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Macroeconomic Topics in Development


Macroeconomic Topics in Development & Transition EC938 Sharun W. Mukand * – PowerPoint PPT presentation

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Title: Macroeconomic Topics in Development

Macroeconomic Topics in Development
  • Sharun W. Mukand

Four meta-theories of institutions
  • Efficiency institutions that are efficient for
    society (e.g., for aggregate growth or welfare)
    will be adopted.
  • Ideology differences in beliefs determine
    institutions (societies choose radically
    different institutions because citizens or elites
    have different beliefs about whats good for
    economic growth).
  • Perhaps North Korea chose planned economy because
    its leaders believed it was better.
  • History institutions determined by historical
    accidents or unusual events, and are unchanging
    except for random events and further accidents.
  • Legal system today determined by past historical
  • Social conflict institutions chosen for their
    distributional consequences by groups with
    political power.

Which approach? (Efficient Institutions)
  • Although, everything else equal, there would be a
    tendency to adopt efficient institutions,
    everything else far from equal in practice.
  • Every set of institutions creates different
    losers and beneficiaries. Efficient institutions
    require either the losers to be compensated or
    the beneficiaries to impose their choice.
  • But in practice, losers generally not compensated
    ex post, and often can be powerful enough to
    block institutional change that is beneficial in
    the aggregate.
  • Empirically, efficient institutions view cannot
    help us understand why some societies adopt
    institutions that were disastrous for economic
  • (approach not very useful)

Institutional persistence some things we know
  • Institutions are by their nature durable
  • e.g., democracy more likely tomorrow if today
    there is democracy than if dictatorship today.
  • Bad institutions create bad incentives and
  • e.g., an extractive state apparatus will give
    incentives to political elites to use it for
  • Bad institutions create instability and
  • e.g., if controlling the state is a major source
    of rents, there will be infighting to control the
    state as in Ghana.
  • Bad institutions affect the composition of assets
    and distribution of income, contributing the
  • e.g., bad institutions ? greater inequality ?
    political power of the rich to sustain bad

Institutional change (1)
  • Towards a theory of institutional change
  • Recall
  • political institutions ? economic institutions
  • Thus important to understand change in political
  • Political institutions a way of regulating the
    allocation of future political power
  • Two axes
  • Elite-driven versus conflict-driven
  • Internal versus external

Institutional change (2)
  • Elite-driven when the politically powerful elite
    wish to change institutions in order to increase
    its rents/utility.
  • E.g., the U.S. Constitution or the imposition of
    different systems of land relations in the Dutch
    East Indies.
  • Conflict-driven when institutional change forced
    from the non-elites. E.g.
  • Rise of democracy because of the threat of
  • Rise of constitutional monarchy resulting from
    the fight between the crown and groups of
    merchants in Britain and the Netherlands.

Institutional change (3)
  • Internal because of internal shocks or dynamics.
  • E.g., rise of democracy.
  • External because of external imposition, shocks,
    or external incentives.
  • E.g., colonial imposition of institutions, Korean
    response to threat of communism.
  • E.g., EU incentives for East European reform.
  • Even with external imposition, internal dynamics
    are very important ? the pitfall of ignoring
    internal dynamics.

Conclusions (1)
  • Institutions matter.
  • Although ideology and history influence
    institutions, in many many cases institutions
    emerge because of their distributional
  • Although everything else equal more efficient
    institutions more likely to arise, there will
    typically be major social conflict over
  • Then the choices benefiting politically powerful
    groups, not the society as a whole, more likely
    to emerge.

Conclusions (2)
  • Summary towards a dynamic theory

Economic institutionst Economic
policiest Political institutionst1
De jure power (Political institutions)t De facto
political powert
Governance matters
Governance matters..
  • Some Considerations
  • Some countries are rich and others are poor.
  • Economic development/Institutional change is
  • Need for coordination ? Role for Government.
  • Political factors further impede governments
    ability to carry out change.

  • Good governance in developing countries REQUIRES
  • 1. Fiscal discipline
  • 2. Reorientation of public expenditures
  • 3. Tax reform
  • 4. Financial liberalization
  • 5. Unified and competitive exchange rates
  • 6. Trade liberalization
  • 7. Openness to DFI
  • 8. Privatization
  • 9. Deregulation
  • 10.Secure Property Rights
  • The international capital market/IMF/World Bank
    insisted in its policy recommendations that there
    is a unique path to developmentpolicy reforms

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In Search of the Holy Grail Policy Convergence,
Experimentation and Economic Performance (2005)
American Economic Review
  • Developing countries have undertaken Washington
    consensus style reform during the eighties and
  • Policy convergence ? Economic convergence??
  • Why the discrepancy?
  • Countries not implementing economic reform in
    first place (i.e. no policy convergence).
  • Universal applicability of policy?? Is it a
    reasonable assumption.

  • Appropriate reforms and policies have a large
    element of specificity and experimentation is
    required to discover what works locally..
  • Two track reform worked well in Dengs China but
    not in Gorbachevs Soviet Union.
  • Gradualism may work in India but not in Chile
  • Import Substitution may be appropriate in Brazil
    but not Argentina
  • Privatization may be necessary in Latin America
    but not Asia..

