The Institutional Organization of the Market Economy Dani Rodrik SW31/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 19 th 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, ).  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 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 rightsPrivate, enforced by the rule of lawPrivate, but govt authority occasionally overrides the law (esp. in Korea). Corporate governanceShareholder (“outsider”) control, protection of shareholder rights Insider control Business-government relationsArms’ length, rule basedClose interactions Industrial organization Decentralized, competitive markets, with tough anti-trust enforcement Horizontal and vertical integration in production (chaebol); government- mandated “cartels” Financial systemDeregulated, securities based, with free entry. Prudential supervision through regulatory oversight. Bank based, restricted entry, heavily controlled by government, directed lending, weak formal regulation. Labor marketsDecentralized, de-institutionalized, “flexible” labor markets Lifetime employment in core enterprises (Japan) International capital flows“prudently” freeRestricted (until the 1990s) Public ownershipNone in productive sectorsPlenty 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