commissioned for this often a dominant player, in the economic game. Every Report, of over 3,600 domestic firms in sixty-nine day, state agencies invest resources, direct credit, procure countries (including local affiliates of international goods and services, and negotiate contracts; these actions firms). These results, too, provide strong evidence that have profound effects on transactions costs and on eco- institutional capability-or the lack of it-has a major nomic activity and economic outcomes, especially in de- impact on growth and investment. veloping economies. Played well, the state's activities can i The third set of findings explores how institutional accelerate development. Played badly, they will produce capability affects not just the environment for business, stagnation or, in the extreme, economic and social dis- but also the overall setting for a country's development. integration. The state, then, is in a unique position: not Using the results from the survey on institutional capa- only must it establish, through a social and political bility, we show that these cross-country differences help process, the formal rules by which all other organizations Figure 2.1 The state. institutions. and economic outcomes Inf,rna rul.i v narid ,s Forma ru esns ] L 6er *vor or t iate agenr:ies S G Technolop Econonif- OL,iconCies REFOCUSING ON THE EFFECTIVENESS OF THE STATE 31 must abide; as an organization itself, it, too, must abide by * By providing the institutional infrastructure-property those rules. rights, peace, law and order, and rules-that encour- Examples of the power of the state to improve the ages efficient long-term investment, and quality of people's lives are not hard to find. From the * By ensuring the provision of basic education, health care, clean water and sanitation systems of ancient Rome to the and the physical infrastructure required for economic elimination of smallpox in this century, public actions in activity, and by protecting the natural environment. the areas of health and sanitation have achieved repeated breakthroughs in public health. And states have long Yet history also teaches that the state can do enormous played a vital role in stimulating lasting development harm: gains by providing infrastructure, security, and a stable macroeconomy. The Internet is only the latest in a long * The wrong kind of rules can actively discourage the line of remarkable scientific and technical advances made creation of wealth. For example, the state may penalize possible by early and significant public support (Box 2.1). private wealth by distorting prices-through an overval- Distilling the lessons of centuries, we see that the state ued currency, for example, or by creating agricultural can improve development outcomes in a number of ways: marketing boards that tax farmers' output and give them little in return. * By providing a macroeconomic and a microeconomic u Even if the rules themselves are benign, they may be environment that sets the right incentives for efficient applied by public organizations-and their employees- economic activity in harmfuil fashion. They may, for example, impose Box 2.1 Building the Internet: A contemporary example of fruitful public-private interaction The precursor ofv hat we tod.as, call the Interner w,s finance tor a hhZh-spcecd backbone intrarLrucrUre tor launched in the Elnined Stares in 1969. Then called the systrem. rhe NSF made erants available to tniversi- A.RPANET. the s!yrem conrpriied just fuur intercon- ties to encouLae themn, to kOrm re. ion.dl nenwork; [har nected computers. Byr mid- 19096. howeve-r. the Inter- v-ould feed into tht t-stem. But[h. nerorlks '..re alln net wasV; accessible in 1-4 countries and on all sev-en wId that they w%ould hase to become selft-ustra.inln. continents, linking together nearl 13 n million host The privcat seetor's involvement has deepened o%er computer sistems. By .2000 that number could %%cll be time. The NSF enceuraced commercial carriers d 100 million. electronic mail to link to [he In[crner. Companies also ARPANET cns%ed its existence to the- econormIcs of began to cre.ate their ow-n backbone facdilitis, and the defense resach>r in the I060,. Its origiri.l purpoe ivas number of tirms supplhying acce-s to the Interntc mul- ro link governiment computers in tar-flung loicatIons tiplied. Thesc trends 'ertc accelcrated bY the creation and soa%oid duplication ot %hatr ertc thcn quilt coisly and rapid growth oftrhe nultimediai part of ihe Inter- compuring resources. In 1968 the Li-S. Department of ner-the \V'orld Wide: \\rt:b. Des eloped u thC lahori. Defense in ired proposals from 14-0 priv.tte companies tories of the Europ-aun Organization flor Nuclear To design and build rhe firsi: four inrerface message Research in Sw:-itzerland-anbthcr publicly- upporred processors, or rnuers. With these in pl.tcc. public con- ar-enIcv-rhe \\eb drwc in talent from Universiries a11d tracLs with leading universities then lcd to develop- firms. leading to yet another e :plosin in u,e: from ment of the crucial set of protocols that could link 13site4s cin lulc I C ito) ovxr '21)ii0ti I in June [ 011%. diverse conmpurer nertorks. IT stas thcse protucols that In 1tIli NSENET -ssai replaced by- a fullh comrmer- later miade the Internet possible. cial isystm. It lalor telcphone comparnIes nol\ pros ide Complem-entar- to rhis public financial support nor oril backbone faoliie-.s hur also Internne acce's to hai been the partnership of academia. business. and their custonmers. Cablc and direct bwoidca:t satellite gos-ernment led by the U.S. National Science Founda- companies are also entering the marker. Fhe public ron (NSFI. InitiallY ti[s p3rtnership primed the con- scctor ik still insolsed in some adsanccd research. bttr ins necrion. of unikersirc comptpuer science departmenrt. tocus has shifted to such questions ai ho%% to eniure equi- but ihs influen;e s'-on exp.pnded. NSFNET replaced table access ek-cmpk. through pricing tulesi. freedom ARPANET in 1990. Besides providing the critical 0f eNpression. protecrion tronm Fratud. and privac. 32 WFORLD DEVELOPMENT REPORT 1997 huge transactions costs, in the form of red tape or bribery, on entrepreneurs setting up new businesses or Figure 2.2 Good govemment helps explain the restructuring old ones. income gap between East Asia and Africa * But potentially the largest source of state-inflicted dam- 6DP per capi.a age is uncertainty. If the state changes the rules often, i rjousaruis of 198'. iraerrnaornal doIIars, or does not clarify the rules by which the state itself will n u behave, businesses and individuals cannot be sure today Contributors what will be profitable or unprofitable, legal or illegal, additional tomorrow. They will then adopt costly strategies to in- 3 growth: sure against an uncertain future-by entering the infor- I mal economy, for example, or sending capital abroad- Fc 'oflicies all of which impede development. E Economic growth and the state cabilite yze a Government's enormous impact on development is well illustrated by the contrasting economic performance of j Unesplained developing countries in Sub-Saharan Africa and East Asia. 1 X l Initial iricoiine In 1960 incomes per capita in much of East Asia were only a little higher than in Africa. Governments in the two S'jr Si ar ir (r, regions were also similar in size, although not in compo- sition: African governments were already spending more 1 F.4s 11992 on consumption, primarily on public employment. By the mid-1990s, however, incomes in East Asia were more 1iots pi.ian, .'srurtr.-ror nll; a r Irr,t5l v,r Ir ,erETessilr. than five times those in Africa. And government con- Ior tti per,.:-Li 4-9 3. :or,Lril-i,r, t1a3n.:air, i . eoucaron. sumption in Africa, relative to GDP, had ballooned to afl e:.Lrer ,at'Ie - c P, l. risi,d1S sre e rf rt racde .w,a in.f LMr.~- I.ii pn, t cli diktora. r.Iie one-and-a-half times that in East Asia. The sources of this , or * esr l!'- rg'r r6ra gremns. sr,o rr divergence are complex, but it is widely believed that the ,,el -; e, i:i,:.ri,a r. a e--inr- i _ee rr.r T.t,rc.i al c.-. superior performance of the state in East Asia-the limits st:r,-,e t aorlo Bn in rj.i:r.j On dud ta p r it set on its own growth, the soundness of the policies it adopted, and the effectiveness with which it delivered ser- vices-made a powerful contribution to the growing gap in the quality of life experienced by the average citizen institutional environment for behavior: the incentive between these two parts of the world (Figure 2.2). structure to which economic agents respond. The private In considering the effect of government size on growth, sector's ability to function will depend critically on the it is useful to distinguish between public consumption and reliability and effectiveness of institutions such as the rule public investment (Box 2.2). Where government con- of law and the protection of property rights. None of sumption spending is very high, it has generally been these benefits-and costs-of the quality of government found to be a drag on growth: a net tax on society with few are ever likely to appear in the national accounts. corresponding benefits. Conversely, certain types of pub- The analysis in this section tries to show this distinc- lic investment spending, particularly investment in infra- tion between what the state does and how well it does it, structure, have tended to exert a positive effect on growth, by reporting on both policy content and institutional in part by raising the returns to private investment. Com- capability. Figure 5 in the Overview showed the effect of plicating the picture is the fact that some public con- both factors on income gtowth over the last three decades sumption-teachers' salaries, for example, or purchases of across a large sample of industrial and developing coun- medicine-can affect people's lives for the better, and even tries. In countries with weak state capability and poor raise the efficiency of investment. Cutting consumption policies, income per capita grew only about half a percent indiscriminately to boost equally indiscriminate invest- per year. In contrast, in countries with strong capability ment is clearly not the answer. and good policies, income per capita grew at an average But even sophisticated measures of the size of the rate of about 3 percent per year. Over a thirty-year period, government only tell part of the story. As noted above, these differences in income growth have made a huge dif- governments also play a leading role in setting the broader ference to the quality of people's lives. A country with an REFOCUSING ON THE EFFECTIVENESS OF THE STATE 33 Box 2.2 Measuring the state-its size, its policies. and its institutional capability ,\ cornnlNon measure of gserimnitni size t' [he ritio of aailable onl, a. a aggregate of public and pth dtc gov-ernment e.pcndiruare tO the econoinyv total e,-pen- In' ctfnicnt. To facilitae cros;-counirr comparisons dirure or lturl output. But such d:ai are generill; not ve:r time. the;e ratiOS Ire tran4laied into iritnattollal comprehensie, :ind coNcrae of public en[erpri ses is cr pirchasing-puwer-parirt IPPFi values-.i nor en- especiAhl 5kerciw in mnan de-eloping Oluntri. ThIis tirel innoICILLs trinstormrnatin. parrlcaIrlY for low%- nicasure of siZe also tends to Ignore imporrant ciff- ineome c.ttntries where mu,h cit ge-ner (nient ton- budget items. Gov-rnmrent epcnditurc itself an be sunmption is lalb--.r intcnsiek. For rhcn countries. using broken down innc, conlsuJrfptiLLn and in, cstnicinc. GO, - inernati.:onal prices inatlkclv increases rhc Łovetnrmntric ernment consumptton-wxhich mosri, consi,s of rhe consumption rari. public wavwe bill-gise a riirrc,s bur more precise A morc inclusLvC plctLlre o the econornic pre&ence indicator of consumers turrent bencfis from roern- of gV-\ernmncnr rcqLoite' a measure that captures lcy ment spending. Ir`anst.er. su.h a; peniLons or disabil- go'erninenr intecrvetions rhroug.h polihc and insdiru- irs benefits. can be included in go\ernmenr xFpcndi- rion;. in addition to fi'cal intervenions. We sinrnia- tire. but rransfers onlY r'edistribute rcsources. Furthrc r,;e ago;-rninen r s ptuice% s[ance over timie throug-h an complicating niatreri, nominal and real ratios tksr indcex thia comnbincs thrce ieee indicator': the npenness expendi[ure will 'arn sigoiiticanle ovcr [ime. .An aliet- of [he econ,.mni ithe share -fi rade in GDP''. overnalu- native meastire of governnmnt ie that avo.ids these anon of the currency ithc black market e;.chainge rarei. prohlem; is governnment emplo mcrne. but thIs,. too, and the gap bmet;een local and international prices. We has it, draw-backsi. Ftr ex:ample. it innorcs chan ges n also attempt to e' aluare the quality of a ked cNiaipo- the producri virn of government wvorkers. nent o,t government, it bureaucracv. This ev. aluation i- The result, reported in thi, cihaprer usc data on r-al dray-.n trinm surv-e rcsponses by. frrcion in-scstors tin governnient consumption. because the concern is the next section we e'. iluare thc responses of local nmainl- with how the division Of ourput across public investoirs' that foCUS *-n [he amounr of rCd tape in- and private goods attects pertibrniance. informarion on soled in any tran,acrion. tbe regitdat,r cnnvironment, phvsical inv-e,tmenr is also used, but thihs s normially and thc dieree of autonom. fiom politIcal pressure. average income per capita of $600 in 1965 (in interna- ers cannot afford to focus solely on improving policies; tional PPP dollars), with distorted policies and weak insti- they must also look for ways to strengthen the institu- tutional capability, would after thirty years have reached tional environment those policies have to work within. an average income of only about $678 at 1965 prices. On Important though income growth is, it is only one the other hand, a country with strong institutional capa- of several measures of well-being. Our interest in the bility and good policies would have more than doubled its wide range of factors that make people better or worse average income, to $1,456 at 1965 prices. Many countries off suggests that countries' performance should also be in East Asia have done even better than that. judged by other standards of well-being, such as infant Good policies by themselves can improve results. But mortality. High-quality government institutions lower the benefits are magnified where institutional capability is infant mortality by improving outcomes for a given also higher-where policies and programs are imple- amount of social spending. Thus, the capability of the mented more efficiently and where citizens and investors state has an important role in the quality of human life have greater certainty about government's future actions. generally-not simply the pace of income growth. This Thus, good policies such as those being pursued more explains why countries at the same income level can have recently by many countries in Latin America and Africa widely disparate quality-of-life indicators-why Sri would increase growth in income per capita by around 1.4 Lanka, for example, had an infant mortality rate of only percent per year. Such a country starting with an average 18 per 1,000 live births, whereas some countries with income of $600 in 1965 would see it rise to around $900 higher incomes per capita had substantially higher rates: after thirty years. But it would rise even higher with good 67 per 1,000 live births in Egypt, and 68 per 1,000 in policies and strong institutions. The lesson is that reform- Morocco, for example. The amount of social spending as 34 WORLD DEVELOPMENT REPORT 1997 well as the care with which services are delivered makes a To this end a large-scale survey of the private sector huge difference. was conducted for this Report. The aim was to capture Understanding institutional capability better: the full array of uncertainties that entrepreneurs face and The private investor's view to build an overall measure of the credibility of rules in a given country. The responses showed that in many coun- As this chapter has already stressed, the mark of a capable tries private investors give the state very poor marks for state-besides its ability to facilitate collective actions-is credibility indeed. its ability to set the rules that underpin markets and permit them to function. Although private arrangements can Credibility: How private investors perceive the state sometimes supplement formal property and contract rights, The private sector survey covered sixty-nine countries and they can only take the development of markets so far. Gov- over 3,600 firms. Entrepreneurs were asked for their sub- ernments, of course, have to do more than establish sound jective evaluation of different aspects of the institutional rules of the game; they also have to make sure those rules framework in their country, including security of property are enforced consistently and that private actors-business, rights, predictability of rules and policies, reliability of the labor, trade associations-can have confidence that the judiciary, problems with corruption and discretionary rules will not be changed overnight. States that change the power in the bureaucracy, and disruptions due to changes rules frequently and unpredictably, announce changes but in government. fail to implement them, or enforce rules arbitrarily will lack Sometimes the source of uncertainty is the instability credibility, and markets will suffer accordingly. of the rules to which firms are subject. Two key indicators How good are governments at providing credible rules included in the survey were: that will nurture the development of markets? Hard evi- dence is difficult to come by. To begin with, credibility is Predictability of rulemaking: the extent to which entrepre- tricky to measure: it depends as much on perceptions as neurs have to cope with unexpected changes in rules and on hard facts. At first glance, for example, one would policies about which they have had no say. think that the number of times a country has changed its government might be a good indicator of the degree of * The survey showed that entrepreneurs in some parts of uncertainty about market rules, and therefore of the gov- the world live in constant fear of policy surprises. In the ernment's credibility. Yet businesses in Thailand generally Commonwealth of Independent States (CIS) almost considered their environment to be relatively stable, de- 80 percent of entrepreneurs reported that unpredict- spite numerous coups and changes in government. By the able changes in rules and policies seriously affected same token, the environment for business can be highly their business. In Central and Eastern Europe (CEE), volatile and unpredictable even if the government does Latin America, and Sub-Saharan Africa around 60 per- not change. Peruvian entrepreneurs reported severe credi- cent of entrepreneurs voiced the same complaint. By bility problems in the 1980s because rules were being contrast, in the industrial countries and in South and drawn up hastily, implemented by presidential decree, Southeast Asia, only about 30 percent of respondents and often overturned soon thereafter. considered this a problem for their business (top left Measures of corruption might seem another good sig- panel of Figure 2.3). A large part of the unpredict- nal of government credibility. But simple estimates of cor- ability of rule changes came from companies' having ruption, like measures of political instability, may not little or no role in the state's decisionmaking process; capture entrepreneurs' concerns. Some forms of corrup- indeed, they may not even be informed of important tion entail large uncertainties and risks, whereas others rule changes before they take place. This problem may be more predictable and act more like speed money. appeared to be particularly severe in the CIS, CEE, and In the words of one entrepreneur, "There are two kinds of Sub-Saharan Africa, whereas Asian entrepreneurs (even corruption. The first is one where you pay the regular small ones) considered themselves well informed-even price and you get what you want. The second is one where better informed, in fact, than their industrial-country you pay what you have agreed to pay and you go home counterparts did. Unsurprisingly, perhaps, the survey and lie awake every night worrying whether you will get it also revealed that small companies tend to have less or if somebody is going to blackmail you instead." The knowledge of, and involvement in, the drafting of new best way to understand the problems holding back private regulations and were therefore more subject to policy sector development is to ask entrepreneurs directly. surprises. REFOCUSING ON THE EFFECTIVENESS OF THE STATE 35 Figure 2.3 Reliable institutions make for credible states Survey respondents reporting dissatisfaction with: Unpredictable changes in laws and policies Unstable govemment Per: er,t l r P6r.c ent Pr 90I 60 20 C' IEl1 ', HIC SSEA !AEruA GEE LAG SSA CIS IHC ,SEWA !AE0i CEE LaC rS j iS Insecurity of property Unreliable judiciary Percn rm 70 - 90 410 20 h-iC SSEA| MEN GEE L~r _;5 HIl; H,*- S E11SE :, GEE LAC i G Corruption Percen;t -C HIC ' Hi,,,,ri,:9,I,I *.:,L'le-r * , UX * - F Ill 'jlFI'r,e31 2.5 '30- E Q -C EE 310N a'~CaE'ni - 40 - L LSF rw. I' a alt a 2: | 1 I. i -, 3 _ r I,r Hl' SSEA NEIJ4A C EE LAC $5-1 CiS . rle i tor hLArrc,drn l; 53 mi-- o,,;!aII ,;e.L - .* IiT .rie.- . s b*. t - -. r,- *: e. .;3-,- .-1. LEA rd . IY a., i c i,.* &r E iF , -. ln^r * -n' E* rI In3 5Ci.,n 'D* In,F Te.:r,,;,: l .r- :,,, rh's,. ;e;e _ea :.--r * ,.-e .:, irre.a :r LK - i T - r-,iCi : 5ii .303' r. 3ci-cr.:..jr.. ,;.- Irl. Perceptions of political stability: whether changes in gov- * Entrepreneurs in many regions felt that the institu- ernment (constitutional or unconstitutional) are usually tional framework was not well enough entrenched to accompanied by far-reaching policy surprises that could withstand changes in government without serious dis- have serious effects on the private sector. ruption. In the CIS, Africa, and the Middle East over 36 WORLD DEVELOPMENT REPORT 1997 60 percent of entrepreneurs said that they constantly cent, in Asia about 30 percent, and in the CIS over 60 feared government changes and the painful policy sur- percent (bottom panel of Figure 2.3). Furthermore, prises that tended to go with them (top right panel of over half the respondents worldwide did not regard a Figure 2.3). bribe as a guarantee that the promised service would be delivered, and many lived in fear that they would sim- Uncertainty may relate less to the rules themselves ply be asked for more by another official. than to the way they are enforced. The relevant indicators here were: Lack of credibility reduces investment, growth, and the return on development projects Crime againstpersons andproperty whether entrepreneurs When the private sector does not believe that the state felt confident that the authorities would protect them will enforce the rules of the game, it responds in a variety and their property from criminal actions, and whether of ways, all of which worsen economic performance. An theft and other forms of crime represented serious prob- unreliable judiciary forces entrepreneurs to rely on infor- lems for business. mal agreements and enforcement mechanisms. A corrupt bureaucracy that is allowed too much discretion creates * Private entrepreneurs in many countries complained of incentives to seek economic rents rather than in produc- the lack of even the most basic institutional infrastruc- tive activity. A generalized environment of crime and ture for a market economy. Across the globe, crime insecurity of property rights prompts entrepreneurs to and theft were listed as serious problems, which sub- enlist the help of private security agents, or forces them to stantially increased the cost of doing business. A com- pay organized crime for "protection"-if it does not put plete institutional vacuum seems to prevail in some them off going into business altogether. countries, leading to crime, violence, and a generalized Investment suffers because entrepreneurs choose not to insecurity of property rights. In Latin America, Sub- commit resources in highly uncertain and volatile environ- Saharan Africa, the CIS, and CEE almost 80 percent of ments, especially if those resources will be difficult to entrepreneurs reported a lack of confidence that the recover should the business environment turn unfavorable. authorities would protect their person and property Where even the most basic types of property are not pro- from criminals (middle left panel of Figure 2.3). tected, investors move their resources to other countries, or invest them in projects that offer lower returns but require Reliability of judicial enforcement- whether the judiciary less capital commitment. Thus, trade and services may sur- enforces rules arbitrarily, and whether such unpre- vive even in low-credibility environments, but manufac- dictability presents a problem for doing business. turing and, especially, high-technology projects are un- likely to flourish. A similar distortion occurs when highly m A well-functioning judiciary is a central pillar of the talented people choose to become tax inspectors or cus- rule of law. Unfortunately, in many countries it seems toms officials rather than train to become engineers. to be the exception rather than the rule. In developing Therefore, credibility affects not only the level of invest- countries over 70 percent of entrepreneurs said that ment in physical and human capital but also its quality. As judicial unpredictability was a major problem in their a consequence, in a low-credibility environment, growth business operations (middle right panel of Figure 2.3). suffers. Disturbingly, in most regions entrepreneurs felt that The top two panels of Figure 2.4 show how credibility these problems had increased over the last ten years. relates to investment and growth in the countries surveyed for the period 1985-95. After controlling for other eco- Freedom from corruption: whether it is common for pri- nomic variables, countries with high credibility had invest- vate entrepreneurs to have to make irregular additional ment rates significantly higher than countries with low payments to get things done, and whether, after paying a credibility; a shift from a low- to a high-credibility envi- bribe, they have to fear blackmail by another official. ronment makes a substantial difference in growth as well. Low credibility may also help explain why many countries * The survey confirmed that corruption is an impor- do not see the expected private sector response after imple- tant-and widespread-problem for investors. Over- menting stabilization and structural adjustment programs. all, more than 40 percent of entrepreneurs reported Finally, the credibility of rules affects not only the having to pay bribes to get things done as a matter of business environment, but also the environment for the course. In industrial countries the figure was 15 per- implementation of development projects. The same fac- REFOCUSING ON THE EFFECTIVENESS OF THE STATE 37 Figure 2.4 Perceived credibility and economic performance go hand In hand Gro,ss irl:ertinerii tperelrda2e uf GDP) Gr,:w,th .if GDP .er c.:pr;, per.:enl r.e,' !Jr 3. 31 2 , ,1 25 04 20 00% llj -~~~~~~~~~~~~~- J2 '3r C *1/ V l-le Tne r.:p 1'' :9 i'9ntl- sr-, r i-e. I... -rS i.:., t, . 2l , r lrs l ll titlr / @ . ,jr,t,~~~~~~~~~~~~~,e~o~ w.n;.1 r F,.ure 2 i,:r Yr,e Per,&l 1CS4-:'-. * * .:.IllrA .. al,r t .. r ledill: :rrrilte:ll3nee :.i-|1 D:. I r,er. -ro c, .t.ro, .eerahe n;ee ofl , J,: 1 rtIi l ' -1 S il o.lnd Bi,rr * ................................. ~z-,- ;I aualr ,,o; ,rn. i Ei-,,s, un c... . ..-,,n l r.;1 t' e * tors-crime, corruption, uncertainty about policy, and even more widespread in many public projects than in the judicial behavior-affect the outcome for all such proj- private sector. As a result, many projects are delayed be- ects. One reason is that these concerns are part and parcel cause of cost overruns. Of a-ny contractual environment. If corruption affects the The bottom panel of Figure 2.4 shows the correlation private sector, it is likely to affect the outcome of devel- between government credibility and rates of return for 312 opment projects as well. A second reason is that many development projects in thirty countries. On average, in public projects are implemented by private contractors countries with a low-credibility environment rates of re- who, in an environment of weak institutions, are subject turn are substantially higher than in countries with a high- to the same behavioral problems that affect private firms. credibility environment. These results take account of The contractor is awarded a project, pays off corrupt of fi- differences in economic poticies and otther project- and cials, and gets more projects regardless of how the first country-specific factors. The lesson, once again, is that turns out. Pilfering, theft, and enforcement problems are institutions make an enormous difference to development 38 WORLD DEVELOPMENT REPORT 1997 outcomes. Napoleon's insight, cited at the beginning of tainties that have kept markets weak and underdeveloped. this chapter, is as true today as it was in 1815. Countries suffering from such an institutional vacuum Strategic options: Refocusing on the state's risk postponing economic and social development indefi- institutional capability nitely. There is also a danger that dissatisfaction with the state-whether expressed through social protest, capital A clearer understanding of the institutions and norms flight, or the ballot box-will undermine economic pros- embedded in markets shows the folly of thinking that pects even further. (ievelopment strategy is a matter of choosing between the The state's capability-its ability to deliver collective state and the market. As this brief review of the evidence goods efficiently-is central to providing a viable institu- on the relationship between institutions and development tional framework for development. As we have seen, many has confirmed, the two are inextricably linked. Countries developing countries are starting out from a very low base need markets to grow, but they need capable state institu- indeed in this regard. But the state's ability to provide the tions to grow markets. institutional support that development requires can be Reformers the world over need to apply this lesson by improved over time, through matching the state's role to r efocusing attention on institutional capability. The task its capability, and then rebuilding that capability by focus- is particularly urgent in many developing countries, where ing on the incentives that drive the behavior of the state. weak and arbitrary governments are feeding the uncer- We turn to these issues in Parts Two and Three. T C5 Lt@3 TO z C P fSR -ILIgT- AS PART ONE HIGHIlIGHTED, AN EFFECTIVE STATE PROVIDES VITAL INGREDIENTS for development. This part of the Report argues that governments will achieve better results by being realistic in what they set out to accomplish. They must strive to match what they do-and how they do it-to their institutional capa- bilities, not to some idealized niodel. Where government has a long record of failure, seeking a better match between the state's role and its capability can sound like a recipe for disman- tling the state altogether. But market development without a functioning state is not an option. Rather, as Chapter 3 explains, the point is to prioritize. In many countries the state is still not securing the economic and social funda- mentals: a foundation of lawfulness, a benign (and stable) policy environment, basic social services, and some protection of the vulnerable. At the same time, it is overproviding many goods and services that private markets and voluntary initiative could deliver instead. For development to proceed, such governments need to go back to the basics. Chapter 4 explores how governments can find the right match between role and capability in a second area of policy where the state's behavior will inevitably make a large difference to development outcomes: regulation, liberalization, and 40 WORLD DEVELOPMENT REPORT 1997 industrial policies designed to foster markets. Markets and society need and ben- efit from effective regulation of certain activities. But many states are stifling pri- vate sector development by overregulating or, often, monopolizing large chunks of the economy by attempting complex strategic interventions in industry that are beyond their institutional capabilities. Deregulation, privatization, and less demanding approaches to regulation and industrial support in these circum- stances will deliver large and immediate payoffs. These chapters carry four basic messages for policymakers: * States at all levels of institutional capability should respect, nurture, and take advantage of private and voluntary initiative and competitive markets. * States with weak institutional capabilities should focus on providing the pure public goods and services that markets cannot provide (and that vol- untary collective initiatives underprovide), as well as goods and services with large positive externalities, such as property rights, safe water, roads, and basic education. * Credibility is vital for success. States with weak institutional capabilities should also focus on the tools for policymaking and implementation that give firms and citizens confidence that state officials and organizations will not act arbitrarily and will live within their fiscal means. * Matching role to capability is a dynamic process. As institutional capability develops, states can take on more difficult collective initiatives (initiatives to foster markets, for example), and use efficient but difficult-to-manage tools for collective action, such as sophisticated regulatory instruments. SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS W EAK STATES MUST TAILOR THEIR AMBITIONS TO do much to put long-stagnant economies back on track. W their capability, yet some tasks are inescapable. We address the various approaches to government's role The challenge, addressed in this chapter, is to find ways for in effective environmental protection in Chapter 4. states-even states with relatively weak capability-to get Establishing a foundation of law and property rights those basic government tasks right. Sustainable, shared, poverty-reducing development has five crucial ingredients: Markets rest on a foundation of institutions. Like the air we breathe, some of the public goods these institutions * A foundation of law provide are so basic to daily economic life as to go unno- * A benign policy environment, including macroeco- ticed. Only when these goods are absent, as in many nomic stability developing countries today, do we see their importance * Investment in people and infrastructure for development. Without the rudiments of social order, * Protection of the vulnerable underpinned by institutions, markets cannot function. * Protection of the natural environment. The lawlessness syndrome The importance of these fundamentals for develop- Markets cannot develop far without effective property ment has long been widely accepted. But as is shown rights. And property rights are only effective when three below, new insights are emerging on the appropriate mix conditions are fulfilled. The first is protection from theft,' of market and government activities for achieving them. It violence, and other acts of predation. The second is pro- is now much clearer that markets and governments are tection from arbitrary government actions-ranging from complementary, that government action can be vital in unpredictable, ad hoc regulations and taxes to outright laying the institutional foundations for markets. Also corruption-that disrupt business activity. These two are much clearer is that faith in governments' ability to sus- the most important. Unhappily, as Figure 3.1 makes evi- tain good policies can be as important for attracting pri- dent, and as the regional patterns in Figure 3.2 highlight, vate investment as the policies themselves. in many countries neither is in place. The third condition The track record of developing countries in managing is a reasonably fair and predictable judiciary. This is a tall the fundamentals has been mixed. Many countries in East order indeed for countries in the earliest stages of devel- Asia-plus others elsewhere such as Botswana, Chile, and opment, yet firms in more than half the countries sur- Mauritius-have done a good job. But others have not. As veyed considered it a major problem. Box 3.1 reveals, private firms in many developing regions The absence of these critical supports for property are seriously constrained by the absence of such basic state rights gives rise to what this Report terms the lawlessness functions as the protection of private property. Institu- syndrome. Firms in twenty-seven of sixty-nine countries tional impediments are largely to blame and will be hard surveyed-including more than three-fourths of those in to overcome. Yet windows of opportunity for reform can the CIS, and about half in Latin America and Africa (but open and widen even in the most inhospitable of settings. none in the OECD)-are subject to this triple curse on And a major theme of this chapter is that even a modest markets: corruption, crime, and an unpredictable judi- shift in policy priorities in favor of the bare essentials can ciary that offers little prospect of recourse. 42 WORLD DEVELOPMENT REPO3RT 1997 Box 3.1 Weaknesses in fundamentals constrain firms the world over In man!