Finance & Development September 200456

NSTITUTIONS are all the rage. Theabsence of institutionssuch as effi-cient and impartial judiciaries, legalsystems to protect intellectual prop-

erty, tax administrations that are efficientand free of corruption, and credible centralbanksis offered as an explanation for someof the central puzzles in development eco-nomics, including why so many countriesdont grow fast enough to vanquish poverty.

But, unfortunately, economic theory offersus little guidance on how strong institutionsare created and nurtured. And, unless wedevelop a better understanding, simply recit-ing the mantra institutions offers little inthe way of constructive policy advice to lessdeveloped countries, leaving the policy arenaopen to other, more dubious views. Atremendous amount of research is nowbeing conducted on the provenance of insti-tutionsincluding whether they are a proxyfor deeper forces. But my focus here is onwhy mainstream economists have neglectedthis in the past. In particular, I want to askhow much blame for this neglect should beattached to the canonical model in econom-ics: the complete markets model.

Assume a perfect worldIn this theoretical model, which every grad-uate economics student encounters in oneform or other, everyone is fully informed;every eventuality is anticipated in contracts;all contracts are enforced by omniscient,incorruptible courts; and governmentsautomatically take care of all the publicgoods and interfere in none of the privateones. Clearly, this is an abstraction even inrelation to the developed world. Yet it isregarded as a useful starting point for anumber of reasons.

First, it is argued, the model is, in impor-tant respects, a reasonable approximation ofreality. Second, it usefully serves as a commonpoint of departure, deviations from which

and the fewer the betterhave to be justified.This approach disciplines research, preventingoriginal but muddled thinkers from generat-ing results simply by making unorthodoxassumptions. It enables economists to talk toeach other rather than past each other. It helpseconomists see the implications of theirfavorite deviation from the assumptions ofthe complete markets model by comparingthe conclusions from the model incorporat-ing that assumption with those of the com-plete markets model itself. And it enhancesdebate and understanding (and makes refer-eeing for scholarly publications easier). Third,the model is mathematically tractable andallows elegant theorems and proofs.

The point of building models is to learnabout the real world by abstracting fromdetails that are irrelevant to the issue beingconsidered. Without models, we would justhave descriptions. But while some abstrac-tion is important, gross abstraction canmake a model irrelevant. And for many situ-ations, at least in the developing world, thecomplete markets model is too far distancedfrom reality to be useful.

Take, for example, armed conflict, whichplagues many poor countries. It is usuallyviewed as wasting resources and, therefore,being economically inefficient. There is noroom for conflict in the complete marketsparadigm: with complete markets, we wouldsimply anticipate all possible situations ofconflict and contract them away. But, in truth,an important reason for continued conflictsin some countries is that there is simply nocredible mechanism to enforce contracts.Warlords may sign peace treaties but, know-ing they wont be enforced, exploit the ensu-ing peace to prepare for the next war. How tobuild commitment against predation andenforce contracts at the national level are first-order economic issues. Early economists, likeHobbes and Locke, reflected on them. Butwith a few notable exceptions, economists

Assume anarchy?Why an orthodox economic model may not be the best guide for policy

Raghuram Rajan

Raghuram Rajan is IMFEconomic Counsellor andDirector of the IMFsResearch Department.

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neglected them for many decades, in part, perhaps, becausemany were trained in developed countries, where the com-plete markets model is somewhat less absurd. Only recentlyhave economists returned to these questions.

Although the model can be a useful abstraction in somecircumstances, it is an intellectual straitjacket when applieduniversally, particularly because it ignores the costs of con-tracting and enforcement. Requiring card-carrying econo-mists to stay within a few standard deviations of the modelmay greatly hinder their ability to focus on what is essentialin environments different from the one that gave birth to themodel. I say this even though several important break-throughs in economics in the past three decades have comefrom one-step deviations, such asassuming that not everyone has thesame information (known in the jar-gon as asymmetric information) orthat economic activity is carried outby organizations where employeesmay not share the goals of the organi-zation (known in the jargon asagency).

A poor guide for policyOne problem with relying on modelsthat are within a few standard devia-tions of the complete markets modelto guide policy in poor countries isthat solutions may seem far easierthan they actually are. For example,in these countries some contracts areinflexible or dont exist. The facilepolicy prescription from the model is to advocate greaterflexibility or create the missing contract. Yet there may be fardeeper deficiencies that need to be addressed to rectify theproblem.

For example, the inflexibility of labor contractsparticularly the difficulty of firing employeesis seen asinefficient because it doesnt permit firms to react quickly tobusiness conditions. Often, these prohibitions are ascribed tooverly strong unions that hold the economy for ransom. Butif courts are slow and corrupt, so that a worker who iswrongfully fired has no redress, perhaps the prohibitionon firingbecause violations are so easily and publiclyobservableis the only way to protect workers from arbi-trary decisions by employers. Job tenure may also act as aform of social security, necessary because the governmentdoes a miserable job of providing a safety net and privateinsurance markets do not exist. Admittedly, these explana-tions are speculative, and the truth may lie elsewhere. But mypoint is that crude, inefficient prohibitions on firing may bea robust response to a number of deficiencies in the system,many of which reinforce each other in subtle ways. If so,unions may command strong popular support because ofdeficiencies in the system rather than be the cause of them.This is not to say that inflexible contracts are without costbut that altering them may require deep-rooted reform.

Consider another example. Small entrepreneurs in devel-oped countries often have to pledge property as collateral for aloan. The poor in developing countries often lack clear title totheir assetssuch as the land they occupy. So, some analystssuggest, a way to give them access to finance is to give themclear title. In practice, however, this suggestion is hard toimplement when so much else doesnt work. For one thing,how is the tenuous protection of existing private propertyaffected when squatters obtain property rights? How willinformal ways of establishing ownership by determining thehistorical antecedents of a particular piece of property be mis-used when local thugs and politicians can coerce the citizenry?Instead of analyzing the effects of introducing contracts in a

world where everything else works, abetter approach might be to investi-gate the effects of introducing a legiti-mate contract in a world wherenothing works. Our analysis would bebetter informed by assuming anarchyas a starting point rather than a pris-tine world of complete contracts.

I am not suggesting that policy-makers do actually analyze problemswith a complete markets model inmind. They do, of course, makeadjustments for the world they con-front. But their worldview is naturallyinfluenced by the frameworks theywere taught. And because thoseframeworks assume so much that isunrealistic, how confident can policy-makers be in their recommendations?

Nor am I arguing for undisciplined economic thinking, foran anything goes school of theory. Economics has come along way in the past half century, and much that we havelearned is of great relevance. Respectable economists, such asOliver Hart and Jack Hirshleifer, have escaped the straitjacketof the complete markets model without sacrificing sensibleeconomics. But a sizable group of economists still thinks thereis only one model, and complete markets is its name. One canonly suspect that elegance rather than relevance is its appeal.

Assume anarchy?Institution building is one area where international financialinstitutions and policymakers have learned from experienceand have used common sense to devise practical approaches,without much guidance from academia. And there is hope,supported by a growing body of research, that more studentsof development are realizing that a better starting point foranalysis than a world with only minor blemishes may be aworld where nothing is enforceable, property and individualrights are totally insecure, and the enforcement apparatus forevery contract must be derived from first principlesas inthe world that Hobbes so vividly depicted. Not only will thiskind of work more closely approximate reality in the poorest,conflict-ridden countries, but it could also lead to moresensible policy.

One problem with relyingon models that are within afew standard deviations of

the complete marketsmodel to guide policy in

poor countries is thatsolutions may seem far

easier than they actually are.