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  • Are we implying that economic principles work
    differently in different places?
  • No.
  • We distinguish between economic principles and
    their institutional embodiment. Most first-order
    economic principles come institution
    freeincentives, competition, hard budget
    constraints, sound money, fiscal
    sustainabilityare central to the way economists
  • However, these universal economic principles do
    not of themselves map into specific institutional
  • Property rights can be implemented through common
    law, civil law or Chinese-style socialism

  • Countries located on unit circle countries
    differ in terms of their location dictated by
    differences in history, geography, culture.
  • Country location given by zi.
  • Country can either Imitate and adopt
    institutions developed and refined in other
    countries or Experiment and engage in
    institutional innovation.
  • Both Imitation and Experimentation have both
    an upside and a downside.
  • Imitation ? no uncertainty about the blueprint
  • ? may adopt institutions that
    are not appropriate for
  • local conditions (loss in
    output) (-).
  • Experimentation ? uncertainty (-)
  • ? institution may be
    adapted to local needs ()

  • If a countrys location is zj and the
    institutional/policy choice is ai then the
    expected output is given by
  • yi -?(ai - zj)2
  • Government preferences Vi yi ?K
  • ? 1
    if govt. experiments and,
  • ? 0
    if govt imitates policy/institutions.
  • K
    private fixed cost paid by govt. if it
  • Uncertainty with Experimentation Government has
    imperfect control if it chooses ai zi ? ,
    where ? N(0, s2).

  • Imitation
  • Eyi(IMIT) -?(a1 z2)2
  • Experimentation
  • Ey(EXPT.) E -?(a2 z2)2 F
  • Experimentation versus Imitation Govt. in
    country i will prefer imitation to
    experimentation if
  • Ey(IMIT) Ey(EXPT.)

  • In the immediate neighborhood of the successful
    leading country, follower countries prefer to
    imitate the leader ? growth pole across the
    successful leader.
  • Countries far from the leader the
    far-periphery will experiment. Economic
    performance is on average worse than that of the
    leaders ? but much greater variance than the
  • The worst performing followers should be at some
    intermediate distance from the leader country.
  • Economic Performance should show a U shaped
    relationship when plotted against distance.

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Institutional Adoption The Transition Economies
as an Experiment
  • Around 1990 socialism has failed! There is no
    ambiguity about whether countries searching for
    new institutions to replace socialism.
  • Set of countries searching for new institutions
    can be cleanly identified all former socialist
  • Plausible notion of distance.?...

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  • Provides a framework to think about the
    specificity of policy implementation.
  • Economic Policy (universal economic principle)
  • Institutional Specificity
  • Economic Outcomes (e.g. economic growth, pcy)
  • In light of specificity, insistence by
    international K mkt., IMF, World Bank that
    developing countries adopt the Washington
    Consensus set of policies/institutions to be
    successful ?

  • In light of specificity, insistence by
    international K mkt., IMF, World Bank that
    developing countries adopt the Washington
    Consensus set of policies/institutions to be
    successful ?
  • Transition economies ? even a decade later, had
    yet to catch up with pre-transition levels of pcy
  • Sub-Saharan Africa did not take off despite
    significant reforms
  • Frequent and painful financial crises in LA/East
  • Latin American Recovery of the90s was
    short-livedcrash of Argentina (the poster boy
    for Washington consensus policies)
  • (Goodbye Washington Consensus, Hello Washington
    Confusion? Dani Rodrik (2006), Journal of
    Economic Literature

  • IMF claim Policy Reform did not yield sustained
    results in many developing countries because
  • (i) genuine reform was skin deep with no follow
  • (ii) Reforms in face of poor institutions was not
    sustainable. Regulatory mkts weak, Corruption
  • New set of Washington consensus reforms ? heavy
    emphasis on Institutional Reform.
  • Are Institutions key to growth and development?

Comparative Growth Experience
Per capita GDP 1960 Per capita GDP 1990 P.C. growth (1960-89)()
South Korea 883 6206 6.82
Taiwan 1359 8207 6.17
Ghana 873 815 -0.54
Mozambique 1128 756 -2.29
Brazil 1745 4138 3.58
Argentina 3294 3608 .63
Globalization and Governance
  • Developing countries
  • Weak political institutions ? Political Selection
    weak ? poor leaders ? Bad governments.
  • Poor Economic institutions ? imperfect contract
    enforcement, rule of law..
  • Weak Economic and Political Institutions ?
    Economic Insecurity ? low investment ? low
    economic growth ? poverty and underdevelopment.
  • How do we develop new, better quality growth
    promoting institutions?
  • What is the impact of globalization on a
    governments incentive to adopt good quality

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Globalization and GrowthHow to make poor
countries grow when Governance poor?
  • Attract capital(one way)
  • (i) attract Foreign Aid
  • (ii) IMF help
  • (iii) Foreign Investment (FDI, Portfolio equity

Bad Governance and the Globalization of Capital
  • LDCs typically have a high marginal product of
    capital. So investment should flow to developing
  • However, typically developing countries lack
    financial markets that allow transfer of funds
    from savers to borrowers
  • Weak enforcement of economic laws and regulations
  • Weak enforcement of property rights makes
    investors less willing to engage in investment
    activities and makes savers less willing to lend
    to investors/borrowers.
  • Weak enforcement of bankruptcy laws and loan
    contracts makes savers less willing to lend to

  • Over the past decade, emerging market bond
    markets have deepened markedly.
  • Volume of international securities by emerging
    market sovereigns and corporates has increased
    from a level of 325 million in 1995 to roughly
    700 million in 2003.

