1. Lecture 7 The Kleptocrat Prof. Dr. Johann Graf Lambsdorff Anticorruption and the Design of Institutions 2012/13

2. ADI 2012/13 157  Lambsdorff, J. Graf (2007), The New Institutional Economics of Corruption and Reform: Theory, Evidence and Policy. Cambridge University Press: 81-108.  Myerson, R. (2008), “Perspective on Mechanism Design in Economic Theory”, American Economic Review Vol. 98 (3): 600-602. Literature

3. ADI 2012/13 158  How should we define corruption when the government (the principal) is maximizing only his own interests and disregards public interests?  The term corruption is misplaced when applied merely to a disobedient agent. Instead, the principal’s own self-seeking behavior may be termed corrupt.  ”misuse” is not clearly related to the trespassing of rules, because rules are themselves the result of self-seeking: –Markets are distorted where this profits the principal. –Public resources are allocated to further the principal’s economic interests. –The principal is above any rules and immune to any accusations.  ”misuse” must be related to public interest (at the cost of offering a less concise definition). The Self-Seeking Government

4. ADI 2012/13 159  Harden [1993: 186-7 and 208-13] reports about the devastating environmental effects of the Turkwel Gorge Dam in Kenya and how it was motivated by overpricing and kickbacks. But feasibility studies did not have to be falsified, they were just forbidden to be carried out in the first place. When the Financial Times published information from a whistleblower, copies of the newspaper were seized at Nairobi Airport.  Inefficiencies that can be detected are there by design.  In contrast to a single agent, the principal (government) can follow its corrupt goals in a much more systematic way.  The principal does not have to circumvent laws and regulations but can design them to serve his own interests. The Self-Seeking Government

5. ADI 2012/13 160  The principal (government) thus takes advantage of his monopoly position.  A common conclusion is that prices are likely to increase. Market restrictions and price increases already occur with corrupt agents. But principals can impose such restrictions in a much more forceful way by making them part of law.  While we may feel desperate about such a ruler, welfare losses are difficult to prove. Imagine a “perfect” kleptocrat, a totalitarian ruler who seeks to maximize this wealth.  Welfare losses reduce the kleptocrat’s potential to take away income from the citizenry; a kleptocrat therefore dislikes welfare losses.  A kleptocrat attempts to organize a corrupt system to operate like a tax. The Self-Seeking Government

6. ADI 2012/13 161  He contains low-level corruption among the bureaucracy.  He prevents individuals from ”overgrazing” the market.  He dislikes low quality in public procurement.  He dislikes white-elephant projects.  He attempts to take more from those who can give more.  It is argued that the “stationary bandit” exercises power consistent with the interests of society, (Olson 1993). A ruler has an ”encompassing interest” (unlike the predator).  Murphy, Shleifer and Vishny [1993: 413] argue that the problems with corruption are mitigated when corrupt rulers can collect bribes efficiently.  So, why worry about this type of corruption? The Self-Seeking Government

7. ADI 2012/13 162 Return from investment 0 sectors Supply Demand Dead Weight Loss Consumer surplus with maximum price Producer surplus with maximum price Welfare losses due to monopoly price setting The Self-Seeking Government

8. ADI 2012/13 163 Return from investment 0 sectors Supply Demand Kleptocrats surplus The kleptocrat can levy the burden equally by price discrimination The Self-Seeking Government

9. ADI 2012/13 164 Wizard of ID, Parker and Hart, September 17, 2000 The Self-Seeking Government

10. ADI 2012/13 165  Example: One of the grandchildren of President Suharto in Indonesia attempted to make a cut from taxes on beer which was collected by his private company. But as a result tourism in Bali was suffering from a shortage of beer and inflated prices, forcing President Suharto to withdraw the tax.  Counterexample: One illustration of a strong and corrupt government is that of Mobutu in Zaire, an uncontested kleptocrat for decades. But his regime crippled the economy and established a strong example that public welfare bitterly suffers from such regimes. The Self-Seeking Government

11. ADI 2012/13 166  In reality various problems exist for kleptocrats.  They assign property rights to comrades and contestants (rather than to those making best use of resources) in exchange for loyalty.  A flourishing economy may threaten their power.  A short time horizon motivates them to “run with the loot while they can”.  But, is an eternal dynasty of uncontested rulers the solution? Wizard of ID, Parker and Hart, May 11, 2000 The Self-Seeking Government

12. ADI 2012/13 167  Investments require the committing of resources, hoping that their initial investment will be honored.  Their resources are sunk and cannot easily be transferred or assigned to different tasks. Railroads cannot be removed, power plants cannot be relocated to different countries. Investors fear for the expropriation of their future revenues. They carry out investments if political promises to honor their revenues are credible.  Kleptocrats can impose an excessive tax burden on investors; they can apply the law arbitrarily and even draft laws that set investors at a disadvantage. The Problem of the Kleptocrat

