The Institutional Organization of the Market Economy

Dani RodrikSW31/PED-233/Law School 2390

Spring 2013

Richer countries have larger governments– why?

The chart shows the relationship between (the logarithm of) per-capita GDP and the share of government consumption in GDP in 2003, for all countries for which data exist in the World Development Indicators of the World Bank. The estimated slope coefficient is 1.5, and is statistically significant at more than

99%.

More open economies have larger governments – why?

Changing conceptions of market capitalism: capitalism 1.0

Insight: the market is the most creative and dynamic economic engine known to man

Textbook renditions (still common) presume it requires a minimal state National defense, protection of property rights, and the

administration of justice Not necessarily Adam Smith’s own view

Corresponds to the 19th century “liberal” view and today’s libertarian vision “you need small government for markets to flourish”

Changing conceptions of market capitalism: capitalism 2.0

Insight: markets are not self-creating, self-regulating, self-stabilizing, or self-legitimizing

Therefore they need to be embedded in a wide range of institutions Regulatory institutions, redistributive institutions,

monetary and fiscal institutions, institutions of conflict management, …

In practice: Keynes + the welfare state “An extensive government apparatus is needed to render

markets stable, sustainable, and consistent with social values”

Changing conceptions of market capitalism: capitalism 3.0?

Capitalism 2.0 is a national system of capitalism, not a global one Based on national institutions

But national institutions impose transaction costs on economic globalization and hence restrict it

Fully global markets require fully global institutions “global governance”

Questions of feasibility? desirability?

Why markets need states: outline The institutional prerequisites of markets A typology of institutions Sources of institutional divergence

Institutions: definitions Institutions are “the rules of the game in a society”

(Douglass North) Institutions are "a set of humanly devised

behavioral rules that govern and shape the interactions of human beings, in part by helping them to form expectations of what other people will do." Lin and Nugent (1995, 2306-2307).

Can be formal (laws, regulations) or informal (patterns of behavior, conventions, moral codes)

Institutional prerequisites for markets (I) Markets are about gainful exchange. Why would they not

exist or perform poorly? Consider potential seller S who has something (a

commodity, labor services, money to lend, an idea …) that is of greater value to potential buyer B.

What is required for the exchange to actually take place? excludability (good is private, not public) ownership (property rights) compliance (enforcement of contracts) information (observability of all relevant attributes of the

good/service) stable and reliable medium of exchange (unless there is “double

coincidence of wants”) a physical (or virtual) marketplace to bring parties together

(transport/communication) adequate peace and security …

Institutional prerequisites for markets (II) When these conditions are not met, there are transaction

costs Direct costs of exchange Costs of disruption of exchange Costs of opportunistic behavior (“cheating,” “free riding”)

Some types of goods/services more prone to such transaction costs: markets for credit, insurance, ideas, differentiated goods, “public

goods” Good (economic) institutions are those that minimize these

“transaction costs” at reasonable cost

Market-supporting institutions (I) Informal institutions

cooperative behavior sustained through reciprocal exchange and repeated interaction

e.g., informal credit markets, village markets, community irrigation schemes

Conditions under which these work? Small setup costs, but rising costs as the number of participants and

geographical scale increase Belief systems

behavior that is driven by internalized ideas about what is right morals, religion, ideology … examples?

Golden rule: “do unto others as you would have them do unto you” Fads and fashions in economic policy

Central planning, free trade

Market-supporting institutions (II) State institutions

Cooperation achieved through “third-party enforcement” of rules and contracts

Implicit force of state punishment Contracting in the “shadow of the law” Costs and benefits

Large setup costs (judiciary, police froce, regulatory insitutions), but smaller marginal costs of expansion

a. Market-creating institutions i. Property rights

incl. corporate governance ii. Contract enforcement

b. Market-regulating institutions

i. Regulatory institutions Anti-trust, prudential regulation, environmental and safety regulations, etc

ii. Labor market institutions iii. Correction of market and coordination failures

“Industrial policies”

c. Market-stabilizing institutions (macroeconomic management) i. Central banks, treasuries and fiscal ministries

d. Market-legitimizing institutions

i. Redistribution (taxes, expenditure systems) ii. Social insurance (health, unemployment, family assistance programs)

iii. Political democracy

A typology of state institutions

Institutional heterogeneity: example of labor market institutions

Variety of institutional arrangements:

Degree of centralization or coordination of wage setting Degree of employment protection Importance of minimum wages Generosity of unemployment benefits Extent of “active” labor market policies? Unionization rates Labor representation/participation in company boards

These refer to differences only among advanced nations!