- countries the Fundamentals nieeded to allowv a Policv-related problems-notably regarding raxa- firms to go about creating wcalth are nor in place. tion and the operation of financial markets-also The sun-eY of busineispeople described in Chaprer 2 rend ro rank high iexcepr in Latin America;. But ir asked firms to rank the relative importance of eight dis- is imponsible to tell from the survey results alone tincr obsacle to economic arivir.to identil- which whether these widespread perceptions reflect the aspecrs o0 governmcnt action most need improving. Ads uni%ersal desire of firms to pay lower taxes and to the cable belou shows: borrow more at lowver interest rates, or w%hether the- are symptomatic of funda-mental polikw shortcom- o Obstacles associcaed with uncertain properr rights ings. Nlore telling is the perception in countries of and dealin2 itrh arbitrariness-corruption and the CIS that policy instabilint is a major constraint. crime-rank amon, the top three everwAvhere except U Poor infrastrutCure emerges as rhe leading constraint among the high-income countries of the Organization in South Asia and the Mliddle East and North for Economic Cooperation and Development. Regu- Africa, and as one of the top three consta-ints iLn lation does not emergt directly as a major obstacle. Latin America and Sub-Saharan Africa. Firms' rankings of obstacles to doing business iworst = 11 Sub-Saharan Latin America East and Eiddle East and High-income Obstacle Africa and Caribbean Soth Asia North Aftica CIS CE OECD Property rights Corruption 1 1 3 2 3 3 5 Cnrne and tneft 5 3 8 s 4 6 6 Regulation 8 8 7 7 8 8 4 Polics Taxes 2 5 2 3 1 1 1 Financing 6 4 5 4 5 2 2 Inflatior, 4 7 4 6 6 4 8 Policy instaoility 7 6 6 5 2 7 7 Public nwesrrment Poor infrastructure 3 2 1 1 7 5 3 Source Private sector suwes conuctu}ea f-i ints Peton. Corruption emerged from the survey as a major prob- America, for example, between 1980 and 1991 the mur- lem. Its consequences often do not end with paying off der rate rose from 12.8 per 100,000 people in 1980 to officials and getting on with business. Arbitrary govern- 21.4 per 100,000 in 1991, with increases evident in vir- ment entangles firms in a web of time-consuming and tually all countries and subregions. economically unproductive relations. More than half of Much remains to be learned about how to reverse law- senior managers in firms surveyed in the CIS-but only lessness among private citizens. But the solution is likely about 10 percent of those in the OECD countries- to embrace many of the reform priorities highlighted by reported spending more than 15 percent of their time this Report, including better protection of the vulnerable negotiating with government officials over laws and regu- and stronger overall capability of state institutions. A lations (Figure 3.2). The burden of red tape is less in other community's descent into lawlessness can evoke a sense of developing countries, but still consistently worse than in helplessness among the law-abiding. But as Box 3.2 de- the OECD countries. Chapter 6 examines in some detail scribes, a recent initiative in Cali, Colombia, has shown how the scourge of corruption can be tamed. that, even under the most difficult of circumstances, civic The high ranking by CIS firms of the two other ele- action can start a reversal from despair to hope. ments of the lawlessness syndrome-crime and judicial unpredictability-partly reflects the unique institutional More complex institutional underpinnings vacuum created by the rejection of central planning in the Containing lawlessness is necessary to secure property transition economies. Yet indicators from other regions rights, but it may not be sufficient. Information and coor- suggest that institutional decay is widespread. In Latin dination problems can also impede development by under- SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 43 mining markets and property rights, a problem often found in low-income countries. Figure 3.1 The lawlessness syndrome Information problems occur because people and firms inevitably have limited information and understanding, Nlun,t)er of countries wvhere one or mnore aspects of or because the rules of the game are unclear. The scope of IaWesress are seriOu 5 acies to doing husrness property rights-including the right to use an asset, to permit or exclude its use by others, to collect the income Y generated by the asset, and to sell or otherwise dispose of AAS it-may not be well defined. People and firms may lack meE 5 Gnme oj knowledge of profit opportunities, or of the probity of d al dr' ) potential business partners. The costs of seeking out such 4 information decline as markets thicken and their support- ing institutions develop, making economies more infor- mation intensive. In developing countries, however, the costs of learning can be high. Coordination of economic activity is difficult because self-interested people and firms behave strategically-they [h tihree I generally are willing to share information only when they 21 do not lose by doing so. The presence of moral hazard- the risk that other parties might opportunistically renege on agreements-hinders firms from taking advantage of u-r* a ':Kiuiir*. ils X.ir. T-l. I hill K hO,'? or is rer rrOng um s.:o'ed is 3rLii Ji 1 ci I? Or- a C 31 i~ opportunities for mutual gain. As markets develop, insti- I" T A Airrt iiwer du6 ndociinrig ge.rer s..fveri alrnd v.1lr tutional arrangements evolve to facilitate cooperation nn riel r:eOp ar a ifearIJC perrercni o' Frms 3coredtorn among firms. Again, however, in developing countries as i1r .2 and ire a Cer3e r rne r: o ercenaees empd Oi5 peircEri. So-urcE. Pri.,ale Se~fri su.e, .condtimIE= where those institutions are underdeveloped, such cooper- thr etr-, enpcri ation can be difficult to achieve. Spot markets can emerge even when information and enforcement mechanisms are weak, since the fact that the exchange is simultaneous makes it more difficult to cheat. symbiotic development of markets and institutions: new But for other transactions the costs of providing adequate industries create demand for more-complex institu- information and enforcement mechanisms to enable busi- tions, which in turn enable the industry to develop fur- ness to proceed can be formidable. ther. Consider the example of mining in the "Wild Well-functioning institutions can reduce these trans- West" Nevada territory of the nineteenth-century United actions costs. History provides abundant examples of the States. Figure 3.2 Negotiating with government officials can be arduous Percentage of firms cde%otng nore than 15 perenei of nianagers' rime it negonating aith ohiciais cis . -' Latin America and Canboean Middle East and 1lNorth Africa 38 Sub-Saharar. Africa 7 CEE 31 Souitn and Southe3st Asia 25 Hignancon'e OECD 0 10 20 30 -LO 50 6c- ScUIre: Pritare sector surs.. ccrnd'reo TOT This Reronn 44 W ORLD DEVELOPMENT REPORT 1997 Box 3.2 Standing up to crime in Cali, Colombia One of the centers of the illegal xtorld trade in cocaine. * Puiblc education campaigns promoted tolerance Call saQ irs homicide rare leap front 23 per l0h.Iil(u and reptect tor r[hl righrN of others. Coniniunin' ciuzen, In 19183. t o%er lItI per 10(i.(0)0 In the earls leaders .erc traine-d in peaceful dispute settlement: VW0)s. Mlanv nmurders could be dirctlyI artribuEcd to children were -ncouracd tro jioin a Friends of Peace drug trafficking. but many more seemed due to a program: hunmoroius TX commerciak aimed to re- preadin culture ot-j.ltcIne. Fed tip w ith tihe grow%ing educate citizen; tro follo%n the rules of everyday Iife. lawlessncs.. in 1'-° the city celeced as mawor a rc- such aS obeying trafti> signals, or waiting in line to specred plwicni.an who put combating iulcent crimc ar board a bus. [he center of his polirical ptarnirm. U Public services were dircted at redLcing ineqwries. Within nionrhb the newn maior had mounted a Primar. and secondan- chcols vrce expanded in malur anricrime injritijai. the Program for the Dedcl- depressefd areas of rhe cir. : warer. lighr. and sewer- opmenr of S3fety and Peace. Starting from chli princi- age scrf ices w-ere introduced into squarter areas: and ple that preiention should take precedence o'er repres- youth centers and enterprise developnment programs sion-arid after ain cxhauivie anal sis taf the parterns Worked to bring ternage gang memnber5 back into ot crime-the program i'.U rked tc consibar crime acrens society- . mainsircain. a %dric-t of fron[t: U Catalyrts of violent crime were directiy confronted. The cirv banned the carr ving oif handguns on certain * Orgarnizations oI civic order wcrc upgradcd. Special high-risk wetekrends. and sales of alcohol w%ere re- education and hoLLsing w programis wve[e establi4ied For stricted late at night and during holidays. police officers. and inprop-ementns %%ere made in [he qua-lir -t c,rnIes including legald and conciiarion In after seven coroccurie 'ear5 of increase to a iemrVces axLiI-able in rhe frontline inspecrorare oftices peak of over 1210 mifders per 100.000 pec.plel. Calt s where titzens nile complaint; ot criminal action. murder rate finally began to dciline. In the 1850s a few hundred miners worked a forty- The progress of land titling in Thailand is a more con- square-mile area of seemingly marginal value. Only loosely temporary illustration of how the formal specification of tied to the U.S. polity, they operated under entirely property rights can unleash "locked-up" assets and accel- unwritten and informal ownership agreements. The dis- erate private sector-led development. Thailand has issued covery of the gold- and silver-bearing Comstock Lode in more than 4 million title deeds since 1985, in two land the late 1 850s precipitated a flood of prospectors. Within titling projects. A third project to title another 3.4 million five months the new miners had established a formal min- parcels is under way. Land is an ideal form of collateral, so ing camp government, which enacted written rules on pri- possession of secure title has improved access to formal vate holdings and enforced them through a permanent credit. Three years after the first titles were issued, Thai claim recorder and an ad hoc miners' court. farmers who had received titles had increased their bor- By 1861 the surface ore was exhausted and miners rowing from the formal sector by 27 percent. By enhanc- resorted to subsurface mining-a substantially more ex- ing security of tenure, title to land can boost investment pensive and capital-intensive undertaking. With more at in land improvements (irrigation, fencing, destumping). stake financially and with disputes over underground min- Newly tided Thai farmers increased their use of inputs by ing rights increasing in complexity, the miners pressured 10 to 30 percent, their rate of capital formation by 30 to for, and won, creation of a formal territorial government 67 percent, and their investment in land improvements by with a more extensive judiciary-subsidized in part by the 37 to 100 percent. Even after adjusting for other factors, U.S. Congress. productivity on titled land was between 12 and 27 percent By 1864, with mining production still expanding, the higher than on untitled land. territorial judicial system was overwhelmed by a massive Not every country is in a position to achieve such case load, which could have taken up to four years to results. In Thailand certain background conditions played clear. At the end of that year Nevada was admitted to the an important role. First, formal credit markets were union as a state, and within a year some important judi- already well developed, and lack of formal title (and hence cial rulings resolved disputes over subsurface rights. Prop- of collateral) was the only reason why many farmers could erty rights stabilized, and legal uncertainty ended. not get loans. By contrast, in a number of African coun- SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 45 tries with weak credit markets, no measurable impact of pribumi) business community used its extended Southeast titling on borrowing and investment could be discerned. Asian network to kickstart exports of garments and furni- Second, the Thai titling projects took place against a back- ture. A World Bank survey showed that over 90 percent drop of land disputes that threatened security of tenure of the initial export marketing contacts of non-pribumi but could no longer be adequately resolved through tradi- firms were made through private business connections. tional mechanisms. This is not always the case. Indeed, Indonesia's non-Chinese exporters relied much more on where land is cultivated individually but owned commu- initial support from public agencies. nally, strengthening traditional, community-based systems Even when parties cannot rely on social enforcement, of land administration could increase security at a fraction mechanisms of information sharing can allow quite com- of the cost of establishing individual titles. This is a par- plex transactions to take place. Box 3.3 shows how in ticularly attractive option where communities can switch Brazil, for example, sophisticated credit information sys- to individual titles once the efficiency gains from allowing tems have developed to enable firms to bypass some of the sales to outsiders, and from being able to collateralize land problems created by a predictable, but cumbersome, judi- for borrowing, outweigh the benefits associated with com- cial system. munal tenure. But some complex transactions can proceed even with Focus on the foundations simple judicial systems. A well-functioning judiciary is an Taken together, the evidence presented here offers reasons important asset, which developing countries would do for hope-and a major challenge. The hope comes from well to build up. As Chapter 6 details, creating a workable the fact that simple institutions can do much to facili- formal judicial system from scratch can be slow and diffi- tate market-based economic development. The challenge cult. But the best should not become an enemy of the comes from the recognition that so many countries better. Even less-than-perfect judicial systems that are presently lack even the most basic underpinnings of mar- cumbersome and costly can help sustain credibility. What kets. The first priority in such economies must be to lay matters is not so much that judicial decisionmaking be the initial building blocks of lawfulness: protection of life fast but that it be fair and predictable. And for that to hap- and property from criminal acts, restraints on arbitrary pen, judges must be reasonably competent, the judicial action by government officials, and a judicial system that system must keep judges from behaving arbitrarily, and is fair and predictable. legislatures and executives need to respect the indepen- Once a foundation of lawfulness is in sight, the focus dence and enforcement capability of judiciaries. can turn to the ways in which specific parts of the legal Without a well-developed judicial system, firms and cit- system can buttress property rights. The legal terrain is izens tend to find other ways of monitoring contracts and vast, ranging from land titling and the collateralization of enforcing disputes. These can often make quite complex movable property to laws governing securities markets, private transactions possible. In the early Middle Ages, for the protection of intellectual property, and competition example, European merchants devised their own sophisti- law. However, reforms in these areas-especially the more cated legal code, the lex mercatoria, to govern commercial sophisticated ones-will yield fruit only where institu- transactions; the code helped revive long-distance trade. A tional capabilities are strong. In many countries, more widespread alternative to legal mechanisms is social basic challenges remain to be met first. enforcement, based on long-term personal relationships. Cheating is deterred, not by the law, but by the "long Sustaining a benign policy environment shadow of the future": both parties pass up the one-time Property rights are the foundation for market-led growth gains from cheating in expectation of the larger gains from and poverty reduction. But much more is needed. Firms a long-term business relationship. The extended family need an environment that induces them to allocate re- plays just this role in supporting business transactions in sources efficiently, to improve productivity, and to inno- many Latin American countries. Although family size lim- vate. And unless firms are confident that policies will re- its the number and variety of possible transactions, families main reasonably stable over time, they will fail to invest, find ways to, in effect, expand their membership, for exam- and growth will lag. ple through marriage among business families or "adop- This section reviews international experience with tion" of trading partners as godfathers, uncles, and aunts. some key policies that support development. It highlights The extensive business networks created by Chinese some institutional reasons why countries find it so diffi- clans, some of which have global reach, are another exam- cult to put good policies in place-and the increasing ple of social enforcement at work. Against the backdrop risks, in a more integrated world, of pursuing bad policies. of sound economic policies in large parts of East Asia, The emphasis throughout is on finding ways in which these networks have been very successful in generating countries with different institutional capabilities can lock wealth for their members. Indonesia's Chinese (non- in good policies. 46 WORLD DEVELOPMENT REPORT 1997 Box 3.3 Contracting and the judicial system in Brazil The Brazilian Judicial svsrenm is elceeclingh- cumnber- ers nd hbu-eri of iarmenEs finds its uay into court- fume froni a arm s pcrspectixC. A complexr mre of lax s onl- one in e%er, 2.601)1 docs so un Chile. and one in mav ippl-, ru an ocher.ise simple business transaction. e'erv 20(001) in Pleru. In 181, l. hor exanmple, geming an pxport license Eool,: A second reason why firms shrug tft rhc slc.N. new, ot 1.4-th scparate legl iction. inv%olving thirteen gcvern- [he judicial sx-stem i, thar (as in all private markeE menr niniilsrie aild tirf-r agencies. The legal proces is econoniiesl priva[e institutional arrangements have also c:.ceedinl- ilrw. prin,aril- because of a cinpleN e0 olvrd io ri,strain opportun!smn in business de.lings. appealb procedur. Y~et surprisngl%-. when acked to s.hile bypassing court prvceedings. XXWe cite three ev-aluare the reij[aie Imporiance lt a diverse array- ot e samples. First. Brazilian firms tcadily provicde short- coniriinris on doing budnes>. tirms issigned a low term credit e en tl newz cuqromer-s with whtom they rainkin, to problernm ai ciared x ah the legal ˘ vccrni. have hid no prior lealings; they base rheir confidertce One reaswin i chi[. cumbrrsonme chou.h it f. Ion J w,ell-de%elopd crediti intfrmarion sy-stem tbick- Bra.7il judicia s..stem ncnecheleos seemr to provide a scopped by a juridically sanctioned mechanism for secure bickdrcup of judicial recouLrse tor businecs trans- publicizing information on people w\ho fail to paY rheir accons NlIc.st irmi reporr that th: - judican.- is rcason- debts). Second althoijch it iS difticult ro claim plleded ablx fair :Ld prediable. anid th,- do OI chl,lion turn propern w;hen loans are not repaid. under Brazilian to it: two,-thirhLr,t ofa 'amplc of Brazililan tirms have dis- lawv leised propert- can be rcclaimed much more read- agreed w-ith a go' ernment official dnd ;ouehr to ha,-c a il-so Br.uliliani nmake liberal use of leasing arrange- ruling changed. ii) percent ha%ve taken the go-ernment ments. Third. 6or some simrple financial Eranmacion5, tc court, and o'er Sii percenr %%ould do so agaLin. Si m- speciaJ judicial nicchanisnim allow rhie usual proceed- ilarly. onie in e'ern I ,L0lJ transaciloim amc'nin produc- in-s tu b, bypassed. Good policies promote growth signals and incentives for economic agents to accumulate The past few decades have yielded a rich crop of lessons resources, use them efficiently, and innovate. Over time, about the kinds of economic policies that support develop- as we saw in Chapter 2, getting these basics right can have ment. The East Asian miracle shows how government and a dramatic effect on living standards. the private sector can cooperate to achieve rapid growth The relationship between growth and macroeconomic and shared development. The recent recovery of some stability is well known. Empirical work has shown that Latin American economies, breaking out of a long history high rates of inflation (above single digits) adversely affect of inflation and into renewed growth, has further con- growth. High inflation creates uncertainty about the re- firmed the power of market liberalization, budget restraint, turns on saving and investment, thus creating a disincen- and credibility-enhancing institutions. Africa, especially tive for capital accumulation. Inflation also makes it diffi- south of the Sahara, has been slower in joining this move- cult to maintain a stable but competitive exchange rate, ment, with the exception of a few countries such as Mauri- impeding the country's ability to exploit the benefits of tius and Botswana. But several more-C6te d'Ivoire since openness and creating wage volatility. the devaluation of the CFA franc, Uganda more recently- As Box 3.4 shows, governments around the world find have embarked on promising new development paths. it difficult to achieve the strong fiscal and monetary disci- Analyses of these and other experiences consistently pline required for economic stabiliry. Maintaining such find a core set of policies that appear to be essential for policies is harder still. But reforming governments will not growth: inspire the confidence necessary to generate growth unless people believe the new discipline will be sustained. We * Providing macroeconomic stability discuss below a range of institutional arrangements that * Avoiding price distortions can help inspire such confidence. * Liberalizing trade and investment. Limitingprice distortions is an essential element of good policies, because price distortions impede growth. They These policies help position an economy to benefit from can discourage necessary investment, divert effort into un- competitive market forces. These forces provide the right productive activity, and encourage inefficient use of re- SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 47 Box 3.4 International track records on fiscal deficits and inflation As die figure shoms, fiscil defic.is in the indusirial c-untrasi, in the first jlt ut rhc P'01 910 neither the cc-incries as a vlhole roie p rogressneIulY h-,r t-wo> decadlci African nor the Mfiddle Eastern Lountries hav-e been s[atring in the early I6t.is. sadbilied briefly- in the late able ro tollocw througzh on dcticir reductioln ichieved IOStit. and rhen bei,an to gro%u again. Pcrsivtenrl high in the second luff ., rhc deficits have boosted public debt exven before un- Intlailon rates ha. e %aried acro.s, regions e%en niore funded pension liabilities are incluededi frocn about -it, than hl'ie fiscal deficits I he intlationanr episode of the percent cif GDP In N t') o -(I ptrcenL in lct9-6. Dc- I 9-Th and early- IiJS(Is spread quickli iround the veloping countries in the aggregart have shown con- %vorld. The coldo-don o: inlation diar scarted in the siderable improvemient in fiscal discipline. alrhou4h indutTri1a coutries in (he early lSi)s has becuin cc- wih suLbsantial variation. Fi'cal defic-its srard fallingz take hi1d. but v.ith a lag. In hch deceloping ciuntrics in the early lS9:ls. mainlY because oft expendicure cuts. inflation bea.n t ni.:oderare in the earlI 11 )N-K. bitt not HoweNer. this aggregate picture reflects mainlv euvervv.-here. Int -mie de. eloptn-, tenons, intlaticn r ies cesses in Asia anid Latin America. where ;ustained and are 5hc.% %ing tign4 it Actontergence roli:ard those ol the dramati:c deficit reductions have bten achie'ed. B'. ilustrial counmies. Fiscal deficits Inflation Percer,rage c;i GDP Percent Ijcr leer ,S _1 12- .3 ~~~~~~~~~~~~~~~~~~~~~~IC-1 17) eIl: _.C S. C .-D;0-.;. .- t 0I~~~~~~ t I,- )~~'. . ' j .,:r ; .1 I 'lll I . '',:, -) -I' E n ~ ~ ~ ~ ~ ~ ~ ~ ~~ 196'1--5 1C,D1-75 lt4.1--c5 i I _95-I --C. 45 l" 71-7- I Cl-SS 19;!-- I ... , ;,;N- I F ; ,, ;,,,,, ,-, E.,.. - B::1..,, .'C 5~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ -. r, 3,1'i|-1 3 ~ ~ ~ ~ ~ ~ ~~~~~~~ 14l,l -~~~~~~~~~~~~~~~~~~~~~~~~~~~~~-l H.,1,./ S ~ sou':e IMF. .ir'r,use Sits ci' 48 WORLD DEVELOPMENT REPORT 1997 distortion by cutting explicit taxes and, often, correcting Figure 3.3 Countries are discovering the overvaluations. The 1994 devaluation of the CFA franc advantages of the value added tax (see Box 3.5) significantly reduced the bias against agri- culture among virtually all the franc zone countries that had not reformed earlier. 90I Harder to detect, but also widespread, are price distor- tions in labor and capital markets. Legal minimum wages, for instance, may be set too high, unintentionally making 7 Ci it more difficult for unskilled and low-wage workers to 60 find jobs in the formal economy. Similarly, the price of capital-the interest rate-is sometimes kept falsely high 50 through heavy taxation of financial transactions or high G0 _reserve requirements. When the authorities respond to borrowers' complaints by clamping a lid on lending rates, 31) or by handing out subsidies to investors, yet another layer 2, of distortion is added to the price system. - Maintaining liberal trade, capital market, and invest- 1U ment regimes is also essential for growth. As Chapter 8 n ___ details, many countries have recently moved toward greater openness. Open markets offer opportunities for 1960s 197C0s 194E'CIS J9r40sQ citizens and businesses by increasing access to supplies, equipment, technology, and finance. Trade linkages with Sc.u';.: T;n~ l l99~5t the world economy also help domestic prices adjust to global market conditions, so that prices reflect the scarcity values of goods and services. And improved incentives sources. Price distortions come in different forms, de- and opportunities allow entrepreneurs to use resources pending on their historical origins. The most common, more efficiently. however, involve discrimination against agriculture, over- Recent changes in the way developing countries raise valuation of currencies, unrealistic wages, and hidden taxes tax revenues show how increased global integration can or subsidies on the use of capital. affect domestic policies. Internationalization of business African agriculture illustrates vividly how price distor- and relentless competition for foreign investment-plus tions can undermine economic development. Agriculture the presence of tax havens and low-tax jurisdictions- accounts for about 35 percent of Africa's GDP, 40 percent imply that countries cannot hope to tax corporate or per- of exports, and 70 percent of employment. Yet histori- sonal income at rates much higher than global norms and cally, African farmers have faced high rates of both explicit still attract investment. And a growing worldwide consen- and implicit agricultural taxation. Explicit taxes (notably sus for lower national trade barriers has put pressure on on agricultural exports) were high because administrative the collection of border taxes, historically a major source weaknesses precluded raising adequate revenue from other of tax revenue for developing countries. (As a group, sources. Implicit taxes were high because pro-urban and developing countries still derive about 30 percent of their pro-industry policies combined with high levels of import revenue from trade taxes.) With increasing integration, protection resulted in currencies being seriously overval- the share of trade taxes in the total revenue of developing ued in real effective terms. In addition, in some countries countries may be expected to fall further. public sector monopolies raised border prices well above With these new constraints on traditional sources of those at the farm gate, absorbing much of the difference in revenue, many countries are turning toward consumption- in-house expenditures. The combination of high explicit based taxes such as the value added tax (VAT). Indeed, the taxes and overvalued currencies contributed to alarming combination of its revenue potential and pressures on declines in Sub-Saharan Africa's agricultural growth rates: other sources of revenue has led to dramatic growth in the from an annual average of 2.2 percent in 1965-73 to 1.0 number of countries using the VAT (Figure 3.3). percent in 1974-80 and 0.6 percent in 1981-85. A liberal and open trade regime is also a powerful dis- Since the mid-1980s many African countries have cipline on the other elements of economic policy. More- made great strides in reversing the long-standing bias open economies are more exposed to external risks, mak- against agriculture. By the early 1990s two-thirds of a sam- ing it more costly for governments to pursue inconsistent ple of twenty-seven countries had reduced the degree of policies. Consequently, economies in which trade looms SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 49 relatively large tend to have lower fiscal deficits than those Favorable surprises can cause as much trouble as where it does not. The need to comply with the rules and adverse ones. The prudent response to a positive eco- conventions of international treaties will be another spur nomic shock is to set aside part of the windfall for future to good behavior. use. When the 1990-91 Gulf War pushed up oil prices, An economy without sound policies is unable to Nigeria used its windfall oil revenue to expand spending engage fully in international trade and investment. But (Figure 3.4). So in spite of the large increases in revenue, being part of an integrating world economy also carries Nigeria's fiscal deficit actually rose in 1990. When oil new risks. Where markets for goods and capital are open, prices and revenue fell in 1991, spending remained at the the state has a hard time suppressing the consequences of new higher levels. By contrast, Indonesia responded to its monetary indiscipline. If it prints too much money, the oil windfall with fiscal discipline, explicitly budgeting a foreign exchange market will quickly expect higher infla- reserve fund to keep the increase in expenditure below the tion, and the local currency will depreciate. This market increase in revenue and maintain budget balance. feedback causes domestic interest rates to rise, and with them the government's financing costs. Good policies are Goodpolicies are hard to achieve needed to cope with the risks of capital flight, volatile Although the recipe for good policies is well known, too arbitrage activity, and sharp movements in commodity many countries still fail to take it to heart, and poor per- prices. Box 3.4 summarized some differences in how formance persists. This often signals the presence of polit- countries have responded to the new global environment. ical and institutional incentives for maintaining 'bad" Foreign capital inflows also impose discipline on poli- policies. cymakers. Inflows tend to make the currency appreciate in Policies that are bad from a development perspective real terms, and they can affect competitiveness and are often highly effective at channeling benefits to politi- domestic saving. They can also be seriously destabilizing cally influential groups. Many macroeconomic prob- because they respond quickly to short-run financial tur- lems-inflation, exchange rate misalignment-are in fact bulence. Recent experience suggests that this turbulence covert ways of levying unexpected taxes on the private sec- can be contagious, spilling over to other countries and tor or of redistributing economic benefits. Similarly, a even other regions in ways not necessarily commensurate broad array of microeconomic restrictions on the opera- with the change in risk. Countries experiencing sizable tion of markets-import restrictions, local monopoly capital inflows may need to run positive fiscal balances, using these precautionary savings as a hedge against the possibility of sudden capital outflows. Capital inflows also have major implications for exchange rate policy; fixed exchange rates, for example, are unlikely to be a workable Figure 3.4 Unlike Nigeria, Indonesia managed option if a country is vulnerable in financial markets. In its recent oil windfall prudently short, the quality of a government's management of the economy is critical. Percer1a9e cf 19i9 re. erj. The risk of capital flight and financial turmoil is vividly Nigeria Indonesia illustrated by Mexico's experience in 1994-95. An impor- -i\o tant reason for the loss of confidence there was an over- 3: valued peso, maintained despite very large current account deficits. As foreign exchange reserves fell below the domes- ,OO tic monetary base late in 1994, the authorities failed to 250 E r.&*dr' bring about the necessary monetary contraction. More- consistent policies could have limited the loss of confidence. 21:(0 e. r ;-.rJ, .., An open economy is also exposed to price shocks aris- t ing from world markets. Energy and food prices are par- - ,,- . ticularly volatile and can affect a country's external pay- iA'be - ments and fiscal positions. Exchange rates and interest - -0,c .0. ,; rates are also volatile. Prudence calls for anticipating ad- verse shocks (a sharp price increase for importers, a price - , 1 1 drop for exporters) by not borrowing excessively and 1990 maintaining scope for new borrowing and by holding ade- quate foreign exchange reserves, and in the medium term . MF ; j it. by establishing a more diversified economic base. 50 WORLD DEVELOPMENT REPORT 1997 privileges, regulatory red tape-serve to shelter powerful suggests that long-run goals are better served by sticking incumbent firms or other favored segments of society. to self-imposed restraints and living with the rigidities The political system in some countries has a built-in they inflict. The examples here concern fiscal and mone- tendency toward chronic budget deficits. Legislators tary policy; further examples in the field of regulation are exchange favors, each promising to vote for benefits to the discussed in Chapter 4. other's constituents, without specifying how these bene- FiscAL POLICY. Many macroeconomic disturbances fits will be paid for. So fiscal deficits rise. start life as fiscal imbalances. Recent research suggests that When revenues fall short and politicians have little changing the institutional features of the budgeting process stomach for cutting spending, governments have to choose can improve fiscal performance significantly. either to levy or raise taxes that are desirable from an effi- Increasing the transparency of budgeting is particularly ciency standpoint, or impose hidden taxes such as the so- important. Although society as a whole will lose from bud- called inflation tax-the tax on real incomes that comes getary ambiguity, it can be a boon for politicians, blurring from financing government spending with debased cur- the cost of favors to special interests, for example, or rency. The latter course is often the easier. Increasing for- understating the long-run costs of short-term profligacy. mal tax collection requires an efficient and honest tax When budgets are not transparent, "creative accounting" administration. Achieving that may first require deep practices, such as off-budget spending and overoptimistic structural reform of fiscal administration. A change in the revenue and growth projections, become all too easy. VAT rate might take a vote of parliament, implying delays Needless to say, all of these gimmicks make it harder to and political compromise. But an increase in the inflation control spending. tax might involve no more than a ministerial order to the How budgets are formulated and approved is also central bank. important. The evidence suggests, for example, that it Even when intentions are good, governments may matters whether a country takes a hierarchical approach to sometimes be forced to use hidden taxes like the inflation budgeting-giving considerable power over departmental tax-although they recognize that in the long run this spending totals to the finance ministry-or one that is brings huge costs and undermines credibility. How does a more collegial. In principle, the hierarchical approach government with a history of inflationary financing con- ought to foster greater fiscal discipline by enabling more vince potential bondholders that it will not inflate its way "top-down" control of spending and limiting the scope out of its obligations this time, or simply default? How for legislators to expand the budget piecemeal. can it convince trade union members that it will not cut A recent study of twenty Latin American countries their real income by raising the cost of living? If it cannot, suggests that moves toward more transparent, hierarchical investors will protect themselves by demanding a higher budgeting could deliver improved restraint (Figure 3.5). interest rate on government debt, and workers will protect It found that budget deficits tended to be higher among themselves by demanding bigger raises. Their doubts may countries that used collegial and nontransparent ap- then become self-fulfilling: the government could be proaches to budget preparation. Countries with the least forced to bring about the inflation that these private transparent and least hierarchical systems ran public agents expect, by loosening monetary policy and allowing deficits averaging 1.8 percent of GDP. The middle third real wages or interest rates to rise. ran an average budget surplus of 1.1 percent, while those These perverse but powerful institutional incentives with the highest combined hierarchy-transparency scores can make policy reform very difficult. And even if reforms had budget surpluses, on average, of 1.7 percent. These are initiated, the skepticism of businesses, workers, and results highlight that countries looking to improve their consumers may be borne out by events, unless the gov- aggregate fiscal management need to scrutinize not just ernment can communicate the seriousness of its intent. their balance sheets, but also the institutional environ- ment that shapes the incentives to spend. Locking in goodpolicies MONETARY POLICY. A well-functioning, independent Once reforms are announced, their lasting success may central bank can effectively reduce the threat of politically depend on designing and implementing policies in ways motivated monetary expansion while maintaining some that credibly signal that the government will not renege flexibility to accommodate unavoidable outside shocks. on its promises. A number of possible lock-in mechanisms Many countries seeking credibility for their monetary pol- are available, all with the same basic logic: to provide icy have chosen the model of central bank independence. checks that restrain any impulse to depart from an- In many cases this enthusiasm sprang from evidence nounced commitments. If institutional capabilities are that OECD countries with independent central banks strong enough to allow some flexibility to adapt rapidly to generally had lower rates of inflation than others-with unexpected events, so much the better. If not, experience no slowdown in growth. But attempts to find a similar SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 51 pattern in developing countries have yielded mixed results, depending on how central bank independence is Figure 3.5 Well-designed budgetary defined. Russia's move to central bank independence in institutions help avoid large deficits the early 1 990s, for example, did not seem to restrain that Priniar,eiCit lperLeniage of GDP' country's inflation. This more complex story for develop- ing countries suggests that monetary restraint through is central bank independence cannot simply be manufac- tured by fiat. It may require a prior foundation of checks and balances on arbitrary action by public officials. 4 0 HOIciur 3 Choosing a conservative central bank governor, one who is more opposed to inflation than society in general, El SaIl. . A r r, Trir.d1l ar,ci TactiTae: may be one way for developing countries to reap the ben- 2 - *. efits of central bank independence while containing the OC,;sa RGtn 3ULrUii risks. Another way is to assign the bank only instrument Peir 'a * 0 independence-the day-to-day setting of policy to achieve c . a certain goal-while leaving the choice of the goal itself Dc,im,r,car, to the political authorities. A third option is to establish a pul)li\ contract for the central bank governor that provides for L-, Lu So ,.er some penalty for deviating from an announced inflation N a target. This mimics the effect of employing a conservative central banker without relying on subjective judgments E ra-,I about the person holding the position. - The mixed success of independent central banks in Cr a 1> restraining inflation raises the possibility that some devel- oping countries may simply be unable to put in place -6 LOS p High mechanisms that credibly signal monetary restraint and at the same time maintain the capacity to respond flexibly Irde' of tl, :uaIrtf of bUdgel rIStitutrOn5. to outside shocks. For these countries the choice may ric., Euai lefid.rs are veraa,d er rr,r trl;-* 190rC'-92. be between commitment through rigid mechanisms and Tr,* pndCeS tO Durveu.' intuLtuL,ri uL conitructiecl Irh,m re;~p~. o ,s s iU'v, a T -uS i,Xr,IrX r.,..OGL ar.*cir. .;nC h:.. ter no commitment whatsoever. A variety of inflexible ap- cunmponeni; Sc-ur,:c: Aele;,na r.aioo,our,d paer. proaches have been tried: * Argentina, in breaking away from a long tradition of These hard-line approaches represent a high-stakes inflation, enacted a currency convertibility law in April race against time. By raising the cost of policy reversal, 1991 that essentially turns the central bank into a quasi such policies contribute to a belief that the government currency board. The money stock must be fully backed will hold fast. In time, however, some exogenous shock by foreign exchange. will be strong enough-or, perhaps, political opposition * Many Latin American countries switched to a fixed to some side effect of the policy will be strong enough- nominal exchange rate to anchor prices and coordinate to demand a reconsideration. At that point, countries that private sector expectations. A fixed rate precludes the have won the race against time will already have put in use of devaluation to accommodate short-run external place more flexible approaches to monetary restraint, or shocks. But as Mexico discovered to its dismay in 1994, will have won enough credibility that adapting the strat- a fixed nominal exchange rate can become dangerously egy will not be interpreted as a reversal. destabilizing when capital inflows or domestic policies Investing in people and infrastructure pull the real exchange rate out of line. * Most of the francophone countries of Africa affiliated Well-functioning markets are usually the most efficient themselves with the CFA franc zone and its suprana- means of providing the goods and services an economy tional central bank. Central bank advances to a member needs-but not always. In particular, markets undersup- government are limited to 20 percent of tax revenues ply a range of collective goods-public goods, and private collected the previous year. This prevents countries from goods that have important spillover benefits for society at substituting the inflation tax for conventional taxes (Box large. Generally these are goods that have a significant 3.5). But the same mechanism can also provoke defla- impact on the quality of life: clean air and safe water, basic tion if growth turns negative, as happened in the 1980s. literacy and public health, and low-cost transportation 52 WORLD DEVELOPMENT REPORT 1997 Box 3.5 Commitment versus flexibility in the CFA zone The CFA franc zone of \Vesr and C-entral Africa is hir h! a pair ofe:xrernal hhocks: A real appreciation of the both a currency uni n and a monetary standard: the French franc against rtie dollar. which led direcl- to a CFA fr3rn is conv-ertible to French francs 3a a fixed real appreciailon of the CFA ftrnc: and a dramatic drop norilinl exchange rate. France esrablished rhe rime inTLhedpricesofsomememb rs majoreports. Thfi:ed afier \'orld \X-ar 1I rto o. cree monetary and financial ec.hange rate ruled our adjustment through a nonminal policies in its .frican colonis,. and Francc conlinucs to de%aluation. Inflation remained lo w in this period. but plan a central role in itsF opertion, at the cost [t Otatjnanr growth. The -ern factorN that had [n exchange tr Franlce s guaraintee ofctonvertibili-v. corributed to rhe credibilit- and s,abilir- of the CFA member countric, urrender the tight t) print ncs. cur- zonc now nmade it extAremely difficiult to devalue rhe renev. Polio changes require malrilateral ncgOtiations CFA franc. B3 rth carlv l1(.