Dont Mess With Moodys New York Times 1995.
  • In the 1960's the most important visitor a
    developing country could have was from the head
    of AID, the U.S. agency that doled out foreign
    aid. In the 1970's and 80's the most important
    visitor a developing country could have was from
    the I.M.F., to help restructure its economy. In
    the 1990's the most important visitor a
    developing country can have is from Moody's
    Investors Service Inc.
  • Because we now live in an age when governments
    are basically broke, the only way for most
    countries to raise cash for development is either
    to enforce savings at home or attract investors
    from the world's major bond markets. Moody's is
    the credit rating agency that signals the
    electronic herd of global investors where to
    plunk down their money, by telling them which
    countries' bonds are blue-chip and which are

  • That makes Moody's one powerful agency. In fact,
    you could almost say that we live again in a
    two-superpower world. There is the U.S. and there
    is Moody's. The U.S. can destroy a country by
    leveling it with bombs Moody's can destroy a
    country by downgrading its bonds.
  • Moody's rates the investment quality of countries
    today just as it rates companies. Those that get
    their economic house in order will be rated AAA
    and be able to sell bonds at low interest. Those
    that don't will be rated C and have to pay
    pawnbroker interest rates
  • .. Moody's and the bond market are now imposing
    on democracies economic and political decisions
    that the democracies, left to their own devices,
    simply cannot take.
  • (Thomas
    Friedman in the New York Times, 1995)

Disciplining and the International Capital Market
  • Disciplining effect of the international capital
  • Can the international capital market improve
    global governance through punishing poor
    governance and rewarding good governance?

Foreign Direct Investment Stocks
  • International integration of product markets may
    be fostered by FDI stocks (FDI is long term and
    flows are volatile)
  • World FDI Stock as a of World Output
  • --------------------------------------------------
  • 1913 1960 1975 1980 1997
  • --------------------------------------------------
  • 9.0 4.4 4.5 4.8 11.8
  • --------------------------------------------------
  • FDI/GDP ratio highest for France/UK in 1914
  • and
    UK/Germany in 1997.
  • Traditionally FDI/Foreign Aid main form of
    capital flows to developing countries. In recent
    decades things have changed.

Net capital flows to developing countries,
Net inflows ( billions)
  • Unofficial flows to developing countries far
    outstrip official flows
  • FDI and remittances dominate unofficial flows
  • FDI is becoming increasingly concentrated
  • FDI outflows have surged dramatically to 40
    billion (South-North and South-South investment)
  • Corporate bonds and portfolio equity will also
    become increasingly important in middle-income

Foreign direct investment
Worker remittances
Portfolio equity
Bank loans
Source World Bank Global Development Finance 2005
External capital structureEmerging and
developing countries
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The Fire Tomorrow Sorting out the sheep from the
The Confidence Game
  • Washington's preoccupation has been not economic
    fundamentals but market confidence. And what does
    it take to restore confidence? Policies that may
    not make sense in and of themselves but that
    policymakers believe will appeal to the
    prejudices of investors--or, in some cases, that
    they believe will appeal to what investors
    believe are the prejudices of their colleagues
    Paul Krugman
  • Governing the Global Economy Does One
    Architecture Style Fit All Dani Rodrik (1999)
    available at http//
  • Globalization and the Confidence Game Mukand in
    Journal of International Economics (2006)

The Confidence Game will the government always
choose a policy in accordance with its private
  • Unknown State of the World SL, SR. Prior is
    that SR is more likely.
  • Different policies appropriate for different
    states of the world
  • SL ------------ aL -?
  • SR ------------ aR ?
  • However, a mismatch results in low productivity,
    e.g. G 0.
  • Y G f(k) G. (k)a
  • Government receives a private signal sj that is
    more reliable than the prior.
  • Govt. then chooses to implement either policy aL
    or aR. (Socially optimal for government to use
    all available information in making making its
    policy choice.)

  • Foreign investors observe governments policy
    choice and decide on how much to invest.
  • Realization of Public good productivity (or
    quality of economic environment). Output
  • Payoffs realized Foreign investors (earn a.y)
    and national income is (1-a)y.
  • ------------------------------------
  • Case I Prior versus the private information
  • Prior ? P(SR)gt1/2
  • Private Signal sL of reliability Fgt?

Bayesian updating
  • Reliability of signal F  P(sRSR)  P(sLSL).
  • Government should always choose a signal that
    accords with its private signal if it wants to
    maximize overall output P(sRSR) gt P(sLSL) gt1/2.

  • Government may ignore private signal and go along
    with priors of the international capital market,
    in order to attract foreign capital and (in
    expected terms) maximize output.
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