East Asian institutional “anomalies”Institutional domain Standard ideal “East Asian” pattern

Property rights Private, enforced by the rule of law Private, but govt authority occasionally overrides the law (esp. in Korea).  

Corporate governance Shareholder (“outsider”) control, protection of shareholder rights  

Insider control

Business-government relations Arms’ length, rule based Close interactions 

Industrial organization 

Decentralized, competitive markets, with tough anti-trust enforcement 

Horizontal and vertical integration in production (chaebol); government-mandated “cartels”

Financial system Deregulated, securities based, with free entry. Prudential supervision through regulatory oversight.

Bank based, restricted entry, heavily controlled by government, directed lending, weak formal regulation. 

Labor markets Decentralized, de-institutionalized, “flexible” labor markets

Lifetime employment in core enterprises (Japan) 

International capital flows “prudently” free Restricted (until the 1990s)  

Public ownership None in productive sectors Plenty in upstream industries. 

Institutional “heterodoxy” is a common feature of successful economies

Sources of institutional diversity and divergence Universal institutional functions do not map into unique

institutional designs Security of property rights, market-based incentives,

outward orientation, macroeconomic stability … can all be achieved in diverse institutional settings

Institutional diversity is grounded in: Differences in social preferences (over equity versus

opportunity, for example) Hysteresis and path dependence due to institutional

clusters and complementarities (US versus Japan versus various European models)

Context specificity of desirable institutional arrangements to promote economic development

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

What type of property rights? Private, public, cooperative?

What type of legal regime? Common law? Civil law? Adopt or innovate?

What is the right balance between decentralized market competition and public intervention?

Which types of financial institutions/corporate governance are most appropriate for mobilizing domestic savings?

Is there a role for “industrial policy” to stimulate investment in non-traditional areas?

UNIVERSAL PRINCIPLES

Property rights: Ensure potential and current investors can retain the returns to their investments

Incentives: Align producer incentives with social costs and benefits.

Rule of law: Provide a transparent, stable and predictable set of rules.

OBJECTIVE

Productive efficiency (static and dynamic)

Multiplicity of desirable institutional arrangements

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

How independent should the central bank be?

What is the appropriate exchange-rate regime? (dollarization, currency board, adjustable peg, controlled float, pure float)

Should fiscal policy be rule-bound, and if so what are the appropriate rules?

Size of the public economy.

What is the appropriate regulatory apparatus for the financial system?

What is the appropriate regulatory treatment of capital account transactions?

UNIVERSAL PRINCIPLES

Sound money: Do not generate liquidity beyond the increase in nominal money demand at reasonable inflation.

Fiscal sustainability: Ensure public debt remains “reasonable” and stable in relation to national aggregates.

Prudential regulation: Prevent financial system from taking excessive risk.

OBJECTIVE

Macroeconomic and Financial Stability

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

How progressive should the tax system be?

Should pension systems be public or private?

Should grant schemes be conditional?

What are the appropriate points of intervention: educational system? access to health? access to credit? labor markets? tax system?

What is the role of “social funds”?

Redistribution of endowments? (land reform, endowments-at-birth)

Organization of labor markets: decentralized or institutionalized?

Modes of service delivery: NGOs, participatory arrangements., etc.

UNIVERSAL PRINCIPLES

Targeting: Efficient redistribution entails programs targeted as closely as possible to the intended beneficiaries.

Incentive compatibility: Efficient redistribution minimizes incentive distortions.

OBJECTIVE

Distributive justice and poverty alleviation

Where do institutions come from? Demand-side explanations: institutions are created by

those who stand to benefit from them Colonial origins (Acemoglu, Johnson, Robinson 2001)

Glaeser et al. (2004) critique Initial factor endowments

Type of agriculture: small-holding versus plantation (Engerman and Sokoloff 2002)

Size of educated middle class (Rajan and Zingales 2006) Expanding international economic integration

Benign theories Trade and capital flows increase demand for “good” institutions

Malign theories Increased trade strengthens “regressive” elites (Latin America, U.S.

South) Supply-side explanations

Imposition by foreign powers East Germany, North Korea, Japan(?),..

Adoption of imported legal norms and rules “law and development” school

Institutional innovation and experimentation Chinese example

Institutional hysteresis, lock-in