-Is. howe-vr. a consensus among the meniber tratec and France. short if vith- "ar fnally reche t hat a devaluatio.n .a ncce arn. dra ing ,,completely from the 7onc. a singl country A 5iX percent de, aluarion v aŽ announced in lanit- cannot unilaterall' renege on its comm'ment. dry 1 !-j lts dramatic stue signaled that the de'alua- Compared mrh %imilarly endol .ed neighh-rs zone [ion %as a oncq-andi-bd-.r-all measure. Thus its benefits niember- exprneri,nJl looer 3 -rag icnlation and taŽrer could be reaped uithc.ut unde rnmining the fututr cred- Lrwh rh rhroughout the I tPO and earls Il-c Bi th ' ibilir- (of the fixed excharne rate. Indications to- date second halt oftrhe l l.O, ho%exer. certairn costs ot one suggest that the de aluaEoln has pro ed c largelv- ucce5- membership had becomlie apparent. Thc CFA zone was ful on both counts. and communications. They are also goods whose provi- As World Development Report 1994 highlighted, pub- sion can dramatically affect the welfare and life prospects lic investment in infrastructure boosts private activity in ofthe poorest in society. developing and industrial countries alike. A study of eighty-five districts in thirteen Indian states found that Public investments in health, education, and infrastructure lower transport costs led to considerable agricultural yield high returns expansion by making it easier for farmers to get their Access to safe water and the control of infectious disease goods to market. More broadly, competing for new export are public goods and services with large externalities that markets requires high-quality infrastructure, to transport will be underprovided, or not provided at all, by the pri- goods large distances at lowest cost. vate sector. Infectious diseases still account for a large pro- portion of deaths in developing countries, and the poor Yetpublic resources often do not go to these suffer the most. Nearly 1 billion people in the developing high-return investments world lack access to clean water, and 1.7 billion have no The world over, too few resources are devoted to vital sanitation. Water-borne diseases such as cholera, typhoid, basic services. Governments spend roughly $1 per capita and paratyphoid remain a pervasive threat in many devel- on public health, against a minimum requirement of oping countries, especially for the poor. Evidence from $4 per capita. About 130 million primary-school-age chil- Malaysia shows that traditional public health interven- dren-60 percent of them girls-were not enrolled in tions, such as immunizations and provision of safe water, schools in 1990. Half the children in Africa do not go to can make a significant difference in rates of illness and school. Girls, the rural poor, and children from linguistic death, especially in infant mortality. and ethnic minorities are less likely to be in school than Returns to education are especially high at the primary others. level, because universal basic literacy yields large external- Part of the problem is misallocation of resources across ities to society. Educating girls, for example, is linked to sectors-among defense, state enterprises, and social ser- better health for women and their children and to lower vices, for example. In many developing countries, state fertility rates. Many attribute a good part of the East Asian enterprises produce goods that private markets could sup- countries' economic success to their unwavering commit- ply; the funds these enterprises absorb could be better ment to public funding for basic education as the corner- spent on public goods. Turkey's state-owned coal-mining stone of economic development. company lost $3.5 billion between 1990 and 1996. Tan- SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 53 zania's central government spent one-and-a-half times what it spent on public health to subsidize money-losing Figure 3.6 In Vietnam, the benefits of hospital state enterprises. In low-income countries state enter- care are skewed toward the better-off prises' losses averaged 2.3 percent of GDP between 1978 and 1991. Share of total spending Another part of the problem is the misallocation of N eSe;.n,-rre1-t,cr, uncE" resources within sectors. Spending on infrastructure and QUintil, social services tends to be concentrated in areas where 2 . markets and private spending can meet most needs- urban hospitals, clinics, universities, and transport- | i r rather than on essential public goods. These expenditures often benefit the rich disproportionately, while the poor _ . receive only a small fraction. For example, governments often try to finance the S,.:uni entire range of health care services. Yet public health inter- OLure p., .,esr ,JI11-,tle ciutInule ventions directed at improving the health status of large l . sections of the population, including the poor, warrant a higher priority. Mvlost curative heatth care is a (nearly) pure c. ari 1 I'll .1.: 3 .:,r, 1 ':t private good-if government does not foot the bill, all but the poorest will find ways to pay for care themselves. This may explain why the public provision of clinical care ser- vices had no effect on health status in Malaysia, where Making better use ofpublic resources people have the option of using private clinical services. To focus public resources more efficiently on providing Although some governments are beginning to spend collective goods and services, countries will need to reallo- more on primary and secondary education, higher edu- cate expenditures and learn to use their resources more cation is still heavily subsidized relative to other tiers. efficiently. In many countries this will take both political Whereas the Republic of Korea, for example, allocates 84 and institutional change. The vital first step in institu- percent of its education budget to basic schooling, tional change is a readiness to embrace a pluralistic Venezuela allocates just 31 percent. Thirty-five percent approach to delivery: to permit private participation while of Bolivia's education budget-but only 11 percent of focusing direct public involvement on genuinely collective Indonesia's-is allocated to higher education. The tilt goods and services (although, as discussed below, govern- toward higher education is most acute in Africa, where ments might also choose to subsidize needy groups' con- public spending is about forty-four times greater per sumption of goods even when the returns are wholly pri- student in higher education than in primary schools. At vate). Viewed against the common postwar presumption the extreme-in Tanzania-the ratio was 238 to 1. that infrastructure and social services are the exclusive This emphasis on clinical health services and higher domain of public monopolies, pluralistic approaches education entrenches social inequities. Evidence from might seem radical and untested. In fact, private and com- Vietnam confirms that wealthier groups benefit dispro- munity participation in infrastructure and social services portionately from hospital care: the richest fifth of the has a long historical pedigree (Box 3.6). population are estimated to enjoy some 30 percent of the Only in the twentieth century did governments, first in benefits of hospital spending, while the poorest fifth get Europe and later elsewhere, become important providers only 11 percent (Figure 3.6). of services, in extreme cases excluding the private sector Government decisions about what kind of services to altogether. This transition to a more pervasive govern- supply are not the only reason why the benefits of public ment role evolved differently for different services and in spending are unequally distributed. Differences in different countries, giving rise to wide variation in pat- demand, especially those related to gender, are also impor- teins of financing and delivery within and across income tant. In Cote d'Ivoire, for instance, almost two-thirds of groups. Among low-income countries, for example, the public spending on education goes to boys. In Pakistan, private share of total education expenditure ranges from boys benefit from about one-and-a-half times as much around 20 percent in Sri Lanka to around 60 percent in public spending on their education as do girls. Often the Uganda and Vietnam (Figure 3.7). The breakdown of relative disadvantage of girls is even greater in poorer health spending shows similar variation. In Latin America households, reflecting differences in demand in these the private share ranges widely: from one-third of total households for education for girls and boys. health expenditures in Ecuador to 43 percent in Mexico 54 WORLD DEVELOPMENT REPORT 1997 Box 3.6 Private provision of social services: A historical perspective O)nl- in the rtwentieth century did the h rasc assume an borhood doctors. Nor until the tirsr antibiorics were importinE role in pro) iding social vervices such as edu- mass-produccd after World War 11 did W\Vesrern medi- ca[ion and health care. The abilin ot [he tate to prro- cine begin to benefit large groups of people. In de%el- 'ide these ierniccs ha \ aried. hovve%er resulting in dif- oping countries. increased urbanizacion and indusrial- terent public-privaie mixes. izarion led ro the formation of labor groups. which Todas s niodern eucathuion sx stems were i imnded on organized rheni,elxes to provide health insurance privare -:.ten relhious-initiatves. From the Islamic through sickness funds" or pres'ted for publicly ichook In lndonc!a and \X-e-r .Africa to the Hindu urus tinanced social insurance i!'strms. Br 1990 sixteen Latin in India. the Chritan churches in mosr ot Europe. and American couintries had enacted laws ro prov-ide health the village teachers of China. private religious schools insuranct to selected grolps. but only two Atrican and ha%r been reachinm children for ccnrurcs. In ;,eneral. four Akvlan rations had done it". howetr. educat[ionl '.&s a privilege of the elites. Nliss The Internarional Conference on Primarn Health public luc[aioln isa nineteenth-cen[un inmenrion. ori- Care. held in Almna-Aia. Kazakstan. in 19-9. pro- inacing in Europe and Norch America lnd spreiding to claimed health a "basic human righ" a3nd urged gav- former coli,mies afrer independence. Signi`i,inr public ernmenrs to tiake re%pons!bilin ftor the health of their insesEmenc led to e\panidine public sector enrollment>. people." Several go'ernmenrs in de%eloping countries accompanied in sev-cral coUntries by a shrinhng role for created national health svstenis that purporr to provide private chools In Nlalav' i. for example. enrollment in frec medical Lare tc. the entire population. These etibris prm iae primar'- schoolsk eni from -- percent of the total niet ;ich mixed success. and the private sector e:- in 1*56to li iJ percent in 1'1V9'. Ekchcre the inabilir. of panded to Fill the void. In Malaysia, for example. physi- govcrnments to keep tip wiJth demand or overcome div- cians in private pracrice rose from -s percent of the satistaction with public school qaualr led to an increase total in I'-5 [c. 0 pcrcent of the totl in 1'J90. But in pri% 4tr school enrollnments. large parts ot'[he population s[ill lack access to basic ser- Historicllsk most melical sern-ics %%ere priiatelv xices. tihilt others rely chiet%lon private providers paid provided by midl. i%es. traditional healers, and neigh- our of pocket. and 57 percent in Brazil. Eighty percent of health expen- be delivered privately (sometimes, as we see in Chapter ditures in Thailand are private. 4 for utilities, taking advantage of these new opportuni- In many settings unbundling the delivery of infrastruc- ties may require new regulatory arrangements) ture and social services can help achieve a better match * To increase the transparency of the uses to which pub- between roles and capabilities. In bundled systems of deliv- lic money is being put (much harder when many diverse ery a diverse array of activities-private and collective, sub- activities are bundled together within a monopoly pub- sidized and unsubsidized, competitive and monopolistic- lic provider). are all undertaken by a single public provider. When services are unbundled, it becomes possible: Yet organizational changes will not do it all. Perhaps the most important change in the incentive environment * To distinguish between activities that could be financed is to empower users themselves with "voice"-not only to and delivered entirely through private markets, and work in partnership with providers where localized infor- those that have important collective elements-and to mation is key to efficient delivery, but also to monitor begin to shed the former providers' performance and to enforce, through the polit- * To distinguish between those collective activities whose ical process, a commitment to quality. How this can be delivery should remain in public hands, and those achieved is the subject of Chapter 7. whose financing should be public and their delivery otecting the vulnerable private-with vouchers, contracting, and similar mech- anisms providing the bridge between the public and the Over the long term, rapid growth and investment in peo- private sector (Chapter 5 explores these options in ple will cut poverty dramatically. Yet regardless of a coun- more detail) try's income level-and regardless of the gains accruing to * To take advantage of new opportunities for competi- the economy as a whole-some citizens will be left be- tion among the array of goods and services that can now hind, and others will suffer temporary hardship. This sec- SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 55 Figure 3.7 The balance of private and public education differs enormously worldwide Prl%a1e education spendling t,erceitage of total education sperfruiCe Atstii-a Israel Linired States High-income Filnianri economies SxvitierIana 1 South Africa Iran. IslamiTc Rep. of Cvprus Middle-income Coltcri,,bn _ economies lnrdonesia Sri Lanral Uganoa -FLow-income Uganda economies Vierrnaa, Hail, 0 110 20: 30 _I0 5, 60f 7i) 8e^) C41) 0f i4ote D ta are for .anr,us .C.ear i, ,*neein 1. and 1Y9C 99 e. P a:arirorx.I:': 3r,1 i<.l 1NUr tion examines how states have wrestled with the challenge vulnerable in industrial societies. These three programs, of protecting the vulnerable. pensions especially, absorb a rapidly increasing share of national income, and rich countries around the world are A wide variety ofprotective measures revisiting some aspects of their welfare programs (Figure Table 3.1 offers a glimpse of the rich variety of initiatives 3.8). Even Sweden, where the commitment to the welfare governments have tried to protect the vulnerable in devel- state remains firm, and which has an unrivaled record in oping countries. All of these initiatives fall into one of two eradicating poverty, has embarked on wide-reaching broad categories: reforms to find a better balance between the social bene- fits and the heavy-often invisible-economic costs. * Pension, unemployment, and other social insurance In Central and Eastern Europe and the former Soviet programs aim to support people who-for reasons of Union the state has traditionally provided a wide range of age, the business cycle, or other circumstances-are social services. Before their transition to the market these outside the wage economy for some part of their lives. states offered comprehensive benefits, but they differed * Programs of social assistance aim to help the poorest in from those in industrial market economies in four respects. society, those who are barely able to support themselves. First, because the system was premised on full employment guaranteed by the state, there was no unemployment insur- In industrial countries the universal welfare state, ance. Second, social protection focused on those (such as which has influenced welfare programs around the world, the old and the disabled) who could not work. Third, ben- has blurred this distinction. Most of the main transfer efits were decentralized at the firm level. And fourth, in- programs-pensions, unemployment insurance, family kind subsidies (housing, energy) played an important role. assistance-began during the 1930s and 1940s in re- With an unprecedented economic contraction and sponse to the Great Depression and World War II, and tight budgets accompanying transition, some countries in following the realization that the elderly were especially Central and Eastern Europe and the former Soviet Union 56 WORLD DEVELOPMENT REPORT 1997 Table 3.1 Social insurance, social assistance, and poverty-targeted programs in developing countries: Characteristics and lessons Coverage and Program type regional patterns Design issues and lessons Positive stories Pensions Nearly universal in transi- Actuarial imbalances. even in some countries with Innovative schemes in tion countries, very low in young populations, threaten macroeconomic stabil- Argentina and Chile Sub-Saharan Africa, ity, especially in transition countries, Brazil, and medium to high in Latin Uruguay. Transition countries need to increase America Pay-as-you-go pensionable age. Separate redistribution from schemes dominate. insurance. Family Included in middle- to Family size correlates highly with poverty in the assistance high-income countries as Central Asian republics but not in Eastern Europe part of social insurance. It and the rest of the CIS. Poverty incidence deter- is universal at the enter- mines the degree of progressivitv. Where inci- prise level in transition dence is low, means testing is crucial to contain- economies. ing cost. Social Limited in transttion coun- More suitable to countries with relatively low Chile's family subsidy assistance tries. rare in Asia, nonexis- poverty incidence. and old-age social (cash) tent in Latin America and assistance pension Africa. General price subsidies Open-ended price subsidies are fiscally unsustain- Tunisia's price subsidy Food dominate in Africa and the able. distortionary. and regressive Leakages can reform. which reduced subsidies Middle East. Quantity be prevented by innovative targeting. Nutrition pro- costs by 2 percent of rationing is prevalent in grams are more cost-effective than quantity rations GDP and improved tar- South Asia. Food-for-work or general subsidies Programs that set work geting; 1993 Food for schemes are used in Latin reqruirements are more cost-effective than rations Education Program in America. Countries are Political economy often entails an urban bias. Bangladesh shifting toward food stamp and targeted programs. Housing Prevalent in transition Often regressive. Urban poor are best protected by Chile's one-time subsi- subsidies economies. mostly on- increasing and encouraging low-cost housing pro- dies for housing pur- budget; less prevalent in duction. Community organizations and coopera- chase on the private other regions, mostly off- tives have been more successful at targeting. Sub- market budget. sidies in the former Soviet Union complicate functioning of housing and labor markets Energy Prevalent in transition In Asia, Africa, and Latin America gasoline subsi- subsidies countries and oil-producing dies largely benefit the nonpoor They are also countries, such as somewhat regressive in transition countries Venezuela. because of their importance in the consumption basket of the nonpoor Elimination of subsidies would affect the urban poor. Public works The Maharashtra Employ- Provide both insurance and assistance. They are India's Maharashtra ment Guarantee scheme appropriate in areas where poverty is transient scheme: Korea's intro- in India and social funds and there is scope for unskilled labor-intensive duction and cancella- in Africa and Latin America projects. The program wage should not exceed the tion of work program are funded domestically prevailing market wage. In-kind payments attract and by international more women. donors. Ciedit-based Prevalent everywhere Main problem is the inability to borrow in the Grameen Bank in programs especially in Africa. South absence of collateral. Programs should subsidize Bangladesh Asia, and Latin America. transactions costs but not interest rates, use local groups instead of direct targeting programs, orga- nize beneficiaries, and incorporate incentives to both borrowers and lenders to enforce repayment. Incorporate saving as a necessary component Source Adapted from World Bank 1996e. SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 57 Latin America, reflects the shift to nonfood aid and greater Figure 3.8 Pensions and other transfers have cooperation with nongovernmental organizations (NGOs) crept upward in the industrial countries and community-based groups in the delivery of targeted assistance. Labor-intensive public works programs have Perceniage al GDP risen in popularity, particularly in South Asia and Africa. 12 In many countries, social insurance and assistance pro- grams have failed to achieve their objective of protecting 10 _ z the vulnerable. Often they have resulted instead in trans- fers of resources to elite groups, sometimes with fiscally 8 destabilizing consequences. New approaches are begin- ning to emerge for both insurance and assistance. We examine each in turn. Social insurance-options and hazards The generosity of social insurance programs has sometimes - ,l,,.-wrought havoc with long-term fiscal policy. As Table 3.2 2 suggests, in many countries the liabilities implicit in indi- viduals' accrued pension rights far outweigh any reasonable measure of the government's tax-raising capacity. 1965 19,'0 1975 19SO .1985 199'0 Demographic changes partly explain these ballooning pension liabilities. Aging populations account for more ric,iu See ir,_ T=cv,r :., l.x (r fo,o 5Solrce L;'.. .r,ciu, than half of the expansion of pension and other welfare e.r, OECEt 1.,-` benefits in the OECD countries over a recent thirty-year period. Ukraine and Hungary, too, have older popula- tions, which partly account for their high implicit pension are beginning to realize that this system of universal cov- debt. Demographic pressures on pension programs are erage is no longer affordable and must be replaced by likely to intensify especially rapidly in some developing more-targeted programs. Cash transfers as a percentage of countries. China's over-60 population will double from 9 GDP are high. But adapting the welfare system to the new to 18 percent of the total in thirty years-a transition that conditions is proving politically difficult. In Poland trans- took a century in France and Britain. fers doubled from 9 percent of GDP in 1988 to 18 per- cent in 1993. In contrast to the OECD countries, the vast majority Table 3.2 Implicit pension debt in selected of developing countries have created "oasis" social insur- countries ance systems, which grant family benefits and pensions to rperce nEag5e WI GDPI formal sector workers and civil servants. The size of this Implicit pension debt oasis increases with income per capita. It covers 6 percent Country of governments of the labor force in Sub-Saharan Africa, 23 percent in UrugLi&v 29rz Asia, and 38 percent in Latin America. Formal unem- iur.gar-y 2 ii ployment insurance is rare, but the use of the public sec- SziI tor as employer of last resort is a form of disguised unem- Ukraine 1-1 ployment insurance. cr 6 Developing countries have also experimented with a Carner,on 4- variety of social assistance measures for meeting the basic Peiu U needs of the poorest. These have ranged from programs Co)rngo that bundle cash assistance and insurance, to price subsi- Serne.pa 27 dies (food, housing, energy) and labor-intensive public M"1J 13 works (Table 3.1). The design of social assistance pro- Ghansa grams has often been heavily influenced by international Burt r,a Faso 6 aid. The prevalence of food aid from the United States in 1 1.A, .E;'Ce ., a S L ''.er 19^') anl 1" 6 ,n, the 1950s and 1960s, for example, led to the adoption of ,- ,,; e Sl .slcul.;IC St .5 d5:.)'. ''e ol r many food-for-work programs, particularly in South Asia. s, ,0. ra,;e 3- . I Ps''.:s , The emergence of social funds in the 1980s, especially in 58 WVORLD DEVELOPMENT REPORT 1997 economy (generally the targets of insurance programs). Box 3.7 The new Chilean unemployment Experience suggests that failure to make this distinction is insurance scheme virtually certain to undermine both the fiscal viability of insurance programs (because the "insured" can lobby for Chile ha4 i 3 ccrunce pak chemne but no sr-cmn unfunded benefits) and the impact of assistance programs of unempl.o%mrnnc. inurance. Tht ,xcrnnicni ha, (because nontargeted groups are likely to capture re- drateid a lav. io creaie one ecalled PROTA(ik. The sources intended for the poor). desi, rd :, chrnme dep ii Crum modek pre'.ail- With insurance clearly distinguished from assistance, in, in [he OECD cio'[rarics. The prop,sed shrme states can bringprivate participation and competition into criei to circuncnr [he disincen,r ec tc '.rk often insurance systems previously dominated by public a.:, iared with unep[noi-menr insurance. Ir iould monopolies. This can be done in several ways: crea[e dIII Idu-al.31 .iCCC'tiE rc w' hich workers ind cmplo'.er. WOUld i.ini!% conrriburc -4-i ercent ol The redistributive component of pensions can be un- rhe ;'o rker i ;jlan Th c icouni, %iould accumun- bundled from the saving component through a manda- lae L ip ti- m rnrh- of ;alin- and %%.Wld be pri- tory multipillar system, with the saving pillar fully j[elk nmlnaged. poF-°ibv b,- th -.n In(I.uuon. funded, privately managed, and publicly regulated. ch.a nrov nianage Chile s priv.wice persion>. A laid- Redistribution can be accomplished through a flat pub- off %rkr %-. -u!d recce ;ei.erinc- p3V of one lic pension (as in Argentina). nr,c.rirh et s-arv pcr %car ',t .en ice. . a m.c.imum * States can introduce mandatory savings accounts for o0 toe -e,ar;. and c.:uld nmak,e p c t1ke nonthly unemployment insurance, as well as pensions (Box 3.7 N%-i[hdrwA-l, Iromn hiF or her individia.l a-C1omLnt describes a Chilean initiative along these lines). A hilt uncmplo.ed. \orlrk,.r-r c Ahu became uncm- * Companies and individuals can be allowed to choose pliowd folo%. inme a resign .run 'ould only- bc nni- between public and private providers, as in Japan, Sri [kcd to the n,.nchlt xmrahdr%i'alxs The S(tvu V oUld Lanka, and the United Kingdom. reguilac rchee ui,nimpl.-- mcnt inE u r3nCe aCCou)nUS * Management of the assets of public insurance programs and ouaranree: minimn"Lum LnernpIo. men[ benc6c. can be contracted out to the private sector (as in X i[h pen';lo)n. [hi mnirunl.ll cuarmntZee'a ould Malaysia). be pro%ided only after lurads in the accounl irc * States can enlist independent professionals, rather than exh iu5ced. The indi:-idUll account w%ould thus act political appointees, for the boards of trustees of public a, a dediciublc. programs. Of course, private provision of social insurance is only workable if financial markets are well enough developed But at their root the problems go beyond demograph- so that private intermediaries can readily match these ics. Civil servants in many countries view their pensions as long-term liabilities with long-term assets. Yet even in an entitlement, rather than a form of savings: they make poor regions such as Sub-Saharan Africa, thin capital limited contributions to a retirement scheme but receive a markets need not be a bar to the development of private full salary as pension after thirty to thirty-five years of ser- pension funds. Given an appropriate-and enforceable- vice. More generally, influential constituencies success- legal framework for financial sector development, coun- fully lobby for transfers from the budget, which they are tries could set up regional equity markets. This is a par- unwilling to see scaled back even in the face of a severe ticularly attractive option for countries of the CFA zone, fiscal crunch. Or, as in some African countries, public which share a common currency. Already some equity bureaucracies direct toward themselves resources intended markets in Sub-Saharan Africa compare favorably in for social insurance or for vulnerable groups. terms of market capitalization with those in Latin Ameri- Whatever the cause of these problems, unless social can countries that have recently privatized their pension insurance can be put on a sounder financial footing, either systems (such as Peru). the programs will collapse, or countries will be plunged into deep fiscal crisis, or both. An essential first step Sustainable approaches to social assistance toward reform is for governments to distinguish between Unlike social insurance, which can be self-financing, social the goals of insurance and those of assistance-especially assistance requires direct expenditure of public funds. Bal- in developing countries where the gap is often vast ancing the objectives of poverty alleviation and fiscal pru- between the poorest citizens (generally the targets of assis- dence is thus vital to success. (Table 3.1 summarized the tance programs) and those who participate in the formal wide variety of approaches that have been tried.) In the past SECURING THE ECONOMIC AND SOCIAL FUNDAMENTALS 59 the debate was primarily over the relative merits of broad- The challenge of sustaining programs of social assis- based subsidies and means-tested programs. Today, the tance is political as well as fiscal: since the marginalized limitations of both have become more apparent. poor are politically weak almost everywhere, in times of Because means-tested programs (in which benefits are fiscal belt tightening even prudently designed programs set according to the recipient's income) are administra- risk losing support. Self-targeted programs-especially tively demanding, they are likely to achieve their goal at those that impose reciprocal obligations on recipients- reasonable cost only in countries with strong institutional seem more politically resilient than those targeted more capability. But broad-based subsidies have also lost their narrowly, but they too are vulnerable. At its root, then, appeal: they are expensive and relatively inefficient at the task-explored in Chapter 7-is to find ways of giv- reducing poverty. Housing and infrastructure subsidies, ing voice to the concerns of the poor, enabling them to for example, turn out to benefit higher-income house- become more effective advocates of their own interests. holds disproportionately (Figure 3.9). Food subsidies can be more effective if they are targeted toward items consumed primarily by the poor. Tunisia has effectively Each of the four sets of economic and social fundamentals moved from a nontargeted to a targeted program by elim- poses distinctive challenges, but all have some challenges inating all subsidies on goods consumed disproportion- in common. ately by the nonpoor and, for those food products still First, prioritization is vital. As this chapter shows, in all subsidized, by differentiating product lines through dif- too many countries the state still does not provide the full ferences in packaging and the use of generic ingredients. complement of core public goods and services: a founda- These reforms have reduced the cost of food subsidies tion of lawfulness, a stable macroeconomy, the rudiments from 4 percent of GDP in the mid-1980s to 2 percent of public health, universal primary education, adequate by 1993, while still maintaining a food safety net for transport infrastructure, and a minimal safety net. At the the poor. same time states are overproviding a wide variety of goods With both means-tested and more broad-based assis- and services that private markets could supply in their tance programs increasingly in question, attention has stead. Especially in countries with weak institutional capa- shifted to self-targeted approaches. One approach is to bilities, the need is therefore urgent to focus the state's focus delivery on those localities, urban and rural, with role on the fundamentals. disproportionate numbers of poor residents. Another is to Second, skillful use of private, competitive markets and set the level of benefits low and build in some kind of quid voluntary activity can support development while sharply pro quo. Food-for-work programs incorporate these fea- reducing the burden on states with weak institutional tures. So, too, do lending programs for microenterprises capabilities. Market-led growth in a supportive incentive in poor communities. Box 3.8 illustrates how Indonesia, environment is fundamental. Additionally, markets can which has made huge strides in reducing poverty through provide a variety of private goods and services that in broad-based growth, is initiating a variety of self-targeted many countries have somehow wandered into the domain programs in an effort to eliminate poverty by 2005. of public provision, such as higher education, curative Figure 3.9 Housing subsidies in developing countries mostly fail to reach the needy Per cenlage of suts,idies reacrningr- iousenold hlenov toe n,edrari -intoncme SouLth Asia Latin Anmerica and Carbbearn Sub.Sariarr .Africv Middle East and North Africa East Asia Higdh-inconme OECD O If! ':0 d 2li 5( l 9( Hore: aria a*re flry: ,- R_. Source. WcprI.1 R 60 WORLD DEVELOPMENT REPO3RT 1997 Box 3.8 Reducing poverty in Indonesia-how social assistance complements broad-based growth Indonesia's rapid and broad-based grctivh has had a 2.11)(0 villagv--the poorest one-third o,f all spectacular ehecr c,n povermy reduction. Berneetn 19)-1 Indonesian villages-ro be u,ed ae seed capital for and 1'.90 the proportion of the population living income-generating actiVities. The program is com- below the official povern line dcclined from -56 to 1S bined with public wNorks prograrms. percent: ocher indccarors of txelfare. such as infant U The Prosperous Family progrim. launched in 1996. mortalinr, sho%%ved s!milar improvement. The goern- aims to improve tbe conditions of families living in menr has now ser irself thie ambitious targer of eradi- non-IDT village,. and w%hose livingc, standards are caring absolute pc%errv within the next decade. The belos a certain level. through small grants and sub- challenge is that the remaining poor are concentrated sidized credit. in isolated pocket, of poverrty itEh poor natural U Under the Transmiuratcion Program about -h)(,000 resource endou%menti. low poptdacion densiri&e, and families, or over 3.o million people. have been reset- oIrher socioeconorrmic characteristics that make them tled at government expense from overpopulatedjava difficult to reach. Several tarneied interventions have to less populated outer islands. The program aims to been initiated in recent ears,. including the followking: address landlessnes-, as a cause of poverrv and provide new- serler; vith aericiLdmrcil land and other henefirt. * The Inpres Dna Teriinggal I[IDTI program. launched U The Kaampung Improvement Program is xargeted at in l9Pi;i. i dirt-eted at villaces that the country's impro\ ingr he provision of social sen-ices and infra- dev-elopment has left behind. The progran distrib- structure to densely populated. low-income, urban utes grants tot sling b20i- nmillion per year among neighborhoods. health services, and pensions and other forms of insurance. Finally, states should seek ways to enhance the credibil- In a range of other areas-using social funds for poverty ity of their actions. In the short run, while weak domestic alleviation, enhancing the quality of primary education, institutions are being reinforced, stronger ties with external encouraging participation by NGOs and communities- actors-for example, through stabilization programs with reform can greatly improve service delivery. Countries the IMF-can help governments signal their commit- with weak public institutions should assign high priority ment. In the long run, however, as Part Three explores in to finding ways to use markets and involve private firms depth, the vital challenge is to build homegrown commit- and other nongovernmental providers in service delivery. ment mechanisms, rooted in domestic institutions. FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY F EW DISPUTE THE CENTRAL ROLE OF THE STATE IN Many countries with weak institutional capability are securing the economic and social fundamentals saddled by their history with governments whose reach is discussed in Chapter 3. There is much less agreement, overextended; for them, privatization and market liberal- however, about the state's precise role in regulation ization is a key part of the policy agenda. As capability and industrial policy. A counterpart to the rise of state- develops, public organizations and officials will be able to dominated development strategies in the early postwar take on more challenging collective initiatives, to foster years was a dramatic expansion in government regulation markets and to make increasing use of efficient-but dif- in many countries. As countries have liberalized, those ficult to manage-regulatory tools. aspects of the regulatory framework that have proved counterproductive are being abandoned. But govern- Prextzndad liber ments are learning that market reforms and fast-changing overextended states technology pose their own regulatory challenges. States Interest has revived in finding ways for the government to cannot abandon regulation. The task, rather, is to adopt work with the private sector in support of economic devel- approaches to regulation that fit not merely the shifting opment, and to provide regulatory frameworks supportive demands of the economy and society but, critically, the of competitive markets. Yet in all too many countries, state country's existing institutional capability. and market remain fundamentally at odds. Private initia- Attention to the proper match between the state's tive is still held hostage to a legacy of antagonistic relations role and its institutional capability helps reconcile some with the state. Rigid regulations inhibit private initiative. seemingly clashing prescriptions for state action. Many, And state enterprises, often buttressed by monopoly privi- for example, would argue that, in complex industries such leges, dominate economic terrain that could more fruit- as telecommunications, regulators ought to have consider- fully be given over to competitive markets. At the extreme, able flexibility in devising and implementing market rules. a mass of inefficient state enterprises blocks private Yet where institutional capability remains weak, the scope dynamism entirely, even as it imposes an unmanageable for flexible initiatives is limited; the focus should instead fiscal and administrative burden on the rest of the public be on winning credibility with firms and citizens, convinc- sector. In such countries the first step toward increasing ing them that the state will follow through on its com- the state's effectiveness must be to reduce its reach. mitments and will refrain from arbitrary and capricious The recent economic performance of such countries as action. China and Poland provides dramatic evidence of the ben- The same applies even more forcefully to more inter- efits of shrinking the state in former centrally planned ventionist policies-those aimed at not merely laying the economies. But relaxing government's grip, whether that foundations of industrial development but actively accel- grip is maintained through public ownership or regula- erating it. In principle, there seems to be room for gov- tion, can also yield large dividends in more mixed eco- ernment to play such a role. But in practice its scope for nomies. It can: doing so turns out to rely heavily on a range of stringent institutional conditions being fulfilled. Except where role * Free up public resources for high-priority activities. and capability have been skillfully matched, activist indus- Diverting subsidies away from money-losing state trial policy has often been a recipe for disaster. enterprises and toward basic education would have 62 WORLD DEVELOPMENT REPORT 1997 Table 4.1 Estimates of welfare gains from deregulation in the United States 113illrons of dollars Gains to Gains to Total Further potential Industry consumers producers gains gains A, l1, f I ez S S-14.S 4.9 13.7-19.7 4.9 Raolroaos 7 2-9.7 3.2 10.A-12.9 0.4 TrljcFing 15.4 I -48 10.6 0.0 TelecCrninAi-cartsor,s 0.7-1.6 . . 0.7-1.6 11.8 Catrle teIevior :1.4.1.3 0-1-1.3 0.4-0.8 Bro.er.sgr .1 -0.1 0.0 0.0 riJaur.sl ga . .. .. 4.1 Total 32.313 3.2 35.8-46.2 21.6-22.0 rJ)I ;:,I.;l increased central government education expenditures and other objectives preferably at most secondary in by 50 percent in Mexico, 74 percent in Tanzania, and importance 160 percent in Tunisia. * Clarification of the criteria to be used in assessing * Pave the way to better, cheaper services. Divestiture of which regulations are useful, which should be dis- state assets had positive effects in all but one of twelve carded, and which should be strengthened to com- carefully studied cases in Chile, Malaysia, Mexico, and plement privatization the United Kingdom. The benefits came in the form of * Preparation of financial statements and public bud- increased productivity and investment as well as more gets (including information on borrowing from efficient pricing. Deregulation in five hitherto tightly banks) to assess which state enterprises are money- regulated sectors in the United States had by 1990 losers and uncover the reasons for their losses yielded gains of $40 billion (Table 4.1). In Argentina, * Specification of open and competitive mechanisms liberalizing harbor terminals in Buenos Aires led to an (such as auctions) for divesting state enterprises. 80 percent reduction in fees. * Unlock opportunities for private sector development. Such efforts have an added rationale. Often they will Excessive regulation can inhibit market entry, fuel the show whether or not a country is truly ready for reform- growth of informal activity, and even create new indus- whether key political actors want reform and find it polit- tries solely devoted to helping firms navigate the regu- ically feasible to translate that desire into action. If politi- latory maze. Eliminating these excesses enables markets cal will is lacking, further efforts will be wasted. Indeed, to function more flexibly, at lower transactions costs. they may prove counterproductive if interpreted as another in a long line of arbitrary shifts in policy. The challenges of scaling back the overextended state With the initial preparation done, the second phase of are as much political and institutional as they are techni- reform is to put in place a business environment that sup- cal. Success relies on the ability to proceed with reform in ports competitive private markets. Such an environment the face of opposition from powerful groups who benefit includes rules of the game that facilitate entry and com- from the status quo. Chapter 9 examines how reforms in petition, and a complementary institutional, legal, and general can most effectively be initiated and sustained, regulatory framework that can undergird property rights Here we focus more narrowly on programs of market lib- and markets, including (notably) financial markets. eralization and privatization. The economic advantages of early reform of the busi- Initiatives to foster market liberalization and privatiza- ness environment-even before privatization-are sub- tion can be segmented into three overlapping phases: pre- stantial. One advantage is that fostering external and paring for reform, establishing an enabling business envi- domestic competition ensures that many of the benefits of ronment, and privatizing (or liquidating) state enterprises. privatization will be passed on to consumers, rather than Transparency is the vital ingredient as governments begin simply result in a transfer from public coffers to private to prepare for reform. Ideally, transparent preparation monopolies. Otherwise the latter are likely to become includes: powerful, entrenched interests, willing and able to stifle subsequent efforts to introduce more competition into the * An explicit statement of the main objective-to un- economy. A second advantage is that, if clear regulatory leash a competitive market economy-with fiscal structures are in place, bidders will have a better idea of FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY 63 the economic potential of companies being privatized- A strategy of "growing out" of state dominance appears the risk premium will be lower-and government will to have worked in some East Asian economies. But else- receive higher bids. where economic and political considerations will favor More broadly, liberalization of the business environ- keeping privatization on the front burner. Delay imposes ment can be a powerful catalyst, setting off a virtuous three major economic costs. First, money-losing state enter- spiral whereby each reform makes the next one easier. The prises may continue to drain money from the public coffers stronger the business environment, the greater the range (or from banks in the form of never-to-be-repaid "loans"). of opportunities and supports available to entrepreneurs, Unless such losses can be contained, the resulting fiscal bureaucrats, and workers-and thus the weaker the polit- instability can undermine an entire reform program. Sec- ical opposition to dismantling dysfunctional rules and ond, anticipating privatization down the road, managers agencies and liquidating or privatizing state enterprises. and workers in state enterprises can be tempted to steal the The challenge is finding a way to set this virtuous spiral in company's most valuable assets while the going is good. motion. For at the outset those who prosper under the Third, poorly performing state enterprises may obstruct dysfunctional system will have much to lose, while the liberalization and restructuring in other sectors. In Zambia eventual winners are unlikely to have reached the critical market liberalization created opportunities for smallholder mass needed to lobby for their own interests. Box 4.1 farms to expand production and exports of cotton. But describes how Mexico was able to overcome initial resis- before being exported, cotton must be processed, and for tance to the rollback of regulatory controls. some years after liberalization virtually all the country's Because it takes time for the business environment to processors were under the control of a monopoly state become supportive-and because privatization becomes enterprise. Once the sector was restructured, the pace at easier as the environment improves-reformers may be which farmers and businesses took advantage of new mar- tempted to give privatization a backseat. This is precisely ket opportunities picked up dramatically. the approach adopted by China and, in earlier years, Given the importance of keeping privatization on the by the Republic of Korea and Taiwan (China). In the front burner, its sequencing in relation to liberalization early 1960s, state enterprises accounted for about half of thus poses some difficult dilemmas. On the one hand, manufacturing production in Taiwan (China) and one- privatization will yield greater economic benefits, and quarter in Korea. By the mid-1980s their share had fallen impose fewer hardships on society, if it is preceded by to about 10 percent in both economies-not as a result of liberalization and regulatory reform. On the other hand, privatization, but because of the rapid expansion of their the longer privatization is delayed, the more entrenched private sectors. management of state enterprises can become. Box 4.2 Box 4.1 Mexico's deregulation czar In 1188 che president f Nte.ico appoin[ed a deregu- * ULncqunc.cal prcsidential support. signaling tro both lation czar. Each month rhis official reported direcrlv bureaucrjts arnd ci.-tins the need to comply v. ich to the president and his economic council ot nministcrs, the cZar'i decisioni Evern business in Mlexico. largt or simall. had equal * The fact rhar his decisIons could be oxerruled onml access to the czar's office to complain about burden- at the highest level ot government some rules and regulations. W-hen theoffice received a * Thc setting ot ctugh penalties for officials w%ho complaint, it was obliged to find our w%hy the rule failed to implement the rulings existed. hoim it interacted with other regulations. and * The time limit. which ensuLreed quick and visible whether it should continue in effect The office oper- rcsulrs ared under a strict rimetable: if it did not act to main- * The czar s stalf. w-ho xicre sklilled in he economic tain. re-Ise. or abolish the disputled rule wirthin orn - consequences of reculation. their Intcractions *~ith ti-e days. [he rule vas annulled autromatically, other rcgulaidons. and their admtnistratike require- The work of the deregulation czar over his first four ments-no one perso n can effecik ely carm our a years is w% idely credited with greatly accelerating islex- 'odernment-u;de program of'deregulation ico's reforms. It provided struggling private business- * FinalV. the fact that [he czar \von crcdibilirn \ith people Nith an effective, responsive champion at the officials and with the public by giing a fair hcaring highesr level of government. The factors behind this to the pow,erless and the influential alike. and setting succcss include: a consistent record of imparrialicy. 64 WORLD DEVELOPMENT REPORT 1997 Box 4.2 Six objections to privatization-and how to address them 11% c.; ,.-r,";'ow twit!., cc."' i. it .,[I ,/ I 1. i'i t .1 Ilk.?! JO *'1',iW i' Ais nIvC, ll,',t, ,..r irt , ! 1e - ` l'n'd!-.i'hi [i'd ''.) I HO r.i4 t it 7/OI5c C 'I I tti} ' ' .'L i 'l It .// v'ii r,, to ., I' \-innin the iccluicccnceC e mcplolees IS essential C ertainln. prixati3zarion is cier rif a %elll-furtion- to ucce;tul prl ati:arion. eome coun[ries hbae given in, market econom-. including inancial markets, is share- to cniployce' or pri atized throu.gth employee already% in place. Thui. a key compilment iand. if and man;raLcnieenc bluvot.sCs. Ot.rhers haec offered gener- appropria[e. .inced"cnri .t privarizacion is markce lib- i.us se.eranCc pay. Privacization becomsc easier as eralhzation. perhap, accompanied bytLhe activist initia- countrie dve-;clop progranim to protctI chc %ulnerable. lioeS tosrer markecs described later in tiiis chapter. of [he kind described in Chaprer . Even wo. in most setlings i is precikelc the heavy hand .-t the ovri-cxended tate that is restraining priate J"II'.i .iflO'i2;ll I! jlr.r ./UI,|i.-. il'.2l' h ;lV r.>i;r laci hr--the objection confuses cau'e i ich effect. ./, )%:J V z,-j ,,, ,,u' T' ~,, .'C'' ......... - 4 I,' 'i,~'5 i i!~tS ! ll T/1,?t [IIV. WC. t&i:o :1 /t a#'2f 1! *tIa I .-1.t:, ~It.lri't' hiflOf' U t''c~~ ~ ~ ~ ~~~~~~~~~~~~~~~~~~/ c?4Yi rr *'' p,'p ci lit f/I ii, itt I D.il'/O.vi . Process m.tirers. lrisati:arioni musU be based on Regulator rt;rni i another importaniccc)npanl. c0npertitic biddein. %-![h the cri[eria tor selecing - ment [I) privarizacioi: deregulation to remove arificiaIl b.ters cardu i itonopoly priv ilecei. and dev elopment of a regulator. bc done in the open. in full -;if . bt th edia and sc) s.-ss1em [hat credilbk rvsEr.ains che abusect ofeconornic power in nonconpedlitic marklccs. utN'oIi r1 't'i' i wi .a I Na a I fl! i "t,lti c Iic/ fl.'I I I b-rri Broad-b.ecd us' ner'hip can help %in popular sup- True, ifgovernncncs are twilling to put hird budget port tor pricatizanon. One apprtoach. adopted in the constrauits in place. to allow competitio,n fromn pro ate Czech Republicl.Rssia, anid long,Olia 1 o d[isribu[te tirms, and to ;i.e mnanaeri appropriate incentives. pri1t Eiia[!,ln oiticherS rs!o cti'en;S tO be redvemed for the performance of state enterprises can improxe The shares. Another approach. adopted in Argentina. Chile, sad realiy- is thar. altholugbh somie committed govern- and The Lni[ecd KingLdom. ii tc m3ik an initial public nients have reformed their state cnrerprisces in the short tfferinm of shares to) ctaizen' a atraLctiVC prices. B3.oth term. makiino these retfrnis stick is much harder. approiches c:rin be deigned to make roo.nm t'Or a strong qIfil Lh z-ct.liJIlli po .rr 1983 sptc-ightedl a nunmber srrategc parcncr \irh thc incenrive aind expertise to ot w%ell-perthrming itate Crnerprises around the 5clrld; efiectiselt restructrure the entcrprise. b 1dQ3 a maj lrity of thles had sunk into clceine. describes how reformers opting to push ahead with priva- state needs to own less, and although there is no good eco- tization have tried to contain the risks. nomic reason for state ownership to persist in tradable- goods industries, there is no single "correct" stage in the Rolling back overextended states: Two central lessons reform program to start privatizing. The appropriate timing Experience worldwide with attempts to scale back overex- will depend on the dynamics of reform in each country. tended states suggests that success contains two vital ingre- Botter regulat dients. First is a commitment to competitive markets ion and an accompanying willingness to eliminate obstacles to Skillful regulation can help societies influence market out- their operation. Market liberalization enables new entrants comes to achieve public purposes. It can protect the envi- to create jobs and wealth. It also eases the difficulties of ronment. It can also protect consumers and workers from privatization while increasing the potential economic the effects of information asymmetries: the fact that gains. The second lesson is that, although the overextended banks, for example, know much more about the quality of FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY 65 their portfolios than do depositors, or the fact that busi- they can continue to attract deposits-and even aggres- ness managers may know more about health and safety sively pursue them by offering favorable interest rates. risks in production or consumption than do workers or Failing banks often engage in ever-more-reckless gambles consumers. Regulation can also make markets work more to salvage their position, throwing good deposits after efficiently by fostering competition and innovation and bad, and driving up their losses before the inevitable crash. preventing the abuse of monopoly power. And more And third, because banks' balance sheets can be difficult broadly, it can help win public acceptance of the fairness to interpret, especially because a rising share of their port- and legitimacy of market outcomes. folios may now be taken up with derivatives and other With economic liberalization, many areas of regulation new financial instruments that are hard to monitor. have been recognized as counterproductive, and wisely This information asymmetry can be destabilizing. abandoned. Yet in some areas the traditional rationales for Depositors, fearing for the safety of their funds, might regulation remain, and market liberalization and privati- rush to withdraw them when they begin to hear stories zation have themselves brought new regulatory issues to about troubled banks. Bank failures tend to be conta- the fore. The challenge, illustrated here with reference to gious. When one insolvent bank goes under, nervous three important regulatory domains-banking, utilities, depositors may start runs on others. As liquidity drains and the environment-is not to abandon regulation alto- out of the system, even solvent banks may be forced to gether. Instead it is to find regulatory approaches in each close. And a systemwide run can have severe macroeco- country that match both its needs and its capabilities. nomic consequences. For all these reasons-the difficul- ties in assessing a bank's financial health, the adverse Some new rationalesfor regulation spillover and distributional effects of bank failures- FINANCE: FROM CONTROLS TO PRUDENTIAL REGULATION. banks' behavior needs to be tempered by regulatory and Our understanding of financial sector development has other public actions, outlined later in this section. changed dramatically over the past decade. We now know UTILITIES: REGULATION WITH COMPETITION. For util- that the depth of a country's financial sector is a powerful ities, too, regulation has taken on renewed prominence. predictor and driver of development. Just as important, we Here, however, the reason is revolutionary technological know that the control-oriented regulation widely adopted and organizational change, not just conscious shifts in in the early postwar years-directing subsidized credit to policy. The argument for utility regulation used to be favored activities at very negative real interest rates, limiting straightforward. Utilities were natural monopolies. Con- the sectoral and geographic diversification of financial sequently, unless they were regulated, private utility oper- intermediaries-may often work against financial deepen- ators would act as monopolists, restricting output and ing. The near-universal response has been to move away raising prices, with harmful consequences for economy- from controls over the structure of financial markets wide efficiency and income distribution. Today, changes and their allocation of finance, and embark on a process of in technology have created new scope for competition, liberalization. but would-be competitors may need special reassurance Yet liberalization in the financial sector is nor the same from regulators before entering. as deregulation. The case for regulating banking is as com- In telecommunications, dozens of countries through- pelling as ever. Only the purpose has changed, from chan- out the Americas, Europe, and Asia-plus a few in Africa, neling credit in preferred directions to safeguarding the including Ghana and South Africa-have introduced health of the financial system. competition in long-distance, cellular, and value added The banking systemn needs effective prudential controls (fax, data transmission, videoconferencing) services. A few because banks are different. Without appropriate regula- countries-Chile and El Salvador, for example-are even tion, outsiders will be less able to judge for themselves a exploring options for competition in local fixed-link net- bank's financial health than that of a nonfinancial com- works. Electric power generation (but not transmission or pany. Why? First, because outstanding loans are banks' distribution) is also now viewed as an arena for competi- primary assets. So long as banks receive interest on their tion. In China, Indonesia, Malaysia, and the Philippines, loans, outside observers may well judge their portfolios to private investors are adding generating capacity through be healthy, even if (unknown to the observers) the bor- independent power projects, alleviating acute shortages rowers lack the resources to repay the principal or, worse, and enabling private finance to fill the gap left by short- are effectively bankrupt and are only keeping up the inter- falls in public resources. est payments by taking out new loans. Second, because In this new environment the degree of natural monop- unlike many companies, banks can be hopelessly insolvent oly has been drastically reduced (although perhaps not without running into a liquidity crisis. So long as insol- eliminated entirely). But regulation is still crucial, for two vent bankers can disguise their condition to outsiders, reasons. First, it can facilitate competition. Consider the 66 WORLD DEVELOPMENT REPORT 1997 problem of interconnection. By failing for more than a ambiguity and negotiated outcomes rather than pre- decade to establish workable rules to allow different net- dictable and consistent implementation. Poor communi- works to connect with one another, Chile's telecommuni- ties daily confront a dismal bargain, borrowing immediate cations regulators seriously obstructed competition, leaving survival against long-term environmental degradation. Pri- clominant incumbent firms in control of how the system vate firms weigh the predictable costs and the benefits of evolved. After numerous court disputes a multicarrier sys- complying with well-defined environmental regulations tem was introduced in 1994: customers can now choose against the prospect of cutting costs by avoiding regulation their long-distance provider. Within months, six new altogether. Consequently, politicians may often conclude providers had entered the market, and the price of long- that environmental inaction (perhaps veiled behind the distance calling had dropped by half Similar interconnec- appearance of activism) is the politically expedient course. tion problems can arise in the electric power industry when In this climate of ambiguity, as later sections will show, generators supply customers through common-carrier purely technocratic approaches to environmental regula- transmission lines. This is an issue that Argentina, among tion have little hope of success. Especially in developing others, has had to grapple with in the wake of privatization. countries where the institutional foundations for regulation A second reason for improved regulation is that com- are weak, the potential for successfully containing the envi- petition may not suffice to insure private investors against ronmental hazards of unfettered private markets may be "regulatory risk": the danger that decisions by regulators greater with approaches that rely at least as much on pub- or other public agencies will impose new and costly lic information and citizen participation as on formal rules. demands some time down the line. A utility's assets are unique to its business, and nonredeployable in other uses. Where capability is strong, regulation can raise credibility This means that utilities will be willing to operate as long and efficiency as they can recover their working costs. That, in turn, So how should states respond to continually changing, makes them peculiarly vulnerable to administrative expro- and often conflicting, regulatory demands? Three princi- priation-as when, for example, regulators set prices ples are key. First, different ways of regulating have differ- below long-run average cost. Consequently, countries ent costs and benefits, which countries should assess ex- without a track record of respecting property rights may plicitly before proceeding. Second, this assessment should fail to attract private investors into utilities, regardless of also incorporate the administrative dimension: some any commitment to competition in utility markets. As the forms of regulation are intensive in their requirements for next sections show, a well-designed mechanism that com- information, whereas others require much less (or much mits the regulator to a clearly defined course of action can more easily monitorable) information; likewise, some offer the reassurance that potential investors need. regulatory approaches depend on command-and-control, THE ENVIRONMENT: BALANCING SCIENCE, ECONOM- others more on market-like mechanisms. In general, [CS, AND CITIZEN PRESSURE. Economists have long recog- information-light and market-like approaches are easier to nized pollution to be a negative externality. Without some implement, and often at least as efficient. Third, states dif- form of regulatory protection, the environment can fer markedly both in their institutional capabilities and in become an innocent victim of bad business practices. Buy- the structure of their economies. Their approaches to reg- ers seek goods that are attractively priced, and producers ulation should reflect these differences. seek ways of providing these goods at lower cost to them- We begin to show how these principles can be applied selves than their competitors can provide them. Unless in practice by considering some "best-case" scenarios: the there is some countervailing incentive, the temptation to range of regulatory options for banking, utilities, and the cut corners by producing in a cheaper but environmen- environment that only work well with strong institutions. tally "dirtier" way can be great. These institution-intensive approaches combine three Even countries with strong institutions find environ- central elements (Table 4.2): mental regulation immensely challenging. Noxious fumes, poisoned water, earsplitting noise-and their conse- * Relying on public administrators to manage complex quences-are easy to spot. But the costs of many other technical problems forms of environmental damage are diffuse, and may be * Giving regulators considerable flexibility to respond to invisible even to those closest to the source of pollution, changing circumstances who may suffer serious long-term effects. Polluting emis- * Using an array of checks and balances to restrain arbi- sions can also be tricky to measure. And the environmen- trary behavior by regulatory agencies and build their tal consequences may depend heavily on the demographic credibility. and ecological features of the surrounding area. A further complication is that the political incentives of BANK SUPERVISION. Banking sector regulation around community, business, and political stakeholders can foster the world tends to be institution intensive. Later sections FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY 67 Table 4.2 The variety of regulatory experience Utiliti regulation Environmental regulation Financial regulation lnstirLontInrensive Price cap regulatior,. virll the Precise rules lcconlmianic-and DetaileJ regi.1l1tion options regulator setting the price :ont.rol or preferahi,. nic.n tor-e 'p, conileteri Epdiustniejit factor inceiitir.e basedl estarDislicO impartial supemvi,sor' nR rhe reQulatctr, :3jenc', or auftiorities {ro,sci CommitSion. b'L idpeneInC lee,slatire inc luding sonme dePos he;sngs inSUrance1 Instilturion-light Options Regulation rjased o, tiptt Boton; up reglilst,ry ln,entike;irLl MI IrF91 rules. eryr,oraicd in appr'achez public hbsi,l ers ano dep.:sTiors hae transacllon-oec:iftc legal inlrih:iat,in. li 8l initiatives a substantial stal.e r, agreem-ients arid enforceaDle to sjrerwttrien citilens bOiCe m;aintaining banF solvence dotlesticalli or thou).Igh 011 arnd irfiiari.E-s r,i local inte, rintr c.ral mecharni m lijul.[l0eties discuss some new ideas for maintaining the solvency of that their owners have something to lose in the event of banks where supervisory agencies are weak. In many failure. Authorities should also be required to consider countries, however, formal supervision remains a vital the qualifications and track record of proposed owners bulwark. The idea behind it is that well-designed regula- and managers. tion, monitored and enforced by competent supervisory * Restraints on insider lending. Restrictions on lending to authorities, can overcome the information asymmetries bank insiders can cut down on fraudulent loans. Simi- inherent in banking, and detect-or at least contain- larly, many countries also limit a bank's lending to a potentially ruinous banking crises (Box 4.3). Key ele- single client (commonly to a maximum of 15 to 25 ments of such systems include: percent of the bank's capital); this prevents any one client from becoming "too big to fail," prompting the * Capital adequacy and entry criteria. Minimum capital bank to make unsound loans solely to keep that client requirements impose discipline on banks by ensuring afloat. Box 4.3 How government supervision averted financial disaster in Malaysia In 19.35 a sudden Fill in w%orld cornimc.ri-r price billion ir .iss .t bLt ihjcCr to muuch I.- supcr-'i'on rexersed Nlalassia> decade-long boomn. Thc NlaJa%-sian than chc comnimrcial hanks-were in e%ere di'rrecs. stocLkindex., stich had surged tron lillin J c1- t4o Bank super.-isor% at Bank Negara. Nal%suia s central inezarlv 1%,4, tell beluo 20)i hu eail 1Ci?(!; the valuc of bank. de% ned a serr-of conmple. r;scue pacLkges for prime comnnercial property in [Kuala L.unmpur flI bv ch. three alihng conimercial bankls and the rwcnnr-tour e%en mnore. Banlks, . hich had nmved hcaAilk into re.l Ai.lerati e . All cold, i a' a rcsult of the bank- esrare lending in the boom vcar,. faced cht spectcr of ill crisis amotinred it -i. pcrcent ol lits skis I cnsG rising nonpertfo-nming loarns and doubtful debts. eros' national prodlucr i tJNFi. Becauie NlaIav ia hiad maintained a t h high NIal.vii eperie-nce under,core, the \aluc of gutd degree of banking supercisiorn. prc.viiioning ftor non - super'sion. Loise, in the tightlk supervniied hanking performing loan rosc rapidld: frcm 5.i percent otf t:oal set[or amounted to l;, n -f perLcnt of deposi[s-tar lending in 1984 to 1-.5 percentr 1Q88. Eh% Sc. lss. than the -II) percent o epo st ost in the li hth supervisorn inppectnoii) in l 98; idenfti,:d three corn- supCrN 'ed nnbaknl co.opratires. And inacroeco- mercial bmnks hose . Ixrcl'en-c was thr-atencd by prob- r-:niic disaster %ac atrted. The econon\ rc oovered in lem portfolios but hm.ic management rt as e luctuccant i j. and stou:k and prc-pcrry priccs and bank balance to ackinowvledge the full scope of rhe prubleml. Addi- heers reco'.ered s%rWh it. Prompt action had made it rionally. wciirv-four nonbank cdeposir-caking coopera - pos,rble to identrif jnd iddress problem, earl'.. while uIes- \%ith os er ;22.0(10 depositors and abotLl $1.5 diciplined reicue w is suill affordible 68 WORLD DEVELOPMENT REPORT 1997 * Rules governing asset classification. Requiring that banks tors, without having these prerequisites in place. The con- classify the quality and risks of their loan portfolio sequences have often been disastrous. A recent World according to specific criteria, and define and identify Bank study identified over 100 major episodes of bank nonperforming loans, can provide early warning of insolvency in ninety developing and transition economies problems. from the late 1970s to 1994. In twenty-three of the thirty * Audit requirements. Minimum auditing standards and countries for which data were available, the direct losses disclosure requirements can make reliable and timely sustained by governments in these episodes exceeded 3 information available to bank depositors, investors, and percent of GDP (Figure 4.1). In absolute terms, losses creditors. were largest in the industrial countries: official estimates put nonperforming loans in Japan in 1995 at about $400 Building a robust system of prudential regulation and billion; the cost of cleaning up the 1980s U.S. savings and supervision is administratively demanding. It means hav- loan debacle came to $180 billion. But in relative terms ing reasonably reliable accounting and auditing informa- the largest losses were in Latin America: Argentina's losses tion on the financial health of a bank's borrowers. And it in the early 1980s amounted to more than half of its means having a sufficient number of supervisors, not only GDP, and Chile's exceeded 40 percent. Later sections skilled enough to do their job but politically independent examine some ways to guard against bank failure that are enough to do it impartially. not so heavily dependent on formal supervision. Many countries have relied exclusively on prudential PRICE CAPS FOR REGULATING UTILITIES. The use of regulation and supervision to undergird their banking sec- price caps in utility regulation illustrates both the scope of Figure 4.1 Bank crises are all too common and carry enormous fiscal cost D,recr cc- c-ft tar- ,rg crs:, i oercentage of -,DP, Argenrtr,a: 1i96CJ2 Crn,Il 19 ,1-83 Uruguas 1C- .1-S4 IsB3el 1. ,-S.; r..e dI u.-itre 195;-93 A er,ui pa 1995-35 Benir, 1.,1i9-91-9 SFpnlaw 1917-85 BlaurtaraI 9.S4-9_3 BuLgaria 19595-96 Tanzani,a I1 S8 -. - , Fiurigar,, 19C1-93 F,nlancil c19I1-93 Brazil ',t_C5 5s.e.den 1 90,1 Ghar,a 1982-89 Sr, Lsvw.a 19S9-9 Coiorv;t}ia 19E-2-S7 Klal~sia 1985-58 4 I 19S7 -8 C !n,rcld STares 19Fl-I1 Ci IC' 2') 3C: s'o 5.:' Sc,ur.:e' -:Lr.. I FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY 69 authority of an independent regulator and the role of The shortcomings of top-down environmental regula- institutional checks on arbitrary action. Price-cap regula- tion have been even more obvious in developing coun- tion gives the utility an incentive to be efficient and can tries, many of which responded to the surge of interest encourage innovation, but it rests substantial discre- in environmental issues by establishing new regulatory tionary power with the regulator. In the United Kingdom, agencies modeled on this approach. Poland's regulatory which pioneered price-cap regulation, regulators impose agency, for example, although technically competent, an overall ceiling on utility prices, based on the annual found it had limited leverage in negotiations with plant rate of inflation minus an adjustment factor. The regula- managers in communities that were heavily dependent on tors decide the level of the adjustment factor, which they one or a few large enterprises, which funded many com- can change at defined (usually five-year) intervals. munity services. Chile's highly regarded environmental The U.K. regulators are constrained by carefully agency has spent four years trying, and failing, to imple- designed checks and balances: any decisions that the util- ment a system of tradable permits for industrial emissions, iry opposes must be cleared by both the Monopolies and because of difficulties in setting and later measuring base- Mergers Commission and the Secretary of State for Trade line emissions. and Industry. These checks have been strong enough to permit a highly flexible approach to regulation while still The regulatory 'fit" when institutions are weak attracting substantial private investment. If countries with Countries with weaker institutions face a much greater weaker checks and balances sought to adopt this type of risk that relying on administrators' skill and discretion regulation, private investors might reasonably expect the will result in a mass of unpredictable and inconsistent reg- adjustment factor to increase dramatically at the first ulation. The challenge for financial and environmental renewal of the price cap. Consequently, investors either regulation in such countries is to prevent costly oppor- would not invest or would demand very high rates of tunism by private actors-be it banking fraud or pollu- return to ensure a quick payback. tion-when the regulatory agencies' authority cannot be INSTITUTION-INTENSIVE APPROACHES TO ENVIRON- relied upon. With regard to utilities, the trick will be to MENTAL REGULATION. A central challenge for environ- convince potential investors that regulators will not mental regulation has always been finding ways to com- engage in arbitrary and expensive rule changes. Table 4.2 bine technical expertise with political legitimacy, to avoid summarized some of the regulatory options available in the sense that scientists and technocrats are making deci- such cases, each of which is discussed below. sions without regard for community or broader public FOSTERING INCENTIVES FOR PRUDENT BANKING. The concerns. In industrial countries, strong institutions have incentives and interests of bank owners, managers, and been the key to striking this balance. In Frances Ger- depositors can themselves be a vital complement to super- many, and the United Kingdom, for example, elected leg- vision if they are aligned to be compatible with prudent islators delegate the details of policy to environmental banking. The history of banking offers examples of some authorities, who consult with affected parties and respond unusually sophisticated self-enforcing arrangements for to direct political pressure. Decisions by the U.S. Envi- winning credibility. More recently, the World Bank and ronmental Protection Agency are, like many other execu- the European Bank for Reconstruction and Development tive agency decisions, legally binding only if the public is collaborated on a project in Russia designed to influence given advance notice of rule changes and interested parties banks' incentives: banks were chosen to on-lend funds pro- are able to make formal comments. The Dutch govern- vided they agreed to submit to annual audits by interna- ment provides more than half the funding for thirty to tional accounting firms and to adhere to prudential norms. forty environmental NGOs and routinely consults them Using regulation to raise the stakes for bankers is and other affected parties when preparing environmental another institution-light way to protect the health of the legislation. banking system. It is less expensive to monitor the net Viewed through the narrow lens of economic effi- worth of a bank than to monitor each of its transactions. ciency, even these mechanisms have produced imperfect A bank that has adequate net worth will have the right outcomes. Both Germany and the United States, for exam- incentive to behave prudently. The following measures ple, have been strikingly successful in reducing emissions can all help raise net worth, and hence the cost of bank of some important pollutants. Yet partly because of the failure to bankers: need to be seen as responsive to citizen concerns, both countries continue to rely overwhelmingly on command- * Very strict capital requirements on banks: not the and-control approaches to environmental regulation, even modest 8 percent of deposits recommended by the where market- and incentive-based regulation could Basel Committee for industrial countries, but 20 per- achieve similar gains at much lower cost. cent or more 70 WORLD DEVELOPMENT REPORT 1 997 * Tough restrictions on entry, in part to raise the fran- sustained private investment, but only at the cost of lim- chise value of a banking license for incumbents and iting flexibility. Since independence the industry has been thereby strengthen the incentive to stay in business on a regulatory roller coaster, thriving when the country * Ceilings on interest rates for deposits, not only to keep was willing to forgo flexibility, but lagging behind when banks in business but also to create powerful incentives the mood shifted in favor of greater discretion. for banks to extend branch networks, so as to boost Unlike Jamaica, the Philippines has until recently been total deposits and accelerate financial deepening. unable to put in place a regulatory commitment mecha- nism capable of convincing private investors that the rules Another option that builds on prudential incentives is of the game would endure beyond the term of the current punitive contingent liability for bank owners, directors, president. Consequently, from the late 1950s until the and managers in the event of bank failure. Before the mid- early 1990s the country's private telecommunications 1930s, U.S. authorities routinely imposed double liabili- utility rode a political investment cycle. Investment was ties on the shareholders of failed banks. Perhaps in part as high immediately following the inauguration of a govern- a consequence, some 4,500 voluntary bank closures ment aligned with the group controlling the utility, but occurred between 1863 and 1928, but only 650 bank liq- tailed off in that government's later years, and stagnated uidations. New Zealand today imposes stringent require- in periods when relations with those in power were more ments on banks for transparent reporting, coupled with distant. In the electric power industry, the government tough sanctions on bank managers who violate them. resolved the problem of commitment by agreeing on rigid COMMITMENT MECHANISMS TO ATTRACT PRIVATE legal "take-or-pay" agreements with private investors, UTILITY INVESTORS. The Jamaican telecommunications sometimes enforceable offshore. Another option is to use industry vividly shows how private investment can affect third-party guarantees-such as those offered by the the interplay between institutional capability and regula- World Bank Group-to protect private investors and tory roles (Box 4.4). There the government was able to use lenders against noncommercial risks, including the risk of regulatory commitment mechanisms capable of attracting administrative expropriation. Box 4.4 Telecommunications regulation in Jamaica During much of the colonial period and in the scirs coninisi~,on decision;. The result was that price con- inimcdilach f.l.ng independence, rhe terms under trols becanie progressi el-y more punitive-tio the point which laniica s laroest teIccuminlLinications urility that in 10I larrnaicas largesr privatc tclecmnimunica- opcraced .erc laid tut In a legallv binding. precsls rions operator w%as relieted to sell its ases rto the go' 'pecilied. Kirry-',ear licence conrr.icr. Then as noo Lhe erminenr In 19S-. after a decade oftUnderinstcnmeit, utirmart court or appeal ftr lamaica s independent Jamaica repriv-tizcd it; relecoinmunications urilirs. rho' ludiciasN jE lihe Pri-( Council in the Uinired K'in- r'nit using a preciseil specified. legalls binding license doni. This . s ienr ; a, .id.quatc To ccnure sread': -n-wr,wh contract simil.sr to Thos;e uwd prior to I %S' In the next oft recc'n1municat!-orb ser.-ice ,. and the nmibter ot ,ub- three -ear;. Iserage annual in.&etnient x;as motre than scribej tripled between 1'9;50 ind 10fb2. Yet a necly three rnme& shjt iT h.od been over the pre ('ous fifteen. mndependent Jamaica chaed under the apparent restric- Pri'.ate invesrment came at a cc't, howevcr. To riveness of a conce,swtn arraingement That afforded E ir- maintain lon,-standin. iand poliricalh dLticult co wuall; n', opportunity for dcmocratic parRicipation. climiroate) cross-subsidoes betw-cr local and long- (',.nseqIucnth%, in h106 tile co-untry- tiablishcd the distarce wrices. upOnpria. rzarion Jamraica awarded a Jaaica Public Utnltn c,mnoiision. Miodeled on the single celcconirnunicaRIO:'ns pro.vider a tswnty-five-year l !. sistem. tihe coirrirn;soo held regular public hcar- concessi.n to operate thy entire ysstenr. Rievenues trom one; aniid .as ftorded broad iscope to base ITs rfegullatrn the highly profittable long-dtiance nenvork w%ere used decisions,on iiptot. froml a osId% variert of tak-eholders. To extcnrd theh unlpoftitable local fixed-link nerork. Howne.-cr, Iamaica Ia,led the other nstiturtions Dcbate continues on ishhether, even within ItS pOlitical nedcd,d o miake such a s'.srtcnm %ork:able. \Whcre',- the ct,nqranint. larnica could ha:.e retained room for LiU. rvten1 ha' a aner; of constrJints on reguldaiory- coImpetitrion in ome value added sen-ices. therebv pre- dmcretiln I 1inuding .cdl-d-d.eloped rules of asdminis- SLrxing at lc-at a modicum oft pressure t;r inno-ation trative proc,ess and con,tirutio.nal prorccrionl on prop- and productL ' irT impr'en-Lcnrs in an era of rapid err',. .Jamanica had itrualls n, hed:s and balances on gIlobal technological change. FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY 71 COMMUNITY PRESSURE TO HELP PROTECT THE ENVI- RONMENT. In settings where institutions are weak, public Box 4.5 Environmental activism in information and community pressure can be powerful Yokohama. Japan spurs to ever more credible and efficient environmental regulation. In 1 Ci1O lo-cal medica' al.. 'Cions in iokobhinm Experiments with transparent, information-intensive began to petitioil 'iifnlr oil rctinern enu>Ioni.i and initiatives can help moderate industrial pollution even rhi he.ealth danl.iges thleV ucd,cd. Shor'k thereaher when enforceable formal rules are lacking. In Indonesia, rtie municipal go%uifnient. u hich had been drai- for example, a largely voluntary Clean Rivers program, .mn, its tfee on cne itOnlmellral is.usc. 'v3as o:,usted m launched in 1989, had reduced total discharges ofthe 100 elk:utins bi- a retormi;t nvior . ho pledged to participating plants by more than a third by 1994. A pro- implement pollution pres%ention pulcici. A Ilurrx gram announced in mid-1995 to set, and publicize, envi- ,ft .lc[I - Irl'tBII-;ed,. runctuatdcd h- ihc establish- ronmental ratings for factories also seems to have induced nient of ,; neil pollu.ion control uitfi[ wttlhin cir- many poorly rated factories to improve their performance. .g-r.ernn-ment 1uxhich bh the end oti 19-i hald a s.rff In both programs the secret to success was the reputation It' [ie, a 3 reodenr emn Ironnien tIl orIgnizat7 .._. II. effect of making public to business peers, communities, . nd a i.m-% a n son group c.-rmposed of communiri and consumers the extent to which individual firms were representies,. acadlemlics. 3nd bu4niness cIttri%. good environmental citizens. Althougi the cirv had no1 Ic;gal Authorin t,o Environmental programs built entirely around public imposc controls on pollunion. by December I 9H4 it information have obvious limits. Nearly half the firms h3d cntered [into- a tOrnial. v0oluntary agrccment ri rh participating in the Clean Rivers program did not reduce a new- coal-tired pover plant to dra.ricallk reducc the intensity of their polluting activities. Information- emisson~. rlu..-c -remnIlt uttcred a prccedent t;r driven programs do help signal where the most severe subsequcnt 'olunt.rv agreementi irk other new. problems are to be found, but often additional measures anid e-.irine laree thcct-ries. which rceuced eni - are necessary to get heavily polluting firms to clean up. sins r. ..us; 'i percntclt he-ir acn erlier projetedr Ice- And clearly, as countries develop they will need to move els. ( h er thc nex r. o decadca Y!okoaimai pr,.eres- toward more institutionalized approaches that integrate si.clv uncrcaed hlc s[ringency ol rhese s.-luntarv community pressures with more formalized mechanisms a.gremenl:-and c:.n.i,centl': maintained higher for enforcing compliance. envirounielllal control ;randards tihan did la.pin In a pattern seen throughout the world, initiatives naronal goxernmenr wlinhi ilsf 1a.. conrinlai.bll- from the bottom up can set the stage for formal action at raising its standard,. the national level. In the first two decades after World War II Japan rushed headlong into industrialization, with little concern for the environmental impact. At the national level this period of neglect ended in 1967, with the landmark Basic Law for Environmental Pollution than as an automatic response to problems. Moreover, Control. But well before then, grassroots initiatives in countries' experiences with financial, utility, and environ- many localities had set in motion sustained environmen- mental regulation show how competition, voice, and self- tal reform (Box 4.5). regulation can achieve social objectives once thought to require rule-based solutions. Lessons: Clarijying regulatory options Does the country have the institutional and political The reality of imperfect markets brings regulation onto underpinnings necessary for formal rules to serve as a basis the development policy agenda. At the same time, how- for credible regulatory commitments? On the political ever, the reality of imperfect government cautions against front, the relevant question is whether the country has the hasty enactment of institution-intensive regulatory sys- political will to follow through on what it enacts. On the tems in settings where institutions are weak. The key to institutional front, a critical issue is whether the country success is to focus the regulatory agenda and adapt the has an independent judiciary, with a reputation for impar- available regulatory tools to fit the country's institutional tialiry, whose decisions are enforced. If not, other com- capability. Two questions can help guide countries in the mitment mechanisms (sometimes extraterritorial) may be search for better regulation. needed. In countries where political coalitions capable of Are formal rules necessary to correct the market imper- amending rules are difficult to stitch together, legislation fections? Regulation's mixed record suggests that the use may suffice; in other countries it may be desirable to of formal rules to regulate markets is better viewed as a embed formal rules in binding legal agreements with indi- complement to other measures (or even as a last resort) vidual firms. 72 WORLD DEVELOPMENT REPORT 1997 If formal rules are called for, these must be workable forms of competition, they will have little incentive to use not just in theory but in practice. In an ideal world flexi- resources efficiently or to innovate, productivity will not ble rules are preferable to rigid ones. But what constitutes improve, and industrial expansion will not be sustained. a good regulatory "fit" in the real world may bear little Third, a country's strategy for industrial development relation to ideal conceptions of efficiency. In countries has to be guided by its evolving comparative advantage- that lack appropriate checks and balances, flexibility may by its relative abundance of natural resources, skilled and have to be sacrificed in the interests of certainty and pre- unskilled labor, and capital for investment. Some propo- dictability. What appears at first blush to be less than effi- nents of activist measures have favored efforts to nurture a cient may thus turn out to be the single best solution from nascent comparative advantage by encouraging firms to the standpoint of matching the goals of regulation to the risk more on a new market than they might otherwise strengths and weaknesses of existing institutions. have been willing to invest. Very few, however, would Can state activism enhance market development? support wholesale leapfrogging: low-income countries, say, seeking to subsidize investments in highly technol- Where externalities, lack of competition, or other market ogy-intensive activities. And there is broad agreement that imperfections drive a wedge between private and social high levels of protection to promote infant industries, goals, most people accept that states may be able to en- without compensating pressures to encourage efficiency, hance welfare through regulation. Much more controver- can be fatal to a country's chances of achieving sustainable sial is whether states should also try to accelerate market industrial development. development through more activist forms of industrial policy. The theoretical case for industrial policy rests on Industrialpolicy in practice the proposition that the information and coordination The many and varied approaches to activist industrial pol- problems identified above can be pervasive-more so in icy can be grouped under three broad headings: invest- developing economies-and can go beyond those ad- ment coordination, network thickening, and picking win- dressed by well-functioning institutions to protect prop- ners. In both the first two approaches the government erty rights. In essence the argument centers on the fact attempts to enhance market signals and private activity- that, in underdeveloped markets with few participants, although the institutional demands of investment coordi- learning can be extremely expensive. Information, more nation are much greater than those of network thicken- readily available in industrial countries, here becomes a ing. The third approach involves government seeking to zealously guarded secret, impeding coordination and mar- supersede the market altogether. ket development more generally. INVESTMENT COORDINATION INITIATIVES. The classic, In theory, governments in such economies can act as "big push" rationale for government activism was that brokers of information and facilitators of mutual learning investment in an underdeveloped country posed a huge and collaboration, and thereby play a market-enhancing collective action problem. With markets undeveloped, role in support of industrial development. But whether firms could not perceive the demand for more and better governments can play this role in practice will depend, as products that the very act of producing them would cre- ever, on their institutional capability. Even aggressive pro- ate. Thus, it was argued, countries could benefit from ponents recognize that activism can enhance markets only coordinating such investments, which are mutually bene- if three critical background conditions are in place. ficial to firms but which they are unlikely to undertake by First, and perhaps most important, companies and themselves. Postwar Japan's development of its steel, coal, officials need to be working on a basis of mutual trust. machinery, and shipbuilding industries illustrates this Firms need to be confident, not only that additional coor- rationale for intervention, as well as the stringent institu- dination has merit, but that the government and the other tional prerequisites for success (Box 4.6): firms involved will make good on their commitments. The participants also need confidence that a given set of * A domestic private sector capable of efficiently manag- arrangements will be flexible enough to adapt to changing ing complex, large-scale projects circumstances. Ordinarily this will mean a credible gov- * A private sector willing to cooperate with government ernment commitment to involve the private sector in in pursuit of the shared goal of competitive industrial implementation. development Second, initiatives to promote industrial development * Strong technical capabilities in public agencies for eval- must be kept honest through competitive market pres- uating private analyses of investment options and, on sures. Competition can come from other domestic firms occasion, generating independent industrial analyses or from imports, or take place in export markets. Unless * Sufficient mutual credibility to enable each party to firms are systematically challenged by one or more of these base its investment decisions on the other's commit- FOSTERING MARKETS: LIBERALIZATION, REGULATION, AND INDUSTRIAL POLICY 73 Box 4.6 Japan's postwar big push in metals industries .A coordina[cd resrruLturing ot the wiachiner-v. tedl. U The coal indusIr- cominiirtetd iiclf to inmest 401 bil- shipbuilding, and coal iniduirrie. contributed greatly o Iloil %en ni [ra ionalie production hrorn domesticlc lapin S economic recoverr atrer \\orld Xar 11. mine,. pro' ided [he ,teel firnbi- tereed ro purchaie INlachinenr companies identified the high coSt ti stel coI.1 troni thein afterard at the ne", prices. %%hich as a major impedinimnt to penetrating Ce\port mnarkets. %%.Ould be 18 percent bcl,- pre ailin le els. Steel coinpnics. in ruin. identified the higih cost of * The tecl aid coal indutErics agreed on an o'eratl tar- a-] as a principal r.aion tor high stcel prices. Hligh get price that steel firmni %l.culd pa% itr coil, to be c:al prices rer i a -:,nsequcrnce .r continued mining achieved by nii,Jng don-iesmc urchamn, and irrs. fronm e:pensi-e Japanese mines and the hi.h cost ot * The steel indismn- cmnimitted itsel tro invci d' bil- shipping imported coal to lapan. hlon -en [o upyride ItS facilities \V'irh this; Building on institutional arrangemcnts nurtured nw-nt, andlower cil l prices, it "ould be able to during wartime, in ]Cj1Ci Jlparn's Nlinitn of Inter- cxporr sccel ar conmpctitie prilce. national 'Trade: and lndutn- tINILTli put in placc a * ri return c;-ir loecr ted prices, the machiner, and joint public-primate delibcrative structure. the (oIU1n- shipbudildig industries were in a posiltLn rto enibark cil for Industrial Rationaliziaion. Composed cf c'ri large. e-:pcirt-oirentecl inmeitment progrims. representatives ot inda-stnral aso:lciations. lcadingz en- 1'hese commitments pro' ided ihe domestic marker terprises from edch inidusrry. and public officials, that rhc steel industrn nceded to cmnbark on its the council includcd rtwcnty-nine secroral branchcs investmenil program and confidence that the ship- and rw-o central branches. Three of the coun.1cils Fping coti5t :iporedcoal Aould decinc. branches-iron and s[tel coal. and coordination- .sorked clo:c-l% together and agreed on th fc*llovinrig O nce the lIpan c)exclopmcnr Bank iafter careful commitments: techilcil analis,. anld in con,ultarion with both MiiT I and the BAnk of Japarni agrced to participa[e in these * The steel and coojrdina[ion branches identifcid the projects. prov idine ftin ncing at only moderately subsi- price of coal thar V-vould niake ir possible to ipridite dued inrtrest raicte Japin s lhr'eet barnk took the lead export steel conipcririvelv. in mioihli?ing the nmc'nmenr funds. ments, and to adapt its actions in response to changing cial turmoil surrounding the fall of President Ferdinand circumstances without undermining the overall com- Marcos' regime intervened. By late 1987 five of the eleven mitment to collaborate. initial projects, accounting for almost $4 billion of the $5 billion, had been shelved as infeasible. A sixth project had Pursuing this style of investment coordination presup- been abandoned because its lack of economic potential poses levels of public and private institutional capability became apparent. A fertilizer plant, completed at a cost of that are beyond the reach of most developing countries. $550 million, was suffering losses that were being shoul- The Philippine experience of the late 1970s and 1980s dered by government. Only four projects, accounting for shows what can happen when the ambitions of policy just $800 million, were operating profitably. do not match up to institutional reality, and efforts to NETWORK-THICKENING INITIATIVES. Activist initia- coordinate investment are pursued where government is tives need not be large in scale-imposing commensurably swayed by powerful private interests. large demands on public and private institutional capabil- Driven in part by the desire to create new business ities-or solely devoted to increasing investment. They can opportunities for domestic allies, in 1979 the Philippine also aim to strengthen the private-to-private networks that government announced a new $5 billion program of flourish in mature market systems. Domestic, regional, "major industrial projects," all in heavy, capital-intensive and international networks create numerous sources of industries. Within a year of the announcement the gov- learning and opportunity for firms: specialized buyers ernment, responding to pressure from critics, agreed to open up new market niches and offer information on subject the projects to another round of economic and product standards, equipment providers transfer techno- financial scrutiny. Soon thereafter the political and finan- logical know-how, input suppliers help with product and 74 WORLD DEVELOPMENT REPORT 1997 process innovations, and competitors are a rich source of tries as diverse as Argentina, India, Jamaica, Mauritius, new ideas. Often, clusters of firms, buyers, equipment sup- Uganda, and Zimbabwe. pliers, input and service providers, industry associations, * Usingpublicprocurement to foster competitiveprivate sec- design centers, and other specialized cooperative organiza- tor development. In Brazil's state of Ceari an innovative tions come together in the same geographic region. cost- and quality-driven procurement program worked Countries whose markets are underdeveloped may through associations of small producers to transform need some catalyst, public or private, to set this cumula- the economy of the town of Sao Joao do Arauru. Before tive process of market thickening and network develop- the program the town had four sawmills with twelve ment in motion. There are three leading examples. employees. Five years later forty-two sawmills em- The first is special support for exports. Participating in ployed about 350 workers; nearly 1,000 of the town's export markets brings firms into contact with interna- 9,000 inhabitants were directly or indirectly employed tional best practice and fosters learning and productivity in the woodworking industry; and 70 percent of output growth. It can also be a useful measure of the effective- was going to the private sector. ness of government efforts at industrial promotion. Many countries have directed credit in favor of exporters and SUPERSEDING MARKETS. Sometimes information and set up export promotion organizations. With few excep- coordination problems are so severe-markets so under- tions, most of them in East Asia, these bodies became developed, and private agents so lacking in resources and expensive white elephants. Other export support measures experience-that market-enhancing initiatives are un- have also been tried, with mixed results. World Trade likely to yield any response. As a way of kickstarting Organization rules may well rule out future experiments industrial growth, states have been tempted to supplant along these lines. market judgments with information and judgments gen- A second type of effort focuses on strengthening local erated in the public sector. These efforts rarely work, infrastructure: physical, human, and institutional. The although the success of some ventures by Korea's chaebol history of Korea's once-lagging Cholla region illustrates (interlinked business groups), made at the initiative of the impact local infrastructure can have. In 1983 this government, suggests that the quest to pick winners is not southern region opened its first large-scale industrial inevitably a fool's errand. estate. Its success set in motion a cumulative process of What distinguished Korea's success from others' fail- learning by local authorities about how to plan, finance, ures was that these initiatives were channeled through the build, and operate such estates-three more followed. It private sector, whereas most such efforts (including some also helped catalyze a transformation of the business envi- in Korea) have been implemented by state enterprises. ronment, from one bogged down by red tape and other When state firms are used as implementing agencies, the bureaucratic obstacles to one of close cooperation and opportunities for venality-or fanciful romanticism-are coordination between the local government and the pri- virtually limitless. A number of countries have subsidized vate sector. By 1991 Cholla accounted for 15 percent of money-losing state enterprises, to the severe detriment of industrial land in Korea, up from 9 percent in 1978, and fiscal performance. The generally sorry experience with the rate of growth of regional manufacturing output was investment in state enterprises has convincingly demon- above the national average. strated that the production of tradable products is best left Third, and increasingly popular, are public-private exclusively to private firms. partnerships, with the public partners drawn from either local or regional governments. These can take a variety of Walking the industrial policy tightrope forms, including: These experiences highlight why the debate over indus- trial policy has been unusually heated: industrial policy is a Initiatives directed at individualfirms or groups offirms. combustible. Economic theory and evidence suggest that Sometimes these are focused events, such as joint par- the possibility of successful, market-enhancing activism ticipation in a trade fair. Others are aimed at achieving cannot be dismissed out of hand. But institutional theory a broader shift in the business culture to favor increased and evidence suggest that, implemented badly, activist cooperation. A promising approach involves giving industrial policy can be a recipe for disaster. How, then, matching grants to firms, typically on a 50-50 cost- might countries proceed? sharing basis, to help penetrate new markets and Taken together, the economic and institutional per- upgrade technologies. Easy to implement, with man- spectives suggest drawing a sharp distinction between ini- agement delegated to private contractors, and demand- tiatives that require only a light touch from government driven, with participating firms paying for half of any (for example, some network-thickening initiatives) and initiative, such programs are now under way in coun- initiatives that require high-intensity government support FOSTERING MARKETS: LIBERALIZATION, REGIULATION, AND INDUSTRIAL POLICY 75 (such as coordinating investment or picking winners). to prove ineffective at best, and at worst a recipe for cap- High-intensity initiatives should be approached cau- ture by powerful private interests or predation by power- tiously, or not at all, unless countries have unusually ful and self-interested politicians and bureaucrats. strong institutional capability: strong administrative capa- How, then, should countries proceed if they lack the bility, commitment mechanisms that credibly restrain administrative and institutional wherewithal to make such arbitrary government action, the ability to respond flexibly approaches work? The long-run strategy, explored in Part to surprises, a competitive business environment, and a Three, is to strengthen and build the requisite institu- track record of public-private partnership. tions. In the meantime this chapter has indicated two pos- By contrast, light-touch initiatives (those that are sible pathways toward reform. One is to focus on the inexpensive, and supportive rather than restrictive or com- essentials and take on a lighter agenda for state action. mand-oriented) offer more flexibility. The essential insti- The second, which need not conflict with the first, is to tutional attribute for success is an unambiguous commit- experiment with tools for state action that are better ment by government to public-private partnership. When aligned with the country's capability. Much remains to be this commitment exists, when countries do not overreach learned, but this chapter has highlighted two strategies their institutional capabilities, and when the business envi- that appear to have great potential even where institu- ronment is reasonably supportive of private sector devel- tional capability is weak: opment, the benefits of experimentation with light-touch initiatives can be large, and the cost of failure low. * Specify the content of policy in precise rules, and then lock in those rules using mechanisms that make it costly to reverse course: in utility regulation, for exam- In the realm of liberalization and privatization, regulation, ple, these might include take-or-pay contracts with and industrial policy-indeed, in the full range of state independent power producers. actions probed in this Report-there is no one-size-fits-all * Work in partnership with firms and citizens, and, where formula. Privatization and liberalization are the appropri- appropriate, shift the burden of implementation entirely ate priorities for countries whose governments have been outside government. In industrial policy this may mean overextended. Every country must also look to build and fostering private-to-private collaboration rather than adapt its institutions, not dismantle them. This chapter building a large industrial bureaucracy. In financial reg- has distinguished between institution-intensive and insti- ulation it means giving bankers an incentive to operate tution-light approaches to regulation and industrial pol- prudently, rather than just building up supervisory capa- icy, stressing how the choice of approaches might appro- bility. And in environmental regulation it means using priately vary with a country's institutional capability. information to encourage citizen initiatives, rather than Successful institution-intensive approaches generally promulgating unenforceable rules from the top down. share two characteristics. They require strong administra- tive capability. And they delegate substantial discretion The policies that rely on these approaches may not be for policy and implementation to a public agency, embed- first-best policies in a textbook sense. But as state capabil- ded in a broader system of checks and balances that pre- ity grows, countries can switch to more flexible tools, capa- vents that discretion from degenerating into arbitrariness. ble of squeezing out further efficiency gains. Throughout, If institutions are strong, these state actions can contribute states must maintain the confidence of firms and citizens to economic well-being. If they are not, the evidence and that flexibility will not be accompanied by arbitrary behav- analysis of this chapter suggest that such actions are likely ior-else the foundation for development crumbles. II REIN VIGO RATING INSTITUTIONAL CAPABILITY PARTS ONE AND TWX'O HAVE UNDERSCORED THAT THE STATE MAKES A VITAL CON- triburioii to economic developmenlt when its role matches its institutional capa- bility. But capability is not destiny. It can and must be improved if governments are to promote further improvements in economic and social welfare. This part of the Report discusses how this can be achieved. State capability refers to the ability of the state to undertake collective actions at least cost to society. This notion of capability encompasses the administrative or technical capacity of state officials, but it is much broader than that. It also includes the deeper, institutional mechanisms that give politicians and civil ser- vants the flexibility, rules, and restraints to enable them to act in the collective interest. Three interrelated sets of institutional mechanisms can help create incentives that will strengthen the state's capability. These mechanisms aim to: * Enforce rules and restraints in society as well as within the state * Promote competitive pressures from outside and from within the state, and * Facilitate voice and partnerships both outside and within the state. Over the long term, sustainable institutions have been built on formal checks and balances, anchored around core state institutions such as an independent 78 WORLD DEVELOPMENT REPORT 1997 judiciary and the separation of powers. These are essential for ensuring that nei- ther state officials nor anyone else in society is above the law. But rule-based government is not enough. State capability will also be improved by institutional arrangements that foster partnerships with, and provide competitive pressures from, actors both outside and within the state. Partnerships with and participation in state activities by external stakeholders-businesses and civil society-can build credibility and consensus and supplement low state capa- bility. Partnerships within the state can build commitment and loyalty on the part of government workers and reduce the costs of achieving shared goals. The flip side of partnership is competitive pressure-from markets and civil society and within the state itself. Such pressure can improve incentives for per- formance and check the abuse of the state's monopoly in policymaking and service delivery. Similarly, competitive or merit-based recruitment and promotion are crucial for building a capable bureaucracy. This part of the Report starts with a look at ways to reinvigorate state insti- tutions, by building the foundations of an effective public sector (Chapter 5) and, more broadly, by instituting formal checks and balances and controlling corrup- tion (Chapter 6). Chapter 7 then examines how to sharpen competitive pressure, strengthen voice, and promote partnership by bringing the state closer to the peo- ple-an important means of which is decentralization, or the shifting of power and resources to lower levels of government. Finally, Chapter 8 discusses partner- ships and competitive pressures that cross the boundaries of nation-states, and how countries can cooperate in providing collective goods. BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR Sire, a vast majority of civil servants are illpaid... The result is that skilled and talented men shun public service. The Government of Your Majesty is then forced to recruit mediocre personnel whose sole aim is to improve their weak pecuniary situation ... intelligent, hardworking, competent, and motivated individuals should direct Your Empires civil service .... It is Your Majesty s prerogative to introduce the indispensable principle of accountability, without which allprogress is retarded and work inevitably destroyed. -From The Political Testaments ofAli Pasha, Grand Vizier to Ottoman Sultan Abdulaziz, about 1871 (quoted in Andic and Andic 1996) T HE SAME PROBLEMS THAT PLAGUED SULTAN ABDUL- emphasis here is on the incentive framework guiding aziz haunt today's public bureaucracies. The history behavior-what government agencies and officials do and of development in Europe and North America in the how they perform. Few countries consciously set out to nineteenth century, and that of East Asia in this one, have encourage bureaucratic corruption and inefficiency. But shown the economic rewards of building an effective pub- the mere existence of formal rules forbidding bribes, say, lic sector. But examples of this kind of institution build- or the abuse of patronage will rarely be enough to root ing are all too rare. these things out. What matters is whether the actual rules Building the institutions for a capable public sector is and incentive mechanisms embedded in the system can essential to enhancing state effectiveness, but also im- translate the fine words into reality. mensely difficult. Once poor systems are in place, they The foundations of an effective public sector can be very difficult to dislodge. Strong interests develop in maintaining the status quo, however inefficient or Evidence across a range of countries has shown that well- unfair. And those who lose out from present arrangements functioning bureaucracies can promote growth and reduce may be unable to bring effective pressure to bear for poverty (Chapter 2). They can provide sound policy inputs change. Even when the incentives are there to improve and deliver critical public goods and services at least cost. public sector performance, formidable information and During the nineteenth century most industrializing states capacity constraints often thwart the attempt. modernized their public administrations. Early leaders in- How can governments with ineffective public insti- cluded France, Prussia, and the United Kingdom. The suc- tutions begin to put things right? The complex problems cess of the British civil service reforms in the last century involved in building and managing a public bureaucracy provides an early example of the importance of nurturing do not lend themselves to Clear, unambiguous solutions. effective, rule-based bureaucracies. As Box 5.1 describes, But this chapter outlines some institutional building these reforms heralded the careful cultivation of a profes- blocks of an effective public sector and discusses promis- sional meritocracy, which helped pave the way for a half- ing options for putting these in place. This focus on insti- century of English dominance over international commerce. tutions is very different from the traditional approach of More recently, some East Asian economies have estab- technical assistance, which emphasizes equipment and lished and nurtured the foundations of capable bureau- skills and administrative or technical capacity. The cracies. Many low-income countries, however, have been 80 WORLD DEVELO3PMENT REPORT 1997 Box 5.1 Laying bureaucratic foundations: The Northcote-Trevelyan reforms In the United Kingdom LUntil the earls nineteenth tncuf l the affaur, 4.f the imn thc ov-ernmenrts %%,,rk into two classes-inrellec- rtate n the Linited Kingdlonm w%ere admniniMrcred hw trial ipolicy and adrnnistraion)l and mechanical (cler- public officials who ovwcd [heir posirion% u' pohicil [Call-and recatinga career iJvil SCerie to car ittout. patronage and inlui-ence. Thcre ,.as no comrnmfln ix-- Staff capihle ot pe!torming the iitellectual w-ork terin cit pa%. bribe; augiented L'fticial Jaltries. and ;ould bc recriarred frorn the newly reformed un-crsi- officeholders, wiho viewe1d their posiriois aj propern ries; the besr talent v.ould be seltedcl [hrough rouph thit could be sold. ntrtei engagcd and paid their o%%n comipettive e';Jmtna[tionssuperv-ised bY a board ofcivil itaff. Although [he Ystem did nor rule Our advance scnrice commissioners. bl- 1!ldividual abdlir%. ict s av nor a bask; tfor ,ould )ppopirion was s[rong. Although a ci'il oercike admnnimrrat.an. comnI;sion was estabi,bed in I S;. mrranyo'ernnicnt A, the \VIcorian crd progresscd. hoe.-cer, tihe departments continued rccruiting in their accustomed Linitcd Klndornm underrent a perIod of ntense wa\ until I. %N hcn parronage vasadbolished and the reh:irm driven hL% social and economic change and tile t-wo. Ogrinde, w%ere mide compukon- tor all department%. denmandi of an c.pandin-. educatd miiddle clais. Uni- The Ncarrhl-co ree- lin reftrms w%ere iollc.i%ed by versitres. rlie armed force;, lihe ludiciarv. and central retbrrms in the armrd fotrces, rhe iudician. and, later. and local bureaucracies %erc ill refotrmed. municipal go:ieritnnent. There %%ere also extensive The blucprinr t;:r cnil service refornm . a rlie chanes in the rules 3nd rcstraints governing polic- Northco[e-Tre'elvan Report 4 134. %%hich ad%o- tormation and implementation. By the end of t[he nine- careld he creation o.f a mdoeril bureaucracy based on a tcenth centary [he LUnited Kingdom had laid [he tbun- carccr civ-i en ice Dray. ing on idc adv.ancel for thl dationns of a modern to%ernrnenE and fcirmallv instru- Indian cii-, ern ice by Thoima% Nlacaulav. Sir Statturdl tionalized the values of honern-. economy . and political Norrhcoce and Sir Ch.irles Trevelvan proposed divid- neutrality-. unable to create even the most rudimentary underpin- their expert counselors the flexibility they need to for- .nings of a rule-based civil service. Their formal systems mulate policies, but embed their decisionmaking in often resemble those of industrial countries on paper. But processes that allow for inputs and oversight from in practice informality remains the norm. Merit-based stakeholders. personnel rules are circumvented, and staff are recruited * Efficient and effective delivery systems. Here, too, reform or promoted on the basis of patronage and clientelism; involves setting the right balance between flexibility budgets are unrealistic and often set aside in any case by and accountability. For activities that are contestable ad hoc decisions during implementation. At bottom, all (that is, where there is scope for actual or potential these problems can be traced back to weaknesses in the competition from various suppliers) and easily speci- underlying institutions: poor enforceability of the rule of fied, market mechanisms and contracting out of ser- law both within and beyond the public sector; a lack of vices can often improve delivery dramatically. But for built-in mechanisms for listening to, and forming part- many other services there is often no substitute for nerships with, firms and civil society; and a complete delivery by the core public sector. Here giving citizens absence of competitive pressure in policymaking, the greater voice and allowing client feedback can exert delivery of services, and personnel practices. pressure for better performance, but ultimately perfor- To tackle these problems at their root and lay the foun- mance will depend on the loyalty of civil servants and dations of an effective public sector, countries need to their compliance with established rules. focus on three essential building blocks: * Motivated and capable staff These are the lifeblood of the executive. Able and dedicated staff inject energy into * Strong central capacity for formulating and coordinating the public sector. Uncommitted staff stifle it. Civil ser- policy. This is the brains of the system. Politicians for- vants can be motivated to perform well through a range mulate visions and set goals, but for these to material- of mechanisms, including merit-based recruitment and ize they must be translated into strategic priorities. This promotion, adequate pay, and a strong esprit de corps. requires mechanisms that lead to well-informed, disci- plined, and accountable decisions. A constant challenge Effective bureaucracies take decades to develop. And in for all countries is to set rules that give politicians and seeking to build-or rebuild-the foundations of such a BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 81 bureaucracy, reformers must, as always, be conscious of capacity in these countries tends to be weak and frag- what they are building on. For example, where countries mented, with few institutionalized mechanisms for input have been unable to establish credible controls over man- or oversight. agers' use of resources, giving them greater flexibility will only encourage arbitrariness and corruption. But certain Policymaking mechanisms in industrial countries reforms can generate early payoffs even in the worst sys- Many OECD countries have built up well-functioning tems. These are discussed further below. policymaking mechanisms over time. At the heart of these systems are mechanisms for properly preparing policy proposals, estimating the costs of alternative proposals Politicians set goals and broad strategic directions. But within a disciplined overall budget framework, ensuring sound institutional arrangements can determine whether their critical evaluation through consultation and debate, the visions of political leaders get translated into effective and reaching and recording decisions and monitoring policy priorities. They can make transparent the costs and their implementation. A vital complement to these mech- benefits of competing policy proposals. And given that anisms is effective capacity at the center of government- adequate information is inevitably in short supply, they the Cabinet Secretariat in France, the Ministry of Finance can make sure that leaders are as well informed as possi- in Japan, the Office of Management and Budget in the ble, through processes that provide input and oversight United States-to facilitate consultation and coordinate from internal and external stakeholders. All these mecha- proposals among ministries before they are submitted. nisms will help produce better-informed decisions and There is always room for improvement. Australia is a raise the credibility of policymaking in general. good example of an industrial country that has introduced The rules and norms embedded in the policy- reforms explicitly aimed at making the policymaking making process should be designed to curb the kind of process more transparent, competitive, and results- uncoordinated political pressures that can lead to poor oriented. Several features of these reforms are of particular decisionmaking and bad outcomes. If politicians or relevance to other countries: the emphasis on publicizing bureaucrats pursue only their own or their constituents' the medium-term costs of competing policies; the effort immediate interests as they are voiced, the result may be to facilitate debate and consultation on policy priorities, collectively undesirable, even destabilizing-there is no within hard budgets, both in the cabinet and among agen- invisible hand in statecraft, automatically shaping individ- cies; and the attention to results (Box 5.2). ual initiatives toward a common good. The aim must be The United States and some continental European to build mechanisms to discipline and coordinate the pol- countries have instituted other mechanisms for consulta- icy debate and call competing policy proposals into ques- tion and oversight in policymaking. Corresponding to tion. In some countries politicians have delegated macro- the cabinet in a parliamentary system, congressional com- economic and strategic policy coordination to capable, mittees in the U.S. presidential system are the principal relatively autonomous central agencies, whose activities arena for policy debate and consultation. U.S. executive are guided by consultative processes that are transparent to agencies, for their part, are governed by the Adminis- outsiders. In others, politicians themselves collectively trative Procedures Act of 1946, which imposes certain restrain and challenge each other in established forums procedural requirements, enforceable in the courts, such where decisions are made in common. But many countries as public announcement of new policies, while pre- have none of these mechanisms, and their absence reveals serving flexibility in the substance of policymaking. This itself in incoherent strategic policies and macroeconomic procedures-oriented approach to policy formulation instability. allows legislators to shift the substance of policymaking to Although the precise institutional arrangements vary, specialist agencies and other interested parties closer to effective public sectors the world over have generally been the problem. This kind of decentralized mechanism uses characterized by strong central capacity for macro- citizen voice and the judiciary to ensure accountability, economic and strategic policy formulation; by mecha- but with the inevitable side effect of slowing decision- nisms to delegate, discipline, and debate policies among making. government agencies; and by institutionalized links to Many continentaL European countries rely on admin- stakeholders outside the government, providing trans- istrative law and specialized courts for judicial review of parency and accountabiLity and encouraging feedback. As administrative actions. Citizens can chatlenge administra- discussed below, systems in many industrial countries and tive decisions on legal grounds or for factual errors. The in much of East Asia exhibit many of these characteristics. European Union has adopted this system for the Euro- Their absence in many developing economies is a major pean Court of Justice, allowing it to oversee decisions obstacle to building a more effective state. Policymaking made by EU institutions. 82 WORLD DEVELOPMENT REPORT 1997 Box 5.2 Australia's mechanisms for transparent, competitive, and results-oriented policymaking One of the main objectives of Australia's putblic sector addirion, the projections made resource flowvs to the reforms has been to institute a process for disciplining line ministries more predictable, since the projected and coordinating policies and exposing them ro vigor- figures were automatically rolled over into the actual ous debate. Some of the challenges the Labor govern- budget if no changes in policy intervened. This helped ment faced when it came to power in the eariv 1980s improve decisionmaking and the operational efficiencv were similar to those confronting man)' developing of line agencies. countries today: the new government had to manage The reforms also reqtured that line ministries propos- both an immediate fiscal crisis and the unsustainable ing any new policv, or anv changes in existing policy long-term fiscal commitments of previous policies. that would increase spending, also propose offsetting To discipline policy formulation and win political savings (see figure at tight). This ensured that spending support for a resetting of national strategic priorities, stayed within the resource envelope agreed to in the cab- the new administration decided to publish estimates inet. The cabinet focused on changes in strategic priori- of furure spending under existing policies. T'hese pro- ties-which new policies to adopt and which existing jections painted a bleak pictuie of unsuistainable real ones to cut-to stay within macroeconomic constraints. growth in spending requirements, underscoring the Policy proposals were debated vigorously vithin the need to scale back. Once the government had pub- cabinet, and all affected ministries and agencies were lished these estimates, however, it became incumbent required to submit written comments on the sound- upon the government to contintue to do so, to show ness of other agencies' proposals. This helped legitimize the continuing declines in future commitments that it and build consensus on policy priorities. Finally, the had promised. Indeed, succeeding projectionis fell reforms focused attention oni results, throug,h mandated markediv, in what became called the m'alling man" periodic evaluation of new and existing policies and pattern (see figwe at left). Open financial markets through reporting on performance and outcomes. imposed additional discipline. The results? Australia's deficit of 4 percent of GDP The reforms also required the government to pub- in 1983 became a surplus by the end of the decade. Iish a reconciliation table, shossing how the projections Accompanying this achievement were significant for exiscing policies differed from [hose for the new changes in the composition of public expenditures, policies. These measures helped make apparent the reflecting both broad strategic shifts identified bv the chan,es in the government's strategic priorities, as well cabinet and changes in pilorities within ministries, as in the medium-term costs of new commitmcnts. fn often identified by the line agencies themselves. Projected growth in total spending Changes by category, 1983/84 to 1992/93 Percent (cumulative) Billions of Australian dollars 15 / March 1984 5 4 \-4 New spending - Net change Projection dates 3 - 10 / 2 - May 1985 0 r _ 5 / | November 1985 December 1986 -1 - a -2 August 1989 / I / / S-3 Savings from existing policy 1982/83 1984/85 1986/87 1988/89 Defense Education Health Social Transpor Other security tatlon Fiscal years Source Adapted from Campos and Pradhan 1996, Dixon 1993 BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 83 Elite central agencies in East Asia public-private deliberation councils, which would expose The successful East Asian cconomies have adopted a pro- costly programs to rigorous review. Such transparent and cedural approach to policymaking that shares some key institutionalized consultation mechanisms gave those out- aspects of systems in industrial countries. Several East side of government power to restrain or even veto its Asian leaders have formulated long-term visions for their actions, while preserving flexibility for policymakers to countries; examples include, in postwar Japan, the Liberal adapt to changing circumstances. Democratic Party's declared aim to catch up with the Deliberation councils require substantial technical West, and more recently, in Malaysia, Prime Minister capability if they are to use the information supplied by Mahathir Mohamad's Vision 2020. They have then private participants to make coherent policy. There is also worked to create the institutional arrangements needed the problem that such councils exclude broader segments to translate their vision into a highly focused set of strate- of society from their deliberations. If a country's private gic priorities. Powerful elite central agencies have been sector is small, deliberation councils can all too easily delegated the authority to develop policies that will achieve degenerate into well-oiled mechanisms for unproductive the leaders' long-term objectives. Although relatively rent extraction. This probably explains why African ver- autonomous, these agencies' deliberations have always sions of deliberative councils-such as the francophone been embedded in processes-such as public-private coun- countries' experiments with economic and social coun- cils-that provide input and oversight from private firms. cils-have generally been ineffective (with the notable These elite agencies often play an immensely important exception of Botswana's). If such councils are to support role in setting their countries' economic course. The Min- sustainable development, they will need to be comple- istry of International Trade and Industry (MITI) in Japan mented, as they were in East Asia, by attempts to win and the Economic Planning Board in the Republic of legitimacy from society more broadly. Korea are considered the prime movers behind their coun- tries' industrial policies and use of administrative guidance. Weak capacity andfragmented policymaking in In Thailand the Ministry of Finance, the budget bureau, developing countries the central bank, and the National Economic and Social Many developing countries, especially in Africa, Central Development Board-the so-called gang of four-act in America, and the Caribbean, lack the critical mass of unison to cap spending and control inflation. In Indonesia effective capacity and internal coherence to formulate and the Ministry of Finance and the planning agency Bapennas coordinate macroeconomic and strategic policies. Central have been the guardians of the purse and the brains of the capacity is weak, stretched thinly among a handful of civil service. These central agencies are staffed by profes- senior officials who must attend to numerous tasks. These sional and capable employees recruited on the basis of strains are compounded by problems in the bureaucracy: merit, often through highly competitive examinations. low pay at senior levels, rampant political patronage, and The delegation of macroeconomic policy to competent an absence of meritocratic recruitment and promotion. and reputable technocrats has recently been a common One especially costly consequence of weak central feature in several Latin American countries as well, includ- capacity is an inability to make budget forecasts based on ing Argentina, Colombia, Mexico, and Peru. The effects sound and realistic assumptions. This undermines trans- on performance have been noticeable. This delegated pol- parency and predictability in decisionmaking. For exam- icymaking, combined with the kind of hierarchical and ple, in recent years the difference between budgeted and transparent budget procedures described in Chapter 3, actual recurrent expenditures has averaged more than 50 was important in reducing inflation in these countries percent in Tanzania and more than 30 percent in Uganda. during the late 1980s and early 1990s. Chile, in particu- Transparency and coherence are also compromised by the lar, appears to have developed the kind of esprit de corps use of extrabudgetary funds (equivalent to more than half among senior officials that has long fostered partnerships of total federal expenditures in Nigeria, for example) and in the Indonesian technocracy and Japan's MITI, among by long lags in the production of financial accounts and others. Most striking are the parallels between Chile's audits. Often decisionmakers will have little sense of the group of high-level advisers-the Chicago boys-and costs or outcomes of policies. Partly as a result, budgeting Indonesia's Berkeley mafia and Thailand's gang of four. focuses almost exclusively on the allocation of inputs As already noted, although the central agencies in East rather than the results they are intended to achieve. Asia had considerable flexibility in policymaking, they In aid-dependent countries donors sometimes allevi- were embedded in a larger network of deliberation coun- ate, but too often worsen, the problem of weak central cils and external think tanks. In Japan, Korea, Malaysia, capacity. To the extent that their policy advice supple- Singapore, and Thailand, information about the costs of ments weak capacity at the center, they help solve the industrial policies was distributed through a range of short-term problem at hand. But such advice-does nothing 84 WORLD DEVELOPMENT REPORT 1997 to build long-term capacity if politicians fail to recognize would need to triple over the succeeding four years, the need ultimately to rely on local experts. Donors may implying drastic cuts in other expenditures (left panel of also fragment central capacity for polity formulation, Figure 5.1). Moreover, the recurrent costs of donor-led entering with ministries into bilateral deals on multiple investment projects were shown to be unsustainable (right projects without determining whether their cumulative panel of Figure 5.1). The same inadequacies play out effects are collectively sustainable or mutually consistent. across the developing world, as newly built roads fall into In many countries public investment programs have be- disrepair, and schools find themselves without textbooks come passive repositories of donor-driven projects, whose and health centers without drugs. recurrent costs after completion continue to accumulate, Several initiatives have been launched to address these contributing to an expansionary fiscal bias. Lack of coor- problems, but all are still in their early stages. The Africa dination between the ministry of planning and the min- Capacity Building Initiative seeks to strengthen the capac- istry of finance sometimes further impedes the integration ity of African governments in policy analysis through a of capital and current expenditures. more professional civil service, improved information All these problems seriously erode the capacity to coor- systems, and enhanced external inputs from African uni- dinate, challenge, and discipline decisionmaking. Guinea versities and civil society more broadly. Governments and provides a case in point. Although the government has donors have also launched sectoral investment programs designated primary education, public health, and road to coordinate donor assistance. The Agricultural Sector maintenance as spending priorities, funds often end up Investment Program in Zambia replaces 180 individual being allocated to other areas instead. And no system donor projects. But although they consolidate fragmented exists for costing out policy proposals or subjecting them policies in a shared arena, such efforts can create coordina- to rigorous scrutiny. An exercise to cost out Guinea's poli- tion problems of their own as long as capacity remains cies to meet the government's stated priorities revealed weak. Malawi and Uganda are among those countries that the share of priority programs in total spending moving to the next, crucial level of reform: developing a Figure 5.1 Guinea's policy goals and spending allocations do not add up Government expenditure 1994 Projected costs of investment projects Roadc Milliorizs of corisi ,nt Guinea frani:s - nainteLiance -100 pdut.aIcr d 5Cs' ne le a: I _oLrer ^ 15 E _ 11 | g .> ~ ~ ~~ v 8:-,,. t .,30 ^- bnLI LJ, Projected 2000 200 rec(url i t Maintenance 15 C0 PUN,DIC 0hr Ci alstsl I e 3 . 546... inC isper,dr;g '14.; l _ _ * 5_ 5C' Prinmar, 1996 1997 1998 1999 2000 ' oou 3i.r, Source. A-;pred ira ron, 'Jo Bank 19963. BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 85 systematic process to set strategic priorities across sectors remains highly centralized. The Apparat of the Cabinet of and within aggregate spcnding constraints. Colombia is Ministers has retained responsibility for policy formula- instituting ex post evaluation systems to assess whether tion and coordination and directs the activities of central policies and programs already in place are achieving their government departments. The number of central govern- intended outcomes. ment bodies remains large (over 110), their responsibili- ties often overlap, and lines of accountability are unclear Policy coordination in transition economies (Figure 5.2). The cumbersome structure makes coordina- Although the shortage of administrative expertise is not as tion difficult, delays decisionmaking, and reduces trans- much of a problem in the transition economies of Central parency. However, efforts to reform this system are now and Eastern Europe and the former Soviet Union, their under way following the adoption of a new constitution experience shows the equal importance of mechanisms in July 1996. that can channel that expertise into coherent policy. Some Central and Eastern European countries with When the communist regimes in these countries col- similar although perhaps less severe problems have initi- lapsed, so did the centralized decisionmaking apparatus ated promising reforms of their central decisionmaking for coordinating the activities of ministries and depart- mechanisms. Poland and Hungary have both introduced ments. As a result, confused and overlapping responsibili- reforms to streamline multiple and conflicting responsi- ties and multiple rather than collective accountability bilities and speed decisionmaking. In Georgia, streamlin- emerged-a sure-fire formula for policy disaster. ing has removed overlapping and conflicting positions, Ukraine exemplifies such problems in the extreme. and the fate of draft laws is now decided in the presence Following independence in 1991, a central machinery of all members of the president's economic council before of government was established which reflects many of submission to the parliament. Such reforms have aided the features of a former Soviet system. Decisionmaking consultation and coordination in central government Figure 5.2 Decisionmaking in Ukraine is bogged down by overlapping responsibilities First Vice - Prine Minmter I Ve a a 110 4 O _ I, ,' ,.: I! :.1 . 1 * -[~ ~ ' I rl -I:11 ,1, ,. I .1 ,,-, .- Deparin;'ent-s and D.rectlorates 111partneris Depr~rnets D.~r rmers Dejar uner,r D epartn)emls l Deparinils Deparrme-nts DIpa o Geanew,s l B6 WORLD DEVELOPMENT REPORT 1997 decisionmaking. But most countries have a long way to go to build the institutional capability needed to respond Figure 5.3 Most firms rate government effectively to the many demands of transition. services poorly, but some services score Reforming institutions for delivery higher than others The best-designed policy will achieve little if it is badly Percentage of respondents implemented. Poor quality, high cost, waste, fraud, and 100 _ corruption have marred the delivery of services in many developing countries. More often than not, the problems can be traced back to a belief that government ought to be the dominant-if not the sole-provider. The expansion of the state under the state-dominated 60 - development strategies outlined in Chapter 1 has pro- vided countless opportunities for politicians to exploit their positions for political gain (Box 5.3). More broadly, J0 - governments have simply overextended themselves, with disastrous results. Examples abound of services not being 20 delivered or being delivered badly. Power system losses in low-income countries are more than twice those in other Malail Customs Roads Healthi c.are Box 5.3 The mushrooming of Bangladesh's Pau" - Hgn government Nci ser. e oder 5te hincc independcnce in P')-1 the go ernment eofBan- gladesh has eftfe;lvek douhlcd in ize. Thu nuinber ot mniscries ;ncrcased trim rvcn-vnc to thim-r hike ,'er f5nci-% %ears. and beriteen 1'j(j and I14'i tki number ot dcpartments and dircrc'raEes v.ent from 1 (N to 221. P'ublic eccor emplovment in- creaScd romi ii;,11-0 in ic- i tioaliiost I iindhon in countries. In China nearly 1 million hectares of irrigated 199'2-a. tmpound rice of incrcase of 3.u percenr a land has been taken out of production since 1980 because %Lacr. comnpared dtich population gro.tlh oF 2i per- of insufficient maintenance. Only 6 percent of domestic tenr durin l [he amnie period. Civil servicc paY has businesspeople surveyed for this Report in fifty-eight de- I2llcn crn idcrabl.i. eNpcialI for rhoec at the top. veloping economies rated government service delivery as The base pav '4 a pcrmanent secretary Ithe most efficient, while 36 percent rated them very inefficient. senior ci% i! isenice position1 his declined by S- per- Mail delivery fared reasonably well, followed by customs cenr in real terni, Iinc,: I Q-. and roads; health services scored the worst (Figure 5.3). Nc" mrniscrie; di i.ioins. ajnd dcpirtrnenm' "ere These results indicate a broader pattern: the lower-rated Lreacd intpiro mer c ri ne- uch a, envi- services are delivered by government departments (as ronmen[al protection aind wonicn', issues. Bur the opposed to state enterprises) and produce outputs that are sciae has also sprcad it. %ing. into conimnercial acu[v- harder to measure and monitor. iners. Crovc.h has olren been smriulated by political What is needed is better management of the principal- conr.ideations. he increie In miriisrie. allow.ed agent relationships inherent in service delivery. In many ne% mnisiiesrial pu_iti'ons [c. bc hindded out to n-lure countries delivery suffers because neither the principals inrrap.irm- groups-and, of c.lourse. created morc (the politicians) nor the agents (the bureaucrats) live up to lv-ser-Ic; eI johs to be dispensed. Aside tromn ic. bud- their side of the bargain. Politicians interfere in the day- ectn eft cc;t. thii cxpansion has stret-ched imFple- to-day operations of public agencies; services are delivered mcntiac .n capacir. compounded coordination through government departments whose managers have probles,. and nude rgularior miore incruuivt It little operational flexibility and whose resource flows are ha alSo crCa':d ve)red intcrests chat have blocked unpredictable. Even where managers have been able to get effort' qt raticlanliz.uion and reform. around these rules, they have had few incentives to achieve better results. In the many countries where the BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 87 public sector has assumed a monopoly role in the delivery of many services, external pressures for better performance Figure 5.4 Three strategies for improving are eliminated. And few countries have set credible government service delivery restraints to hold managers accountable for their use of inputs or for the achievement of measurable outcomes. lricreas& e\It SLrenrthen Institutional mechanisms to improve delivery Governments are experimenting with a range of institu- \ tional mechanisms to improve service delivery. Greater use .( A of markets is creating competitive pressures and more exit options-alternatives to public provision for users seek- \ - ing better quality or lower cost. Also expanding these options is the practice of contracting out service delivery to private firms or NGOs. Some governments are setting up performance-based agencies in the public sector and enter- ,. ing into formal contracts with these agencies, providing 'racl the them greater managerial flexibility while holding them ac- prwaL sectrpa countable for specified outputs or outcomes. Others are ar;d Io"alt" relying on more traditional bureaucratic forms in the core public sector, emphasizing accountability in the use of in- puts, meritocratic recruitment and promotion, and the cul- budget deficit equivalent to 9 percent of GDP into a sur- tivation of an esprit de corps to build loyalty and improve plus during the 1 980s and cut the unit cost of delivery by performance. Finally, user participation, client surveys, pub- more than 20 percent in some agencies. lished benchmarks, and other mechanisms for increasing cit- Several developing countries are now emulating these izen voice are providing external pressures for better delivery. reforms. But what is feasible in New Zealand may be These initiatives can be classified into three broad cat- unworkable in many developing countries. It takes con- egories: expanding exit options, strengthening voice, and siderable capability and commitment to write and enforce improving compliance and loyalty. Which of these apply contracts, especially for difficult-to-specify outputs in the depends on the incentive environment through which the social services. Which mechanism will prove most effec- service can be delivered (Figure 5.4). Markets and con- tive in improving performance depends on both the char- tracts with the private sector offer primarily exit options acteristics of the service and the capability of the state to for better performance. In the broader public sector- enforce internal and external contracts (Table 5.1). including corporatized state enterprises and performance- For instance, for services that are contestable-such as based agencies-exit options are fewer, but voice begins most commercial products and, more recently, telecom- to become influential. For activities whose outputs are munications and electric power generation-market difficult to specify and that are not contestable, the core mechanisms can generate powerful competitive pressures civil service remains the agency of choice, but it provides for improved delivery. For services whose outputs the no realistic exit options and has considerably less flexibil- state can specify and enforce at low transactions cost, con- ity in financial and personnel management. Here the tracting out to private firms and NGOs is an attractive more relevant instruments switch to citizen voice, the loy- option. Countries with strong capability and commit- alty of the civil service, and well-specified rules for them ment are setting up performance-based agencies and for- to follow. mal contracts even for complex activities within the core Recently, the so-called new public management public sector, such as defense, education, and health care. reforms in industrial countries have sought to move deliv- But countries with little capability to enforce complex ery away from the core public sector (the center of the cir- contracts, and weak bureaucratic controls to restrain arbi- cle in Figure 5.4), primarily by using market mechanisms trary behavior under more flexible management regimes, and formal contracting. New Zealand provides the most need to proceed with caution. dramatic example. Beginning in the early 1980s, com- mercial and other contestable activities were hived off, Using competitive markets to improve delivery corporatized, and often privatized. The remaining large, Overstretched and with budgets increasingly tight, gov- multipurpose ministries were split up into focused busi- ernments are relying more on market mechanisms to ness units headed by managers on fixed-term, output- improve the delivery of contestable services. At the same based contracts with considerable autonomy (including time, a flood of innovation at both the technological and the right to hire and fire). These reforms helped turn a the policy level has been pushing back the boundaries of 88 WORLD DEVELOPMENT REPORT 1997 Table 5.1 Mechanisms to improve service delivery Service characteristics and state capability Environment _ ~~~~~~~~~Easy to specily outpusg i Prv.atp s*ctor Xor trai r OUL ton for-profits t ~~~~~~~~no p ft Iage,cic Broader pblic sector - Set up perfoniance-based agencies - - - - ~Corporatize state enterprises and establish enforceable performance contracts S-rengtnen voice rechanisns | Co)re nulbi,.; secirr what can be considered contestable. Chapter 4 showed market: governments can contract with private firms, how deregulation and the unbundling of activities in selected through competitive bids, to provide services. state-dominated industries such as electric power genera- Contracting out is now a widespread practice in many tion have led to significantly lower unit costs and a rapid industrial countries. Victoria State in Australia provides a expansion in services. particularly dramatic example: each local council con- Other recent innovations such as vouchers and capita- tracts out at least half its annual budget through compet- tion grants have even increased the scope for competition itive tender, including complex community care services. in the provision of some social services. Experience re- In developing countries, where both markets and state mains limited, however, and confined largely to educa- capacities are weak, options for contracting out are fewer. tion. Chile's capitation grant system allows students to Still, where outputs are easily specified and direct compe- enroll in any school, public or private; schools receive a tition is impossible, competition managed through such payment from the state based on enrollment (Box 5.4). arrangements as service contracts, management contracts, Private enrollments have increased, but the program's leases, and long-term concessions can yield efficiency effects on school performance are not yet clear. Vouchers gains. In Brazil, for instance, contracting out road main- are promising but carry a risk of increasing social polar- tenance to private contractors led to savings of 25 percent ization if not properly regulated. over the use of government employees. Leases have in- Indeed, greater use of market mechanisms must be creased the technical efficiency of water supply in Guinea accompanied by effective regulatory capacity. As discussed and of the operation of Port Kelang in Malaysia. in Chapter 4, this is not always easy to achieve. The diffi- Governments are also contracting out the delivery of culties of regulation are even more daunting in social ser- social services, especially to NGOs. Even though outputs vices than in, say, infrastructure. For instance, the private here are difficult to specify, governments have taken this delivery of health care services is unregulated in many de- route where NGOs are perceived to be committed to high veloping countries (Brazil is a notable exception) because quality or where, because of their religious or ideological regulating the vast number of small-scale providers is orientation, they can better serve certain groups (for beyond the government's capacity. example, the Netherlands has long contracted with NGOs for education services). In Bolivia an arrangement with a Contracting out to the private sector and NGOs local church organization to manage public schools is pro- In those areas where competition in the market is not fea- ducing promising results (Box 5.5). And in Uganda the sible, it may still be possible to foster competition for the government is entering into partnerships with NGOs to BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 89 Box 5.4 Vouchers and school choice Voucher, can increae tht stope tfor competirion in begrn providing c:ipitatitn. granis-h xed pa-lnent, providin, education. Studevi are -i%en vouchers per studeiit cnrolled-ro both public and privarc thnded by public tax dollars bui rdcemable at amn schoolb. Because rhe per-siudent pavimenr was based school. private Or public. Letring parenEs chon5e rhe on Ehe a%erage Cost of education in the public school cheir children will attend should induce schools and e>:pendirur,s per student Werc ThJ percent less iII to compete for studenrt. thc private zectcr. privatc icho:c.ls eagerly\ .ied fo;r StU Opponents ot vouchers claim that they vsould lead dents. Bv 1986 priman enrollmen in private schools public school srudernrs-especialk the bctier c,nes-Co had morc Lhan doubled. fromn 14 tr, 2"9 pcrcerot c. total lease in droves. gutting the public svIeem. Such an out- enlcllzmenrt, and enrollment in private Necondan- c-ome would be %%sretul and night lead lo even pooirer >Chools h3i in creascd almost fourtold. Thc effects cn cducation for those v-ho cliose to remain. Yet in a school pcr-formance are not vet clcar. 19!93 pilot: program in Puerto Rico. the 1S percent of Vouchers also preient potential risks. IThe one, most students who did transer to private schools were largely conmnonlk cired are incfca.ed icratdiifation aino ser- o-ffet by the 15 perent who transferred fromn pri.ate to viccs and polarization amonc, users. Socne analssts ha%c public ,chools-hardly a mass e',duius. Pucnr, Rico s criEicized the unfttered rusuh toward School choice in experlfnent was so successtul that in ir, second y-ear rhe the ftrmer Soviet republ,cs. arg; in isc more modcrn scn;e ir reters it) o nmore autonomr in hiring. The Unired Stales, liJke Aus- corps-career svy.tem [ha also includc% loer and mid- uralia. conmplenitnsi U, horizontal recruitment system dlelevecls of the ciil er1icc. RecruItLTent i5 centrallized w.-irh a Senior Executi-v Service aimed at builcding an andt high' selectiv-e. generally on the ba!is of a rigoro.us clite group from -.within he ci vil service. entrance eKarninaticn. Fhe successful canididatcs ire The boldest approach to open recruitment and placed on a List track into rtlhe be,r iobs in governmenv. career dievelopmiient is tound in countries pursuing the For lic niosr part rhese recruitj. W1ho arc Motlv gencr- new: public managrenr reforms. These counrries aliit by cdLdcational background. are hired intc a hav-e significantly devolved recruirment reiponsibili- career stream cir cn.rpi rather than for specific lobs. ties. In Ne"' Zealand, ftor exanmple. igency managers France and lapin best eeinplifv the mandarin s%-- can hire staff at marklet salaries. teni. A t-rance s Natinal School of Admlniistration. Cuuntries ith critiCal shortages of wvell-qualified tuture high-leNel cadres are put through a one-year human re;ources ma.d find nandarin sstems usefult for proftssilonal internsihip folillowed b' fiftern montihs ot establishing a selctive rather than a comprehensi'e cn0iLrse.or0k. Iapan' Tok-vo Univcrsiry produces that approach to personnel dcvelopment. Moreover, a pres- coiuR11s iadniiniktrarive elire. mort otf vhomn haNe a ugicous corps can have ipillovcr eliects. motivating other legal or gencratis[ ediLcation, posscblk supplemented parts ot the ciil ser.ice to perfi0rm well. (p)en recruHl- With in-;ervice rechnica.l training. Vrariants on dhe men., on the othrr halnd. gives managers greater tie-xi- sv,item are tound in Singapore. w-here r.vo-sear cade.- biliry in tindir.g candidates with needed skills includ- hips rotate pronmising recruits. aiid GermanN. where a ing hard-to-find specialist experrise. And open ~ss:ems pracilcumi 4.%siern citter, practical. on0the-job intern- discourage insularity in the civil sernice b' bringing in. shlips for oiuvatanding c.ndidares. at all levels. staff with f'resh percpecriv-es and nev: iecas. The sec.nd s n,rem. kIno-.vn as open rccruirinent. is The downside is that professional standards are less easy a more flcxiblk, dccentralized. and increasinAlv market- to mnaintain acro,s the servict, as is esprir de corps. BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 95 Figure 5.7 In Africa, as public employment has risen, wages have fallen Average real central governm,enk cages relatl'ie to GDP per caw,ta LoH* Hggi C'entr,al rouernrnir,n en';ploa,nient reWrv:e to poiIlatioo] va. ,a 0~1 n Vy.B,Fay percent of private wages; in Somalia the figure is 1 1 per- The contrast berween the size of the wage bill and the cent. (At the other extreme, public sector salaries in Sin- relative level of wages shows through in another major gapore average 1 14 percent of those in the private sector, problem, which will not be solved by across-the-board and in fact senior Singaporean civil servants are better increases. This is the relatively low level of remuneration paid than their U.S. counterparts.) The gap is widening for senior officials. In many countries the wages of higher- in some countries. In Kenya, for insta-nce, the dispa-ricy level civil servants are allowed, often for political reasons, to between public and private wages grew by 3 percent a year erode by more than those of the lower echelons; this wage during 1982-92. Contributing in many countries to the compression makes it even harder to attract and retain relative erosion of public sector wages were fiscal austerity high-quality staff at the vital senior levels. A study of ten measures during the 1980s that tended to lower real wages African countries found that, on average, the ratio of the rather than employment. salaries of the highest- to those of the lowest-grade civil In many African countries, public employment has not servants had declined from thirteen to one to nine to one merely been maintained in the face of rising fiscal pres- during the 1980s. sures-it has actually risen, especially at lower skill levels Prompted by a desire to raise public sector salaries, and (Figure 5.7). Governments have become employers of last by the need to correct aggregate fiscal imbalances, some resort and dispensers of political patronage, offering jobs countries have embarked on initiatives to reduce employ- to family, friends, and supporters. As a result, individual ment, decompress the wage structure, and raise average wages have often been low even though the overall wage pay in the civil service. These efforts have met with mixed bill has been high. Moreover, growdi in the wage bill has success. A study of civil service reform in fifteen countries often outpaced expenditures on operations and ma-inte- in various regions betwveen 1981 and 1991 found that nance, leading to the familiar stories of teachers without wage bill rcduction and salar,v decompression had been textbooks and extension workers without bicycles. achieved in fewer than half the cases. Employment had 96 WORLD DEVELOPMENT REPORT 1997 been reduced in more than half, but reversals were some- members a sense of purpose and belonging and imposes times reported later, and the cuts were rarely adequate to self-discipline that guides members toward achieving the finance substantial salary increases for higher-level staff. In group's objectives. King Arthur's Knights of the Round Peru, for instance, some 250,000 workers were cut from Table, the samurai in Japan, and even the mafiosi of past the civil service over three years, but 163,000 of them were generations all embodied some form of esprit de corps. A subsequently rehired; in addition, poor targeting of the few of today's civil services are also said to do so, includ- cuts resulted in the departure of the most qualified staff ing those in Chile, France, Germany, Japan, Korea, and This mixed and often disappointing experience with the United Kingdom. Most, however, do not. civil service reform nevertheless provides some lessons for It is not impossible to build an esprit de corps within future efforts. First, strategies have focused exclusively on the bureaucracy from scratch. Singapore's civil service is pay and employment and, within those issues, on reduc- now well known for its coherence and sense of purpose, ing numbers (the wage bill and employment). These are even though these characteristics barely existed in the important, but so are other, complementary elements: early 1960s. Getting there was difficult, but the steps were merit-based recruitment and promotion, performance straightforward enough. Each year prospective recruits are measurement and orientation, mechanisms to improve taken from the top 200 (less than 5 percent) of the grad- accountability, and esprit de corps. uating class at the National University of Singapore (and A more careful sequencing of reforms is called for, start- more recently the Nanyang Technological University) ing with wage decompression. Even within constrained and put through a one-year training program. Their edu- overall wage bills, wages at the top of the scale can be cation and training give the recruits a common under- raised relative to lower levels, to attract more qualified standing of what is expected of them as civil servants and people and concentrate scarce skills in strategic areas. In help build trust among them. The country's meritocratic governments that are considerably overstaffed, reforms promotion system gives officials a stake in achieving their have been too modest to downsize them to sustainable agency's goals. The single-mindedness of Singapore's levels. And they have tended to be one-shot reductions leadership and its continuous efforts to imbue the civil rather than a steady program to redimension government service with its desired values help strengthen the bond over the longer term. among civil servants. Some of Singapore's lessons are now Inevitably, pay and employment reforms will face being learned in Botswana, in twinning arrangements that political obstacles, although fears of political backlash have emphasize the two key ingredients of teamwork and often been exaggerated. Some countries have viewed civil group performance. servants as partners in reform and have consulted exten- Worker dedication and commitment are not confined sively with them to find politically acceptable solutions. to the industrial countries and East Asia. In Brazil's poor For instance, in the province of Santa Fe, Argentina, a northeastern state of Ceara, steps to increase worker com- close dialogue between the governor and the local civil ser- mitment dramatically improved the quality of public vice union helped the parties agree on measures for mod- services delivered (Box 5.7). The state government pro- ernizing provincial public administration, including moted a sense of calling among workers and conferred new expenditure cuts of some 10 percent. In addition, the prestige on their jobs. These feelings were reinforced by experience with civil service reform has helped develop a innovative practices such as worker participation and self- good set of technical tools-civil service censuses, func- managed worker teams, multitasking, and flexibly orga- tional reviews, better-designed severance packages-for nized or specialized production. These practices involved managing and implementing reforms more effectively. greater worker discretion and flexibility, greater coopera- But civil service reforms will generate losers, who can be tion between labor and management, and greater trust important constituencies of the political leadership and between workers and customers. Such experiences also therefore a force to be reckoned with. The political econ- underscore the importance of nonmonetary rewards- omy of reforms is discussed further in Chapter 9. recognition, appreciation, prestige, and awards-in moti- vating staff, over and above the adequacy of pay and mer- Building esprit de corps itocratic recruitment and promotion. Effective and capable bureaucracies share a commitment to their organization's objectives. This esprit de corps Strategic options: Steps toward an effective includes a common understanding about what is desirable public sector and undesirable behavior, manifested in formal and infor- Some developing countries lack the most basic under- mal norms and grounded in a set of objectives, and a pinnings of a professional, rule-based bureaucracy. Even devotion to upholding the honor of the group, based on reform-minded leaders cannot translate their goals into this common understanding. An esprir de corps gives reality because the machinery linking policy statements to BUILDING INSTITUTIONS FOR A CAPABLE PUBLIC SECTOR 97 Box 5.7 Building worker dedication: Good govemment in Brazil's Ceara State in l 98- the itate gciernmenr otf Caera In northfa.srern larger varilre- . raoks than usiual. 0ftien volunaril. Bra.il confronted a crippling Fiscal crish. superimposed --ranred greater autonomv and discrenon. worker, on a levacv of mediocre adrninistrative performancc. Atrc able to proside more cus[onmi7cd ver ice. Th6 Yet within fo,ur sears che fiscal crisis had becn ovcr- greater discretion did not result as ir ofticn does eke- come. 3nd the qualiy ol' services had im-proved where. In grater opportunities i'cr rent seekin- bec.aLawe dranmraic-alv. Vaccination coverage t'c.r measles and of pre>5ure, t, be accounrrable. '\orkert wanted L) per- polio more tihan triplekd from 25 percent to '0() per- form better in order to live up to the newC-h trust pliced centr of the child popularion. TI-e state's public '.sotks in themii b%- their cenms. T-his in ramrn fas the refuli of' progranm emnploy-ed more than I million unemploved [he moire .usromized arrangemrens of their n%ork ind farmers during drouehts. And iti busineis extensioll rhe public mcssages ot' respect from. the state. At the and public procurernent program t'or small firms wjs sdame tine,. the comrmuniriei \;here these public str- saving more than 30 percent o.er its previous o-erall vantn w%orked monitored them more clobsclv. The exppndifrte. st3te s pLblicity campaigns and similar nicssages had Miuch of hite credi ftor this success is o-wed tc the armed cirizen, with new inforntiron about their rights 'ivil service irself. The state government contributed in to better government ind about hov public scn iLes an unusual ;nd sometimes inadvertent wvay oU public were supposed to v.york. ThuLs goverIInmenEt played a workers newfound dedication. Usin, rewards for co.cl powcrful rolc in mornitoring. buLE it did ;0 indirecily. performance publik screening method& for new% TI'hese mechanisms createdu irturuu c; cle in hilch recruit., orientation programs. and sheer boasting workers reportcd feeling mnorc appreciited and recno- through the media about its succeses, the stare created nized. not necessarily bY siperiors. but bY their clients a strong sense ot mission around key programs and and the communitics %here they worked. This, in their vsorl;crs. Highly motivated worker, carried out a turn, rontorcecld their declcation to the job. action has ceased to function. As a result, a vast gap has task and by introducing performance measurement on a opened up between what the state says it will do and what selective, sequential basis. When output measurement is it does-between the formal rules of public institutions strengthened and credible controls over inputs are insti- and the real ones. The first step toward building a more tuted, managers can be granted more operational flexibil- effective public sector in such countries must be to close ity in exchange for greater accountability for results. these gaps: to reestablish the credibility of the government's Instituting a professional, rule-based bureaucracy will policies and the rules it claims to live by, making sure they take time. In the meantime some other measures can be operate in practice. This includes setting hard budget lim- implemented more quickly, some of which can generate its, implementing budgets and other policies as approved, early payoffs. Well-functioning policymaking mecha- making the flow of resources predictable, instituting nisms make transparent the costs of competing policies accountability for the use of financial resources, and curb- and encourage debate and consultation among all stake- ing rampant political patronage in personnel decisions. holders. Using the market to deliver contestable ser- Where these preconditions are absent, the new public vices-too many of which are now the sole domain of management must be introduced cautiously. If informal government-can lower costs and improve service qual- norms have long deviated significantly from formal ones ity. Likewise, contracting out easily specified activities (with regard to personnel practices, for example), simply through competitive bids can reduce the burden on over- introducing new formal rules will not change much. stretched capacity and build partnerships with markets Where countries have been unable to establish credible and NGOs to improve efficiency. And reformers need not controls over inputs, giving managers greater flexibility rely only on internal controls: creating more points of will only encourage arbitrary actions and corruption. And access for feedback from firms and the people who use where specialized skills are in short supply, performance public services can do a lot to generate external pressures contracts and other output-based contracts for complex for better performance while internal capacity and en- services may absorb a large share of scarce bureaucratic forcement mechanisms are still developing. capacity to specify and enforce them. Nevertheless, coun- As previous chapters have stressed, getting the state tries can begin by providing greater clarity of purpose and out of the business of providing many of the goods and 98 WORLD DEVELOPMENT REPORT 1997 services it now provides will still leave it plenty to do. tiveness of salaries at the upper end can be raised, to attract Where it is no longer a direct provider, the state must capable staff, even within constrained wage bills, in part by become a partner and facilitator, regulating markets, reducing excess employment among the rank and file. enforcing contracts, and pursuing all the essential roles There is bound to be opposition to these and other outlined in Chapters 3 and 4. That means attracting and reforms from those who stand to lose. But as discussed in keeping capable staff. Rule-based restraint on political Chapter 9, windows of opportunity for reform can open patronage in recruitment and promotion, and more com- and widen. Reform-minded governments should seize petition through meritocracy, will be necessary to build these opportunities to build consensus, address the obsta- this capability. In countries where rapid employment cles to change, and initiate and sustain reforms to build an expansion has taken place in the lower echelons, reforms to effective public sector. The resulting reinvigoration of reduce employment are inevitable. But the relative attrac- public institutions will generate large payoffs. RESTRAINING ARBITRARY STATE ACTION AND CORRUPTION A N EFFECTIVE STATE CAN CONTRIBUTE POWERFULLY the payoffs from, corruption while raising the price and A to sustainable development and the reduction of the probability of being caught. poverty. But there is no guarantee that state intervention will benefit society. The state's monopoly on coercion, Formal checks and balances which gives it the power to intervene effectively in eco- In framing a government to be administered by men nomic activity, also gives it the power to intervene arbi- over men, the great difficulty lies in this: you must first trarily. This power, coupled with access to information enable the government to control the governed; and in not available to the general public, creates opportunities the next place oblige it to control itself for public officials to promote their own interests, or those -James Madison, Federalist No. 51 (1788) of friends or allies, at the expense of the general interest. The possibilities for rent seeking and corruption are con- Restraining the potential use and abuse of state power is siderable. Countries must therefore work to establish and a challenge for any country. Harder still is doing it with- nurture mechanisms that give state agencies the flexibility out depriving state agencies of the flexibility they need to and the incentive to act for the common good, while at do their job. The misuse of state power creates serious the same time restraining arbitrary and corrupt behavior problems of credibility, whose effects linger long after in dealings with businesses and citizens. the event. The expropriation of property and the harass- Chapter 5 focused on building the capability of the ment of entrepreneurial Asian minorities in Uganda public sector. Many of the reforms discussed there will under Idi Amin left a legacy of distrust, which initially contribute to reducing arbitrariness and corruption. Par- posed enormous problems when the current administra- ticularly useful toward that end are instilling a rule-based tion tried to attract private investment. But arbitrary and culture in public institutions, and curbing patronage in capricious state action undermines more than credibility. the civil service. This chapter broadens that discussion to It undermines the rule of law itself, by weakening the look at mechanisms to restrain arbitrary state action and force of whatever rules the state has set in place. And it corruption more generally. fosters conditions that encourage state officials to place The chapter examines first the formal checks and bal- themselves above the law and tempt the rest of society to ances that need to be built into the structure of govern- do the same. Development, in these circumstances, hits a ment, including judicial independence and the separation brick wall. of powers. These promote credibility and accountability. But formal instruments of restraint are seldom enough, Instruments of restraint particularly in countries where corruption has become Sustainable development generally calls for formal well entrenched. Therefore this chapter also analyzes the mechanisms of restraint that hold the state and its officials options for these states and others seeking to make a dent accountable for their actions. To be enduring and credible, in corruption, by examining its root causes. One impor- these mechanisms must be anchored in core state institu- tant lesson is that anticorruption efforts must proceed tions; if these are too weak, external mechanisms such as along many fronts, to reduce the opportunities for, and intcrnational adjudication may substitute temporarily. The 1 00 WORLD DEVELOPMENT REPORT 1997 two principal formal mechanisms of restraint are a strong, bailiffs are not under the control of judges but are em- independent judiciary and the separation of powers. ployed by the Ministry of Justice. Thus, although judges JUDICIAL INDEPENDENCE AND EFFECTIVENESS. To are competent and reasonably efficient, enforcement is prosper, economies need institutional arrangements to slow and often ineffective because the number of bailiffs resolve disputes among firms, citizens, and governments; has not kept pace with the rising caseload. to clarify ambiguities in laws and regulations; and to Developing relationships among the judiciary, legisla- enforce compliance. Societies have devised a broad array ture, and executive that ensure judicial independence and of formal and informal mechanisms to do this, but none reliable enforcement is a gradual process. Studies show more important than the formal judiciary. It alone has that private sector confidence in the rule of law increases access to the coercive authority of the state to enforce with each year a stable regime remains in place. More judgments. And it alone has the formal authority to rule broadly, as Box 6.1 illustrates for Peru, the success of on the legality of actions by the legislative and the execu- third-party mechanisms for enforcement depends in large tive branches. This special relation to the rest of the state part on citizens viewing those mechanisms as legitimate. puts the judiciary in a unique position to support sustain- In countries where judicial institutions are weak, it may be able development, by holding the other two branches at least as important to demonstrate to citizens and firms accountable for their decisions and underpinning the the potential benefits of a well-functioning judiciary, and credibility of the overall business and political environ- to win support for good laws and impartial enforcement, ment. Yet judiciaries can play this role only when three as it is to proceed with wholly technocratic programs of core conditions are met: independence, the power to judicial reform. enforce rulings, and efficient organization. The third component of judicial effectiveness is organi- Independence from the rest of government is the most zational efficiency, which is needed to avoid long delays in important of these. Whatever the precise character of clearing cases. The average case takes 1,500 days to clear in judicial relations with the legislature and the executive, all Brazil and Ecuador, but only 100 days in France. Long de- industrial countries-and many developing countries- lays raise the transactions costs for dispute resolution and rely on the judiciary to hold the executive accountable may block access for some potential users; however, the under the law and to interpret and enforce the terms of internal efficiency of the judiciary is less critical than its the constitution. independence and its enforcement authority. As discussed Judicial independence has been repeatedly compro- in Chapter 3, even when saddled with cumbersome and mised in some countries, and in no country has the judi- costly procedures, judicial systems can strengthen credibil- ciary been immune from political efforts to override its ity in countries as long as their decisions are perceived to decisions. Legislatures and executives have used a variety be fair. Any state beginning from a weak institutional base of gambits to rein in their judiciaries: should consider building this aspect of judicial perfor- mance its first priority. * Judges of the superior court in Malta were suspended SEPARATION OF POWERS. Judiciaries may be capable of one hour before a case challenging executive actions enforcing rules, but if the public has little faith in those was to be heard. rules remaining stable, the state's credibility can still be H A succession of Pakistani governments in the past compromised. The classic constitutional mechanism for appointed temporary judges, whose lack of tenure restraining constant legislative changes is the horizontal made them more vulnerable to political influence. and vertical separation of powers. • Although Ukraine's constitution declares that the courts Power can be divided horizontally among the judi- are independent of the executive, judges remain largely ciary, the legislature, and the executive, and vertically be- dependent on local authorities for their housing. Judges tween central and local authorities. The patterns of a who have ruled against city officials appear to be partic- country's political party organization-which can range ularly susceptible to long delays in getting housing. from a small number of highly disciplined parties to a large number of parties whose members only loosely abide The effectiveness of the judiciary also depends on its by a party line, and that can govern only by forming multi- decisions being enforced. In practice that means that party coalitions-also influence the extent to which polit- other branches of the government must consent to pro- ical power is concentrated or diffused. vide the resources needed for enforcement, including per- The broader the separation of powers, the greater will sonnel authorized by law to serve court documents, to be the number of veto points to be navigated to change seize and dispose of property, and to turn the proceeds any rule-based commitments. Thus the separation of over to the winning party. In many countries this enforce- powers increases confidence in the stability of rules. Mul- rnent capability is constrained. In Poland, for instance, tiple veto points can be a double-edged sword, however: RESTRAINING ARBITRARY STATE ACTION AND CORRUPTION 101 Box 6.1 How popular participation improved property rights and dispute resolution in Peru LTntil 1 "8.l most Peruvians itving in marginal urban monopolies that held a 5tA:e in the old system. sucI as setdemenrs and rural areas did no[ enjov the security lawy-vers' associations and notaries, strongly opposed rho prosided by- formal ownership of [heir real properrv proposed refarnis. communirv-lc\el support carried the ClO percent of the population in urban areas and 80 day. percent in rural areao). The traditional wssrem of prop- in 1989) a new propertt registration system was cay regnistration wlS rn bv the Nlinisrri of Ius;ice. and enacted into law. The new sstem Idramruicalilv reduced conflicts were resolved by rhe judiciary. The system transactions coirs and uncertaint by! reducing the was perceived by poor urban and rural properrt ovn- poctr of the proflessional mcnopolies. Instead the, ers as a sys.tem for the rich, who could better alfford the tern uses community norms, such a: neighbors vouch- high transactions cosis. ing for a parrr-s ownership claimn, ro establish properry In the early I 980s the Institute of Liberty and rights anid resolve conflicts. Subject ro admnhisirariue Democraciy lLD), an NGO. becan a campaign to requirements peclfied by t-he law. any law-yer maser-e improve the property rights of poor Peruvians. The as a third-part- %vrifler, sign the properrt titles, and ILD began by holding extensive public hearings ro resolve conflicts in the tield. Contctcd or complicated gather complaints, idenrihir relsons wthy citizens did cases are re,olved by the new s-vstcnr's chief registrar. nor formally register their propert, and publicize rhe %%ho is appointed by the Mlinistry of Housing. nor the potenrial benefits and costs of registra[ion and secure jud1iiary. OnIv after these mechanisms hav.e failed can property. The group coupled this partiipatory pro(css the contlict be takcn to a judgC. wich a study of the laws and regulations g,oerning By - l. - the new v stnem had registered nearly properrn registration and cnfo[cenient. Based on the l120XItIi entitics. and btwceen 109-14 and it)6 re2us- resulting diagnossi,. the 1ID then developed concrete tered an additionall lTp.iiii. Spurred by its demrand- proposals for relbrrm. These were publicly debared and driven decsign. the system continues ro evollve and imi- fine-runed starting in 198t). Although the profre'ional tlatics are under w-ay to e-pand it nationv.ide. they make it just as hard to change harmful rules as to anchored by any domestic institution. On the trade front, change the beneficial ones. both the European Union and the North American Free Many developing countries, including some with for- Trade Agreement have been able to play this role, and mal separation of powers, have few effective checks and many countries will find it an important reason to join the balances on the actions of political leaders. In some coun- World Trade Organization. Clearly, sovereign countries tries legislative oversight is weak because of poor capacity can still reverse course on, for example, trade policy by and inadequate information. In others the executive dom- withdrawing from such agreements. But they then have to inates a compliant legislature. But like the development of calculate not just the benefits and costs of the policy rever- a well-functioning judicial system, the formal elaboration sal, but also the broader costs of reneging on an interna- of constitutional checks and balances, or their more effec- tional commitment for which their partners will hold tive institutionalization, is a gradual process. them accountable. The threat of international censure EXTERNAL MECHANISMS. To some extent, extraterritor- makes countries less likely to reverse course. ial and international restraints can substitute for limita- Agreements with multilateral organizations, such as the tions on the ability of national institutions to enforce rules IMF or the World Bank, often include some degree of pol- or to signal credibly that the rules will remain reasonably icy conditionality: in order to borrow funds, for example, stable over time. One option is to use extraterritorial adju- countries undertake certain reforms. This can have a simi- dication to underpin the domestic judicial system. Confi- lar benefit for some countries. These conditionalities can be dence in the Jamaican judicial system is buttressed by the viewed as a sign of national commitment to the policies that fact that the United Kingdom's Privy Council serves as its are included as conditions. Countries with weak domestic appellate court of last resort. Because of the weaknesses of commitment mechanisms can strengthen their credibility the Philippine judicial system, many firms, domestic as by binding themselves to pay a penalty should they violate well as foreign, prefer to adjudicate their contracts offshore. the agreement. One of the intentions behind World Bank As Chapter 3 noted, international agreements are a sec- guarantees is to accelerate the flow of private finance to ond mechanism for strengthening commitments not developing countries by underpinning such commitments. 1 02 WORLD DEVELOPMENT REPORT 1997 Building inflexibility 1996 a blockbuster movie, Hindustani, expressed an ex- Instruments of restraint are a vital foundation for sustain- treme form of popular outrage over corruption. The able development. But excessive restraint can lead to movie depicts horrific tales of callous politicians and paralysis. Instruments for restraining government need to bureaucrats willing to let hospital patients die and poor be complemented by institutional arrangements that pensioners starve unless they receive their cut. build in flexibility for the executive branch in formulating Fiction thrives on exaggeration. But it is also a mirror and implementing policies and adapting to new informa- that society holds up to itself to reflect entrenched prob- tion and changing circumstances. lems. These tales-a century and a hemisphere apart- As discussed in Chapter 5, countries have tried a vari- remind us that corruption is nothing new, nor is it con- ety of institutional arrangements that combine flexibility fined to any particular corner of the world. It is a problem with restraint. Some arrangements-such as deliberation that has deeply affected the lives and stirred the resent- councils in East Asia and the Administrative Procedures ment of citizens and businesspeople the world over. Act in the United States-delegate substantial autonomy Today, citizens everywhere demand greater probity of to executive agencies to define the substance and under- government officials, and the new transparency in domes- take the implementation of policy. But they also require tic and global markets brings corruption more quickly to these agencies to follow procedures that open their deci- the public eye. In the past few years allegations of corrup- sions to input and oversight by other arms of the state and tion have contributed to the fall of governments through- by civil society and businesses. Other arrangements rely out the world. Two former presidents of the Republic of on mechanisms within the executive branch to promote Korea have been prosecuted and indicted. A president of flexibility within restraints, such as the devolution of Brazil was impeached on charges of corruption. In Octo- managerial authority to executive agencies within set bud- ber 1996 more than 250,000 people protested the Belgian gets and performance targets. government's handling of a pedophile ring and alleged But even if bureaucracies are embedded in processes corruption in judicial appointments and enforcement. that provide ample opportunity for outside input and And a fierce debate has erupted over the financing of oversight, the risk remains that officials will pursue per- political campaigns and its influence on public policy in sonal rather than organizational goals. Self-seeking behav- the aftermath of the 1996 U.S. presidential election. ior can degenerate into corruption when private interests Corruption has been defined in many ways. This wield their influence in illegal and secret ways, circum- Report defines it as the abuse of public power for private venting the legal and bureaucratic rules designed to keep gain. Although corruption tends to get the most atten- them out. Whether public institutions succumb to these tion, it is a symptom of a more general problem of per- and other sources of corruption will depend on the verse underlying incentives in public service. Corruption strength of their institutional defenses. How these are flourishes where distortions in the policy and regulatory built and maintained is the subject of the next section. regime provide scope for it and where institutions of restraint are weak. The problem of corruption lies at the Controlling corruption intersection of the public and the private sectors. It is a A Congressional appropriation costs money. . . . A two-way street. Private interests, domestic and external, majority of the House Committee, say $10,000 wield their influence through illegal means to take advan- apiece-$40, 000; a majority of the Senate Commit- tage of opportunities for corruption and rent seeking, and tee, the same each-say $40,000; a little extra to one public institutions succumb to these and other sources of or two chairmen of one or two such committees, say corruption in the absence of credible restraints. $10,000 each. Then seven male lobbyists at $3,000 Corruption violates the public trust and corrodes social each; one female lobbyist, $10,000; a high moral Con- capital. A small side payment for a government service gressman or Senator here and there-the high moral may seem a minor offense, but it is not the only cost-cor- ones cost more. ruption can have far-reaching externalities. Unchecked, -A U.S. railroad company owner in Mark Twain the creeping accumulation of seemingly minor infractions and Charles Warner, The GildedAge: can slowly erode political legitimacy to the point where A Tale of Today (1877) even noncorrupt officials and members of the public see little point in playing by the rules. Mark Twain's damning tale was a thinly veiled caricature Studies have shown a clear negative correlation between of corruption in the U.S. Congress in the 1 870s. Twain's the level of corruption (as perceived by businesspeople) novel followed closely on the heels of the infamous Credit and both investment and economic growth. This is con- Mobilier scandal, in which two prominent businessmen firmed for investment levels by the results of the private brazenly bought their way into the Congress. In India in sector survey conducted for this Report (Figure 6. 1). As we RESTRAINING ARBITRARY STATE ACTION AND CORRUPTION 103 saw in Chapter 3, the survey identified corruption as one of the major obstacles to doing business in many countries. Figure 6.1 High and unpredictable corruption Yet it is not just a cost of doing business. Other surveys and hurts investment anecdotal evidence suggest that the greatest victims of petty corruption are usually the poor. Gross ,nies.rnenEn- - Despite such evidence, many parts of the developing GFeocen-. world retain a certain ambivalence toward corruption. A commonly heard view is that corruption merely greases - the wheels of commerce, and that without it there would be no transactions and no growth. Apparent support for S i". this argument comes from the fact that some countries 20 that rank high in surveys of the level of corruption have | ' . i also excelled in economic growth. The predictability of 15 corruption-both that of the amount one has to pay and that of receiving the outcome one has paid for-provides li some insights into this apparent paradox. For a given level of corruption, countries with more predictable corruption have higher investment rates (Figure 6.1). But even in - E i these countries corruption has an adverse impact on eco- LCl . nomic performance. Figure 6.1 also shows that, no matter Kgh how high the degree of predictability of corruption in a Level of Predictability country, its rate of investment would be significantly corruption of payments ... . . . ~~~~~~~~~~~~~~~~~~~and outcomes higher were there less corruption. Countries that have so far achieved high rates of eco- 4i1e. E:c I, a br T PePuir- nomic growth despite serious corruption may find them- ire r,s-i .l *r a reu*- , unr,r2 di CT, rr,,rr. ne selves paying a higher price in the future. Tolerating cor- arue-.r I'*tnr;ne ouflC. C,:nr.II,r,a o ,,-.:.n,r iu-: B!)fl hu,j ruption that siphons off payments of, say, 10 percent on p bhrt - ArfiC .cr, :-,l T3rrrn,-l b Jre i.r.jet, ii >s-r rr average may generate pressures to increase the take to 15 sirJ,:,r sjr e :r,*..b-i ior I-S Rcs:*r. or 20 percent. Corruption feeds on itself, creating a widening spiral of illegal payoffs until ultimately develop- ment is undermined and years of progress are reversed. And the very growth that permitted corruption in the past endemic, these officials may create additional red tape and can produce a shift from productive activities to an unpro- delays to induce even higher payments. Of course, corrup- ductive struggle for the spoils. Over time corruption tion also occurs at the highest levels of government, in the becomes entrenched, so that when governments finally do awarding of major contracts, privatization, the allocation move to contain it, they meet powerful resistance. of import quotas, and the regulation of natural monopo- lies. This helps explain why corruption is more prevalent Causes of corruption in countries with highly distorted policies, as measured by Incentives for corrupt behavior arise whenever public offi- variables such as the black market exchange rate premium cials have wide discretion and little accountability. Politi- (top left panel in Figure 6.2). Any policy that creates an cians, bureaucrats, and judges control access to valuable artificial gap berween demand and supply creates a prof- benefits and can impose costs on private citizens and busi- itable opportunity for opportunistic middlemen. nesses. Public officials may be tempted to use their posi- The probability of being caught and punished (for the tions for private gain by accepting bribes; for their part, person paying the bribe and for the official receiving it) private individuals may be willing to make illegal pay- also affects the level of corruption. Economic analysis of ments to get what they want from government. Thus, a the law suggests that individuals weigh the expected ben- necessary condition for corruption is that public officials efits of breaking the law against the expected costs (the have rewards and penalties at their disposal. probability of being caught and punished multiplied by Some corruption stems from opportunities generated the level of punishment). Corruption may be high in a by the policy environment, at the bottom or the top of country where the government system does little to deter the hierarchy. Payoffs are frequent to lower-level officials bribes. Lawbreakers may believe that there is little chance charged with collecting tariffs, providing police protec- of being caught or, if caught, of having to pay the penalty, tion, issuing permits, and the like. When corruption is since they believe that the system of justice itself can be 104 WORLD DEVELOPMENT REPORT 1997 Figure 6.2 Some factors associated with corruption Inde, o7f crr'plpor Inde. of corruptic'n 6) 6 5 5- 1 S @001 ci ~~~~~~~~~~~2 C' 1 2 3 l 5 6 2 3 4 5 6 P, dtortni nle\ Predict albiirty of judiciarN iriae: Ifnld., cr C.,rruption index of corrupTion 6- 6 3S 2 aa2 gO %- . .'.5 1 C0 I. 2.C' 2.5 0.5 1.0 1.5 2.0 Pa.o r,f ci,,ieerocr- *.9ges Mlerittased recruitnren( irrdex ro manufacturing wages rj..x: L'IC Or .r nru- 'o ,err ozwnei .3"e from r'rr-r'-ne dnJustaI aria id Eoepng countrnes dur;ng 11-i? 1ior rie pn:, disrcrtl,on irde,i and 1996 Jor in* rcrrlept.,)-, mnae; Trhe t;c right panel ., ba-sed or. a re,2ress,in ur.ng aata frorn fun nine ,nausInal and Jevelop.ng courtries juring 199Pi Dmr3 c:r lrhe r 1,r f ,I.pr.rel fre (ron- r.enry, islu;i'al r.Sd *iexeloping counires ir. tuir l3te 19'OS it- ear% 1990s. Tne bottom rrght pnenl , b3a-d r., rEireeF,,:,r. u:,r.,r .tT, irr;n. t5r.1-fr.e aevelopcg counlr., d uIr.rg 1970-90. conrroling flr rnconri See Tre Techrnal r ote to Figure . rcpur.:e ricrd 8r are z;aff ralruriati'ons .p rt%o panels: Van R,p1eghern and We*rer. oac,Ogro:unij paper ittiton, left oaneir ERaris ,n.j Raacn 19:6" u.rt-r ,grtL c.ar,en corrupted. Corruption can even persist in countries with a serious threat if more remunerative positions are avail- substantial press freedom and public resentment against able legally in the private sector. Hence corruption is it, if there is little hope of independent judicial resolution often positively associated with the difference between of important cases. This Report's private sector survey public and private salaries, or what may be termed the found a negative correlation between reported levels of "rate of temptation" (bottom left panel in Figure 6.2). But corruption and judicial predictability (top right panel in simply raising civil service salaries may not reduce corrupt Figure 6.2). behavior. Pay reform must be combined with credible Finally, corruption may thrive if the consequences of monitoring and law enforcement. Merit-based recruit- being caught and disciplined are low relative to the bene- ment and promotion mechanisms that restrain political fits. Officials frequently control the allocation of benefits patronage and create a more impartial public service are and costs whose value far exceeds their own salaries. Cor- also associated with lower corruption (bottom right panel ruption becomes especially likely if the wages of public in Figure 6.2). service do not reflect the comparable private wage. Where civil service wages are very low, officials may try to eke out Reducing corruption a middle-class standard of living by supplementing their Several countries have managed to reduce endemic cor- pay with illegal payoffs. The risk of being fired from a ruption over time. The struggle of the Progressive move- low-paying civil service job because of corruption is not ment against the power of U.S. urban political machines RESTRAINING ARBITRARY STATE ACTION AND CORRUPTION 1 05 of the nineteenth century is a case in point (Box 6.2). theme of Chapter 5: creating a rule-based bureaucracy Containing corruption requires an understanding of the with a pay structure that rewards civil servants for honest benefits and costs under public officials' control. Many efforts, a merit-based recruitment and promotion system officials remain honest despite considerable temptation, to shield the civil service from political patronage, and and many ordinary people and businesses refuse to pay credible financial controls to prevent the arbitrary use of bribes despite the promise of short-term gain. But others public resources. Here we focus on the remaining two succumb. It is unwise to deal with the possibility of cor- parts of the strategy. The first is to reduce the opportuni- ruption by assuming that government officials are of ties for officials to act corruptly, by cutting back on their higher moral standing than the rest of the population. discretionary authority. The second aims at enhancing The actual extent of bribery and other corruption accountability by strengthening mechanisms of monitor- depends not just on the potential gains and risks, but also ing and punishment-using not only criminal law but on the relative bargaining power of the buyer and the also oversight by formal institutions and ordinary citizens. seller of public favors. Reformers must also consider the REDUCING OPPORTUNITIES FOR CORRUPT PRACTICE. fact that anticorruption efforts have marginal costs as well In general, any reform that increases the competitiveness as marginal benefits; the efficient level of bribery will sel- of the economy will reduce incentives for corrupt behav- dom be zero. ior. Thus policies that lower controls on foreign trade, Corruption cannot be effectively attacked in isolation remove entry barriers to private industry, and privatize from other problems. It is a symptom of problems at the state firms in a way that ensures competition will all intersection of the public and the private sectors and support the fight. If the state has no authority to restrict needs to be combated through a multipronged strategy. exports or to license businesses, there will be no opportu- Recent reforms in Uganda illustrate such an approach nities to pay bribes in those areas. If a subsidy program is (Box 6.3). One part of the strategy focuses on a major eliminated, any bribes that accompanied it will disappear Box 6.2 Urban political machines in the United States and their reform In the late ninetcenth and cards tventieth certurie- "Calth- proper"- owvners and tntroduced a plan to man'- U.S. ciries werre dominated bh political piachinle. pSs properrY at mikrkc- E .liLc. The plan increaswd the delined bt one schol.ir "as a politi,al pam., in vhich a assrv-ed value cf real estatc. Io% eredl the tax rare. and boss overiees a hier.uchv of parrt regulars w% ho pro ide incrcased retenues. The cin's btuidet w%as cur b% S1.5 private favors to cirizens in exchange for soies and million ls patronage appoilntees lere rcmoved from who' cipec: gov-rnment jobs in renrtn. ' Machine. CIffice Rcform ma1Vors in manY other U.S. citiei fol- conrrclkdJ ciric, also t-picallt- niude corrupt. collu,ivc lo-m-ed inlilar policies. ceals w%ith private businesses seeking contracts. tran- Refc.rm a1so involvc;d municipal franchises. In chises, or protected markers. Thc politicians driving Philadelphia. for examplc. the machine-controlled cry- these machines operared-and ilouri,hed-in nomi- council regularly .nsarcdced a gs franchise in return lot-r nall- democratiL environments. ccnrriburitns o the RepLiblican Parry-. In 1F11, ret;rm Mlachines wcere costlY to the comLmunities the- doni- m3yor Iohn \(eaxer vtcoed rhc franchise bill. 3p- inated. Spending pcr capit for general adrninistr.irion poiitled A supporret to .i kIc pcsiti6on on the citr coun- and for police and fiie ser-ices-both areas with lots of cc toI en;ure that the 'em %would bc upheld. and had pacronage jobs-v.-as 3-i percent and I - perccnr higher. machine aldhcrenti arrestcd on charges of corruption respctively,- in macuine-controlled thani in nunmachine Cities dominated by nmachinie' paid a high coit in cines. To crik one extreme cas;C, in Bosron the number the fornm of inflated hudgets and inequlicable tax and ot cty clerkE increa-sed by - percnrit beteen 1>i39 arid spending Avrcms. Athou h man% peoplc benetited 1907. while the poptulalon increased by less than a from the lobi and patronage dispenrsed by the quarrer: nican-hile grovl-rh in produvtivity fell b half. rrachines. th, losrs ;lvre nmo!re numeCros still. It ns The Progressive mnovemrient in [he LUnitcd Stace had the A ho, e%enrually organized to elect relornm candi- as one of its main goals the relorm o machinedonri- daltes iii mint% cirie. . The was e of retinr mi n ors nated citie. Refcrm frequently meant properyt rtx effected real change. %%hich persi'ted vs en ishen the reform. Serh Low, New Vork's teform mnayor In the m3ihines fere returned to pcn%er. mainly because the Calrlv I 900s). sva, distres.ed bY rthc tav-ouir-b,n sht.- -n to ritr-rm v.crc pupui.ar and hard to r'c-rse. 106 'WORLD DEVEL-OPMENT REPORT 1997 Box 6.3 Fighting corruption in Uganda LUganda. long plagued by ,-rreniic corruption. hlas ciil service lincluding thousands of ghost workers') latrnched a multipronged battle against it. The ett;rt and a chin and porous tax base. eniovs support frorm the counin-s leaders, who seem Cleaning up the civil senrice will tak-e y-ears, but commirted to Ehc goa f sound governance. Llganda is making some progress. The effort includes In the immediate posrcolonial period Uganda was a polic.- retbrm and deregulation to remove opportuniries kleprocraric itate. By 196- the regime ruled without tix rent seeking: civil service reform to streamline rhe holding elecrions. These beginnings set the stage for public work force, improve rernunerauon. provide train- Idi Amin's rise to power in 19-1. LTnder .Amrn, gr- ing, and instill a code of erhics: resivAl of the Plublic ernment became little more than a system of organized Acctounts CAmnlcrce of Parliament: a strengthened crime used to e:aract rents from the public. Their auditor gencrals office: and a public relations campaign depredations took many forms, including support for against and prosecution of corruption. under the author- econornlcal-1v irraLional projects, exorbitanr militar- ir, tfn inspector general with povers t invesrigate and expenditures, kickbacks on stre contracts. cxtortionate prosecute. Nuch remains to be done before corruption import control, and expropriation of the properties ot can be said to be under conrrol. The insipector general, Asians. Upon emerging from civil war in 198o3. [he hov.ever. has announced prosecutions against common new Ulgandan tovernment under President Yoweri examples of rent seeking (such as cutsoms and procure- Niuseveni inherited a weak. underpaid. and overstaffed ment fraud), which should have a dererrent effect. as well. If price controls are lifted, market prices will can help blunt the incentive to be corrupt. Police offi- reflect scarcity values, not the payment of bribes. cers, for example, must have discretionary authority to Needless to say, reducing official discretion does not make law enforcement decisions on the spot, but pub- mean eliminating regulatory and spending programs with lic complaints will often restrain any abuses. strong justifications. Such programs must be reformed, * Introduce market-basedschemes that limit the discretion of not eliminated. Abolishing taxes is not a sensible way to regulators. This approach also has the virtue of pro- root out corruption among tax collectors; a corrupt police ducing an economically efficient allocation of re- force cannot simply be closed down. Several measures sources. The sale of water and grazing rights, pollution have proved effective in reducing official discretion in on- rights, and import and export licenses can improve going programs: the efficiency of government operations while limiting corruption. * Clarify and streamline laws in ways that reduce official * Adopt administrative reforms that introduce competitive discretion. Mexico's customs reforms cut the number of pressures into government. Open, competitive bidding steps in the process from twelve to four; the remaining for public procurement contracts can reduce opportu- steps were streamlined to reduce delays. nities for corrupt deals. Creating overlapping, compet- * Contract for services with a private company, possibly a itive bureaucratic jurisdictions can greatly diminish the foreign firm with no close ties to the country. When bargaining power of individual officials. If clients can Indonesia contracted with a Swiss firm for customs turn to a second official when the first demands a bribe, preinspection and valuation and for help in collecting no single official has the power to extract a large payoff import duties, corruption declined. Contracting out so long as applicants are eligible for the service. And monitoring functions is pointless, however, unless the if it is the applicants who are seeking something ille- government makes use of the reports it receives-and gal, overlapping enforcement areas can help to check that does not always happen. payoffs as well. For instance, when the state wants to * Make rules more transparent. Simpler, nondiscretionary control illegal businesses, police officers can be given tax, spending, and regulatory laws can limit opportuni- overlapping enforcement areas to reduce opportunities ties for corruption. Sometimes a certain risk of corrup- for corruption. tion is tolerated because the benefits of a discretionary approach to program administration exceed the costs of STRENGTHENING MECHANISMS FOR MONITORING AND corruption. But even then transparency and publicity PUNISHMENT. Independent watchdog institutions that are RESTRAINING ARBITRARY STATE ACTION AND CORRUPTION 1 07 part of the government structure can also curb corruption. units to root out corrupt contractors and propose ways Countries have experimented with various approaches: to reorganize the agency to reduce corruption. * Whistleblower statutes protect and reward public * Some countries have independent anticorruption com- employees who report the malfeasance of co-workers or missions or inspectors general that can investigate alle- government contractors. The United States, for exam- gations and bring cases to trial. The most famous is the ple, has a statute that calls for rewarding workers who Independent Commission against Corruption in Hong report irregularities in government contracts. Such an Kong (China), which reports exclusively to the highest incentive for reporting is often necessary, since people authority and has extensive powers (Box 6.4). Singa- who report co-workers' misdeeds are frequently ostra- pore and Botswana have similar institutions. cized. Such measures are hollow, however, unless pros- * Ombudsmen hear citizen complaints and can help ecutors follow up, courts are incorruptible and effi- increase the accountability of government agencies. ciently run, and penalties are severe enough to deter Under the Ombudsman Act of 199 1, South Africa has potential offenders. established a public protector to investigate alleged improprieties (malfeasance, corruption, human rights Watchdog organizations should focus not only on abuses) by public officials and to prepare reports, which those who receive bribes, but also on those who pay them. are usually made public. The office cannot initiate legal It takes two to tango, and penalties should be equally actions but will refer cases to offices that can. severe on both sides-usually a multiple of the bribes * Some public agencies, such as the School Construction received or paid. Penalties for bribe payers should also Authority in New York City, have established internal include the prospect of being barred from contracting Box 6.4 Hong Kong's independent commission against corruption Corruption w-as endemic in Hong Kong: iChina) dur- at tirsE backed. do,sn and granEed an arnnest\ Tor ing the 1960s. [is entrenched character is suggested by oftenses committed before Januarv- 1l)". Thk set- expressions popular au the time: people had the choice back ssas harmful tO the commission's prestige. but it ol 'getting on the bus u;cTiv-ely parricipatinig in cor- was able to recover with a -orotI public education ruprioni or "running aJongside the bus" ibeing a campaign. Publit sartevy,carried our bet-ween I) and bYstander who did nor interferc with the systerni. 1"19-4 indicatie that public perceptions of corrupTion 'Standincg in fronr of the bus'' reporting or resisting have fallen significantly. Indirect e%idence suggests that corruprion) n:s not a viable option. active corruprion has declined as velJ. Spurtcd to acrion by a scandal in%olvkin a hiph- Stll. the ICAC? is nor %%ithout its problems. The ranking police officer. [he then-governor general escab- main one is thar ir report-s only to the governor. .An lished the independaent Commission Against Corrup- atricorruption commnissIon rep,orung it) an autocratic cion ltIACt in 1074. The commission reports only to ruler could be used as an instrument of repression the governor and is independent of rhe police force. agiinst political opponents. and the ICAC has nor ICAC officials are paid more thani othrr g,overnment been immune to such charges. The ICAC's broad wvorkers and ca:nnor bo transterred tOi other depart- powers could be abused in sysrems less committed ro ments. No one ma!s lease the ItACI t,o work t;r senior the rude of law. A serieN of oversihtr cummititee and officers who have been the subject of an inxesrigation. an independent judician act as a check on the I(,CAC-. The ICAC has rhc powcr to inestingate and prosecute but even so the occasional scandal surfacces. As a fuir- corruprion cases as well as to sponsor public education rher control cn its poiser. such an agencyn mighr re- campaigns. The government s conimitment to reto;rm port not to the chief executixe bur no rhe leigsla- u-as further indicatcd by rhe appointment of a pcrson cure. as do Liganda's lnspeccror General and the LI.S. of unquestioned incegriM as the first head of che com- General Accounting Otffice. A rough. independent mission and bs a polic- of investigating and prosecur- anticorruption agency is a potenlL tool and represents ing "big tigers' from the out.er. a crediblc long-ermrn cormmInrent. but therc should Earl' efforts to clean up corrupt sy udicares within also be checks on its ability to be mistsecl tor politri- the police force, ho'vever. met w,, ith pro'tess. The ICAC cal ends. 1 08 WORLD DEVELOPMENT REPORT 1997 with the government for a period of years. Industrial their constituents. (However, if corrupt payoffs are used countries with strong monitoring capacity can enforce to buy benefits for individual voters, knowledge of cor- such measures on their multinational companies conduct- ruption may do little to stop it.) ing business overseas. But except for the United States, * If courts are independent and citizens can sue to force which adopted the Foreign Corrupt Practices Act in the government to comply with the law, this opens 1977, countries have been reluctant to act unilaterally for another route to control government malfeasance. fear of subjecting their businesses to more stringent stan- * Public exposure of corruption through the media is dards than their foreign competitors. another option. Even undemocratic rulers are likely to be In this context, international organizations provide a sensitive to public opinion, if only because they wish to forum for agreeing on common standards and coordinat- avoid being overthrown. A free press can be a vital check ing action. Regional organizations such as the Organization on abuses of power, especially in countries that lack other of American States have sponsored international conven- means of constraining politicians and bureaucrats. tions making bribery, including international bribery, a crime. A recent initiative by the OECD encourages ending Yet even if both the necessary information and the the tax deductibility of bribes and criminalizing the bribing means of punishing corrupt practices are available, indi- of foreign officials. It makes recommendations to its mem- vidual citizens are unlikely to act alone. Laws that make it bet countries on how to deal with bribery in international easy to establish associations and nonprofits can help business transactions. International organizations are also resolve this collective action problem. Such groups might working to coordinate the fight against money laundering not only seek information from government, but also sup- and, in particular, to expand the list of offenses, including ply information to government about citizens' opinions of corruption. The forty recommendations of the Financial the quality of public services. As discussed in Chapter 7, Action Task Force on Money Laundering include nondrug the nonprofit Public Affairs Centre in Bangalore is en- criminal activities. This opens the way for countries to gaged in a promising experiment to publicize the per- make illegal the use, deposit, or transfer of money acquired formance of Indian public agencies. An international through corruption. nonprofit organization, Transparency International, is Citizens' groups can also be an important check on the working to mobilize citizens around the world to fight arbitrary abuse of government power-if people can orga- corruption and to publicize countries' track records. Yet nize, and if they can find out what is happening. Govern- precisely because open information can be so potent in ments should publish budgets, revenue collection data, promoting government reform, many countries limit such statutes and rules, and the proceedings of legislative bod- groups or make it costly for them to organize. ies. Financial data should be audited by an independent Strategic options: Balancing flexibility with restraints authority like the U.S. General Accounting Office. Unau- dited secret funds or extrabudgetary funds available to Pressures for reform are on the rise everywhere. Private en- chief executives are an invitation to corruption. trepreneurs and firms want the credibility of state actions Freedom-oflinformation acts in the United States and anchored by a well-functioning system of property rights. a number of European countries are an important tool for Citizens are demanding more responsive and effective public oversight. A recent directive of the European delivery of public services and greater probity in the use of Union requires member states to pass freedom-of-infor- public resources. At the same time, globalization is in- mation laws covering environmental information. Such creasing demands for a more agile state, one that can laws enable citizens to obtain government information respond quickly to changing circumstances. These pres- without having to show how their lives are affected by it. sures have magnified the state's dilemma: how to check The availability of information helps citizens discipline arbitrary decisionmaking without building rigidities that public officials at the ballot box and through other inhibit innovation and change. The fundamental chal- avenues of protest, such as legal challenges and direct peti- lenge is to devise institutional arrangements that sustain a tions to decisionmakers. workable balance between flexibility and restraint. Coun- Information is of little value, however, without mech- tries with strong institutions or track records of following anisms for using the knowledge gained to influence gov- through on commitments may have room to respond flex- ernment behavior: ibly (even at the cost of some corruption), but countries with dysfunctional and arbitrary governments may not. * In democracies, citizens can vote officials out of office if States in many developing countries have demon- they believe them to be corrupt. This gives politicians an strated a clear imbalance between flexibility and restraint. incentive to stay honest and work for the interests of They have generally not been credible, accountable, re- RESTRAINING ARBITRARY STATE ACTION AND CORRUPTION 1 09 sponsive, or agile. In several countries the capricious exer- the civil service (for instance, by raising pay and restrain- cise of state power coupled with rampant and unpre- ing political patronage in recruitment and promotion), dictable corruption has undermined development. States reducing opportunities for officials to act corruptly (for with too much flexibility and not enough restraint will instance, by increasing competition and reducing officials' find that their actions are not viewed as credible, and discretionary authority), and enhancing accountability are investment and growth will suffer. These countries need other essential steps. Strengthening mechanisms for mon- to strengthen the formal instruments of restraint-judi- itoring and punishment-of the people who pay bribes cial independence, effective separation of powers-to as well as those who accept them-will require vigorous enhance the credibility and accountability of the state. enforcement of criminal law. But it will also require over- International commitment mechanisms can serve as a sight by formal institutions such as statutory boards and short-term substitute while these institutions are built up. by ordinary citizens (through voice and participation). Yet these actions will not be enough to stop the rot in These efforts can help not only in controlling corruption countries where endemic and entrenched corruption has but also in improving many other functions of the state, undermined key functions of the state. Strengthening such as policymaking and service delivery. The use of formal instruments of restraint is only one element of a voice and participation to reinvigorate public institutions multipronged strategy to control corruption. Reforming is the subject of Chapter 7. BRINGING THE STATE CLOSER TO PEOPLE And, tell me, what use is the ship-of-state if all are not on board? -From Tijan M. Sallah, The State (1996) P EOPLE ARE THE MEANS AND THE END OF DEVELOP- ment, business, and civic organizations, can also enhance ment. But they have different amounts of power their supply. But effective citizen involvement does not and resources, and different interests, all of which the state come easily. One lesson of many such experiments is that must try to represent and respond to if it is to act effec- effective participation requires enlightened government tively. In nearly all societies the needs and preferences of intervention, including improving the institutional envi- the wealthy and powerful are well reflected in official pol- ronment in which social and human capital is created. icy goals and priorities. But this is rarely true of the poor There is another important lesson: bringing govern- and the marginalized, who struggle to get their voices ment closer to some people can risk taking it even fur- heard in the corridors of power. As a result, these and other ther away from others. Not all organizations of civil society less vocal groups tend to be ill served by public policies and are adequately accountable, either to their own members or services, even those that should benefit them most. to the public at large. And although some groups may be A state that ignores the needs of large sections of the quite vocal, the interests they represent may not be widely population in setting and implementing policy is not a shared. In reaching out to groups in civil society, govern- capable state. And even with the best will in the world, ment must be conscious of the interests those groups rep- government is unlikely to meet collective needs efficiently resent, but also of those they do not. Otherwise its inter- if it does not know what many of those needs are. Rein- vention risks creating new disparities between the newly vigorating public institutions must, then, begin by bring- enfranchised and those whose voices remain unheard: ing government closer to the people. That means bringing women and ethnic groups, for example, or people whose popular voice into policymaking: opening up ways for interests have not been adopted by an active NGO. individual users, private sector organizations, and other Some of the same concerns arise with regard to decen- groups in civil society to have their say. In the right set- tralization. Carefully managed, decentralization can do ting, it can also mean greater decentralization of govern- much to improve state capability, creating pressures for ment power and resources. better matching of government services to local prefer- This chapter discusses a wide range of mechanisms to ences, strengthening local accountability, and supporting ensure that policies and programs better reflect the full local economic development. But there are pitfalls: policy- panoply of society's interests. Informing and responding makers in central government may lose control over the to citizens will raise the state's effectiveness by improv- macroeconomy as a result of uncoordinated local deci- ing monitoring of public goods and services and forcing sions, and regional disparities can widen, exacerbating greater transparency in decisionmaking. Encouraging economic and social tensions. Local governments can fall wider participation in the design and delivery of these under the sway of particular interests, leading to abuse goods and services, through partnerships among govern- of state power and even less responsive and accountable BRINGING THE STATE CLOSER TO PEOPLE 1 government. The message, here as elsewhere, is that bring- formance of some state institutions is falling short of ex- ing government closer to the people will only be effective pectations (Box 7.1). if it is part of a larger strategy for improving the institu- tional capability of the state. Electoral participation In a democratic society elections are the primary manifes- Greater accountability and responsiveness tation of citizen voice. The number of democratically through participation elected governments has increased sharply in recent Throughout history nearly all societies have grappled with decades, giving many citizens new opportunities to voice how to make the state reflect the needs and interests of the their opinions through the ballot. In 1974 only 39 coun- population. But it is an especially relevant question today, tries-one in every four worldwide-were democratic. with the spread of education and information and the Today 117 countries-nearly two in three-use open growing pluralism of nations creating new pressures on elections to choose their national leadership, and two- states to listen and respond to the voices of their citizens. thirds of the adult population in developing countries are A sample of public opinion around the world suggests eligible to participate in national elections (Figure 7.1). that belief in government remains solid, but that the per- The trend is especially striking in Central and Eastern Box 7.1 Public opinion and the state V_ie%%s on the stare var ' kc-delv. reflcring perecpuollns of In Latin Ainerica 6i Percent ocitizrni bchie%e chat v.id-ranging political and economc' ariables. To ass&s the staie should inuer.ene to reduce income difference. these perceptionis and concerns. public opinion sur'evs berssecr rich. and poor. Latin ALmericaan respondent; have been carried our in Varous Countries and regions,. also re,ard a, cri tcal the gororncnt s role in main- For o:arnple. a 1991-92 SIJsure found hait 4'i percent cainini., laxi and order, but ol; percen[ haxe lirtle or no of respondentLs tn he United Kingdom. sad 44 percentr cu.,nildence in che ludiciarv or che police f;ree. Onh, 2s in the Uiited StreIs, felt excluded from public decision- percenc base some contilenc in tl chee insLmuions. malking thar directly affected their lives. E[en sc., rati- TIiesc results closelk- mirror the concerns voiced b! faction with the waY Lhcir democracies are dekclopiing is the region's entrepreneurs in the urvne) reported in relarivels high in WCestern Europe anld North Anmerica. Chapter i ranging frcm )-i4 to 64 percent of respondents. B3 con- In Indi3 a 1996 sunev found that. despite strong: tract. in Latin &Arnerica and thc transition economnies ct support for the democratic ~vsitni. v-oter trust in their Easrern Europe only 311 to -I) percent of respondenrt rcpresentatives ha, falleni sine ItV-] Trust in so:me report being satisfied %ith the n a%' theil deuin.c raoc Jice publiL iflluinU1:1 ato d' lo l.' . panic ularl.% Eli police working. In Latin Arnmeric3 lis negateiptrception may 28 percent' and the bureaucrac% 0Y pcenri. Still be related to the fiac t[hat 52 percent of reiponden,c in a the poII founid strong popular partcipiipaon and nMelve-nation surtev felt thar the administratuon ofJle- innol i nient in politics: rhe number of respondents tions in heir countrn i,as tfraudulent. %kho said they p.articmpirtd in a social organization or In Furope public support for the state and its serx ices political parr- doubled bens cen 1 0- I and I 10o. has been consiktentld strong sinct the 07t)QS. in 1990l In contrast to Europe. Latin America. and to some lar,e mapjorities-morerhan -0percent-inis_etern\'t:st- e\.rint A'ia., where statist traditions remain strong, in ern European nalions still belieted rhir the gosernmienr thi Linited Straes ,IJ percent of respundenrs in a recenlt should prov%ide health care, sern ices ro the elerly, aid to poll said they mistru-szted tile government becaus ot irt the unemployed. and assistante to industn. as well as perceived inefficiteny and wkaste. In addition. ptublic reduce income differences. A 199') poll across the fifteen ouppoir for %kelfare programs. particularly targeted wel- countries of the European LUnio.n found that 51 percent fare spcndin . hai dejined. A 1003 poll found that of cirizens believe their governments ,hould maintain onls one-soarh of Americans thought thar the w%elfarc current social benefits and protection lecels. compared sv.rem wa-s working vets %%ell or fairly %%cll. and in with 12 percent who think they should bc cur consider- 1905 tvwo-hirds Ehought thit too much as ,beino ablh- tr enhance ET competitiveness sin orld marlker.. spent on wkelfare programis. 1 12 WORLD DEVELOPMENT REPORT 1 997 Figure 7.1 The world has become much more democratic since 1980 ide' or deIfloec~ r3 rst dernocratic = j) 10 Ea4(ern EurKOe 4 Lah, AqT V n-ar -2 -6 A ,f Srwdrr,a, I`J. j,l E.a'l 39r,.d fJorill Afri,,: 1960 1965 1970 1975 1980 19185 1990 1994 rIvrj Tr,,- p.-ri.o:.j ,rw r ,t dem1C,rC.3,:, ui;e, 7 for I r .ojnLr.e tron, score6 on i-e comn oner,i. ,noacai0rs: conm,epti,ver,1s of poli,cal (,t,D' r,Agjutc,r, r 011E.,,:IIal pai,rrip;ric'n. Co0MeLtare~r, .r C.e(.*.le recruamera, oDerwie,*; oi e,ccubv* recruiLnent, an, consfluIs, or, cr., rel T.*u,Ie. T,e n:rlc Ear,. a;ei nr-i endr;,e an, p3nriulr 'ierrocrac% ,r,je.. F.*e rre Te.nr.r,rci WIEct for t eta,s Source. Jaggefs 3n.j G.l , 1 -r Europe and Central Asia, where the fall of communist democracies in the 1980s shows that women's parliamen- regimes in 1989 and 1991 sparked a series of major polit- tary representation and voter turnout are higher in systems ical changes across the region. These events had repercus- based on proportional representation than in winner-take- sions in other regions as well, particularly in Sub-Saharan all systems. Where women are better represented in par- Africa. In Latin America the gradual movement toward liament, their interests are better protected, through poli- democracy started somewhat earlier. Now all but two cies relating to maternity leave, child care, and flexibility countries in the region have democratically elected gov- in retirement systems. This suggests caution in making ernments, and close to 13,000 units of local government simple generalizations about the representativeness of for- are electing local leaders (such as mayors), compared with mal electoral arrangements: it is important to analyze how fewer than 3,000 in the late 1970s. they play out in practice. The principle of one person, one vote is fundamental to the representative purpose of elections. Without the Diversity and representation necessary safeguards, however, political interference and Concern about the effects of majoritarian rule has some- electoral fraud can seriously affect representativeness and, times led to changes in electoral arrangements to ensure thus, the legitimacy of electoral outcomes. As Box 7.1 adequate representation of minority groups. As the num- noted, for instance, a majority of poll respondents in ber of ethnic conflicts around the world attests, the belief twelve Latin American countries felt that the administra- of certain groups that they are being left behind-in terms tion of elections was fraudulent in their country; only 30 of income, assets, or employment-can be a powerful to 40 percent felt satisfied with the way democracy was source of frustration. This can spill over into direct con- working. Constitutional and institutional arrangements, flict if the lagging groups lack adequate means of repre- compounded by inadequate information, also affect the senting their concerns. Political elites who mirror ethnic ability of minority interests to gain effective representa- differences in competing for power and distributing tion. For example, a study of a number of European patronage will add fuel to the fire. In the conremporary BRINGING THE STATE CLOSER TO PEOPLE I 13 world, states play a significant part in shaping ethnic rela- tions through two related channels: Box 7.2 Managing multiethnic societies in Malaysia and Mauritius U The expansion of political authority enables states to create a competitive arena for the distribution of state Ethnic divisions in Nlala%ssil ha%e cheir rootr in [he resources and access to education, employment, land, colonial period. --hen Ligt. numbers cf erhnic Chli- and credit. nese and lndians immisrateld o take obs and conm- * The extension of political patronage, whether for ad- mercial o.pporrunities that v.ere not being tilled by ministrative convenience or for enhanced control, lets the laigely agrarian narive Mala3is I hule.,p1irpii. 'The governments favor certain ethnic groups over others. l9 C Constltriotu enshrined consociauional princi- ples. achieved Through e\tensive ncgotiaiioni amono Ethnic differences and conflicts are a part of most soci- the major groups. fn 1'9-1. ho%sever. the ne,% parla- eties, yet some societies have managed them better than ment passed a constiutuional amcndment that firmly others. Techniques for alleviating such pressures have established MlaJa]v primacy. The amendnienr made included dispersing the "points of power" (decentraliza- it illegal to cluestion publick or cven in Parliament tion or devolution), supporting electoral arrangements the status ot is¶alay language. [he so%creignry of the that encourage cooperation among ethnic groups (elec- MllaLiv rulers. che spccial position of Nialays ur The toral incentives and coalitions), and giving preferences to cirizenship right. of rhe inimiiranr conirnunines less privileged ethnic groups in public sector employment This ruling dhanged [he character of electoral canm- and other areas. Box 7.2 describes how constitutional paigns. since parties could no longer gain votes b., change and preferential policies were used in Malaysia and aroubinrg ethntc inaoonisnis. Mauritius. By looking at some of the basic rules of the A second uiitiarisc. the Neiv Economic Pro.grain game, including elements of the political or institutional I I)-O-9u . boosted the economic position of structure, both countries seem to have found a way to Nlila s. The program had rtvo miiin element.. The manage ethnic differences effectively. firs.t was Thle promotion of full. producti% emplov- ment of Nlalays and an cxpansion of [he smpply Alternative strategiesfor voice andparticipation of skilled Nlalav la-.-r. Preferentill uni.-cr.i-N Voting rules and electoral incentives can be reformed to adnmiisions -trndlrds for Nlala...- almost tripled make them more representative, but the simple fact that cheir enrolnlment. to three-quarters of the Total. The elections and referendums are held relatively infrequently second wxas the gradual redistribution of asset owvn- (Switzerland is an exception, with an average of five local ership. The gtocernrmenr made it clear that it tsould referendums each year since 1945) limits their scope for nor confiscate Chinese economruic , ealth, but that it communicating timely information about societal prefer- Would promot[e Nlkla- participation in a grouving ences. In most societies, democratic or not, citizens seek economY. Strong growth allksed non-Nlala s to representation of their interests beyond the ballot: as tax- continue To gain x; hile the Nev. Economic Pro- payers, as users of public services, and increasingly as gram ensured that the growih v'.oull be ,hared by clients or members of NGOs and voluntary associations. all cltizcni. Against a backdrop of competing social demands, rising Nlaurivius ha. at least threc maior ethnic :Toups-: expectations, and variable government performance, these Indo-Mlaurii.mn., Creoles. and (Chinese. The de- expressions of voice and participation are on the rise. si wners of the elecrorll ..-.em ansiou. to avoid cre- The rapid growth of NGOs illustrates the trend most scin inscirlniinv rhit ij,-hr evacerbare rbe coun- vividly. Since the late 1980s the number of NGOs oper- rn-'s crhniic divisions. strucrured the systern to force ating in parts of Africa and Asia has almost doubled. In the miain parties lo seek support tronm all communi- Central and Eastern Europe and the CIS the number of ties. lMoreo%cr. Nlauritian governmenlts have gener- NGOs may have increased three- or fourfold from its very ally .hosen hbroadc-based growth and distriburion low base of 1989. In some countries of the OECD, oper- policies oier ethnic pretrereces. Fornmal preferences ating expenditures in the voluntary or NGO sector now in emplov rent and ii education ha%e never been account for almost 4 percent of GDP. u)ed. And All go'etnmenr. s;nce independence hav.e NGOs have myriad organizational forms and func- had to form multethnic coalition, in order to tions, from labor unions to professional associations to assume and maintain po'xer. Gro%kth k..ith rediicri- neighborhood groups to philanthropic trusts. Among the bution has tnrcded ro blunt the appeal of communal most active NGOs today are those providing services politics. directly to individuals and communities, from health and I 1 4 WORLD DEVELOPMENT REPORT 1997 education to microcredit, vocational training, and profes- have had a direct impact on this isolated community. The sional services. In the OECD countries many NGOs committee has an elected executive board consisting of operate alongside public providers. In Japan and the members from each part of the village; villagers rank it as United Kingdom, for example, a large percentage of non- the most relevant and effective organization in the village. profit organizations are active in education. In the United Similar locally based organizations include rotating credit States they figure prominently in health care. But unlike associations, farmers' associations, worker cooperatives, public providers, most NGOs are not obliged to cater to parent-teacher associations, and even religious congrega- the general needs of the population; this makes it simpler tions. These associations are valuable not only for their for them to provide services of a particular type and qual- ability to meet basic needs, but also for the role they play ity to specific groups. in building trust and a sense of public connectedness In most developing countries NGOs engaged in ser- among those excluded or alienated from the formal politi- vice delivery are small in scale, working in communities cal process. But organizations such as these also face limi- and settings where the reach of government or private tations, induding narrowness of membership and repre- providers is weak or nonexistent. In the West Bank and sentation, limited management capacity, and the risk of Gaza, for example, an estimated 1,200 NGOs provide 60 co-option by traditional power holders or political factions. percent of primary health care services, up to half of sec- ondary and tertiary health care, and most agricultural ser- The institutional basis of participation vices, low-cost housing schemes, and microcredit. In The depth and intensity of popular collective activity Cambodia some thirty to forty NGOs provide micro- obviously differ by social and institutional setting. One credit to rural and urban entrepreneurs in the absence of explanation for these differences lies in differing endow- alternative government programs for poverty alleviation. ments of social capital, the informal rules, norms, and The numerical importance of these NGOs reflects their long-term relationships that facilitate coordinated action ability to substitute for weak public sector capacity and to and enable people to undertake cooperative ventures for mobilize funds from a range of different sources, includ- mutual advantage. The presence of rules conducive to ing national and international organizations. social organization can improve the collective efficiency Yet not all NGOs are involved in the delivery of ser- of a community, but the absence of such rules is not nec- vices. Many others are research and civic education essarily a permanent condition. They can be generated groups, advocacy organizations, and professional and busi- by participation itself, and here governments and other ness associations that represent particular interests or seek formal organizations such as labor unions can play a pos- to educate the public about issues in their collective inter- itive role. Government efforts to improve the manage- est. The Socio-Ecological Union in Belarus, for example, ment of irrigation systems in Taiwan (China) and the is actively engaged in public education about industrial Philippines, for example, have yielded numerous collec- pollution and its consequences. The West Africa Enter- tive responses from farmers in managing operations and prise Network is a business-oriented network, with some maintenance and in collecting water user fees. By accept- 300 members from twelve nations, representing the inter- ing co-management of water resources by farmers, public ests of domestic entrepreneurs in dealings with govern- officials achieved a substantial improvement in irrigation ment. In many countries trade unions play an important management. In the state of Ceara in northeastern Brazil role in generating and disseminating information on labor (see Box 5.7 in Chapter 5), community monitoring of an and policy-related issues. The growth of these intermedi- innovative government health program provided the basis ary organizations reflects the larger movement toward not only for a highly successful program but also for more democracy in many regions and, in some countries, the effective cooperation among community members on need to bridge the "missing middle" between citizens and other mutually beneficial courses of action. the state. Unlike the electoral process, however, where all The debate about the contribution of social capital to votes are counted equally, not all these organizations are economic and social development is just beginning, and equally representative, either of their clients' interests or of the early evidence is by no means unambiguous. But some the public interest more broadly. studies are already demonstrating its potential impact on Most intermediary NGOs tend to be one step removed local economic development, on the provision of local from ordinary citizens; by contrast, grassroots organiza- public goods, and on the performance of public agencies tions, community-based groups, and people's organizations (Box 7.3). engage them directly. In Umu-Itodo, a v