13. ADI 2012/13 168  In a survey of business people in Karnataka, India, it was found that the software industry was less affected by the high level of corruption among the local administration. Compared to the construction and manufacturing industries these units could easily shift assets outside the state because this industry depends less on immovable assets. This lower dependency seems to have reduced extortionate demands for bribes among public officials. For other sectors credibility is essential because investments cannot be redeployed. The Problem of the Kleptocrat

14. ADI 2012/13 169  Investors want to rely on binding laws, but corruption motivates rulers to arbitrarily change the law and expropriate resources.  Strong corrupt rulers are motivated only by self-enrichment and face no restrictions.  They cannot credibly commit to effective policies.  Due to kleptocrats' failure to make binding commitments, they are not trustworthy to investors.  Investments will be stopped unless the ruler is effectively limited.  This implies that kleptocratic rulers may have an (apparently very limited) interest to engage in anti-corruption. This is somewhat comparable to Mafia bosses who attempt to legalize their business in a strategy to avoid the hazards for their offspring. Kleptocrats must seek ways to commit themselves to their announced policies, which opens the door to reform. The Problem of the Kleptocrat

15. ADI 2012/13 170  Myerson (2008) provides a good model for the credibility problem faced by autocrats.  Assume production, Y, in a country to be determined by capital, K, and raw materials, n, according to Y=(K+n) 0.5.  An autocrat may honor the investments and allow a return of rK. The variable r is the country’s discount rate, which would just suffice to keep capital in the country. The autocrat would thus tax (or take as bribes) only the difference, which is (K+n) 0.5 -rK. The current value of his income would be ((K+n) 0.5 - rK)/(r+b). The variable b is an additional discount rate due to the autocrat’s exogenous risk of losing power.  An autocrat may also expropriate the capital, which suggests that in future periods capital is no longer provided by international investors (K=0). The current value of his income would then be K+n 0.5 /(r+b).  The autocrat’s moral hazard constraint is thus ((K+n) 0.5 -rK)/(r+b) ≥ K+n 0.5 /(r+b) The Problem of the Kleptocrat

16. ADI 2012/13 171  The ideal capital stock that maximizes ((K+n) 0.5 -rK)/(r+b) is obtained by the first derivative, (0.5(K+n) -0.5 -r)/(r+b) =0  (K+n) -0.5 =2r. With r=0.05 we obtain K=100-n. Let, for example, n=12 and we see that the moral hazard constraint is violated. For any K>0 this results, suggesting that only K=0 (n=100) is feasible.  The autocrat may now liberalize his regime, for example by designing constitutional constraints or countervailing powers that limit his capacity to expropriate. The extent of liberalism, 0 ≤ ≤ 1, reduces his income from expropriation according to (1-  [K+n 0.5 /(r+b)].  There is also a random risk for an honest autocrat to be overthrown, which is 0.05.  His income from honesty thus reduces to ((K+n) 0.5 -rK)/(r+b+0.05 ), which he seeks to maximize by setting subject to his moral hazard constraint, ((K+n) 0.5 -rK)/(r+b+0.05 )≥(1-  [K+n 0.5 /(r+b)] The Problem of the Kleptocrat

17. ADI 2012/13 172  This moral hazard constraint is depicted in the figure below, alongside with the isopayoff-curve.  Optimal liberalization is achieved with =0.504, inviting for capital investments K=52.4 The Problem of the Kleptocrat

18. ADI 2012/13 173  In case of n=0 the autocrat’s optimal regime would have =0 and K=44.2.  Intuitively, a lack of natural resources makes it more costly for the ruler to lose his reputation for protecting capital, and so he can credibly encourage substantial investments even without liberalizing. Examples of such countries may be Singapore, Monaco or Liechtenstein. The Problem of the Kleptocrat

19. ADI 2012/13 174  In case of n=25 the autocrat’s optimal regime would have =0 and K=0.  Intuitively, a great wealth of natural resources makes the ruler unwilling to accept the additional political risk from liberalization, even though it means that nobody will invest in the nation without liberalization. Examples may be Saudi Arabia and Venezuela. The Problem of the Kleptocrat

20. ADI 2012/13 175  The dilemma faced by a kleptocrat arises with a similar logic for the bureaucrat who acts as an agent for a principal.  Imagine a principal in charge of delegating a task to the agent. Both would profit if the task is carried out as agreed.  But if the agent takes bribes he his disloyal and produces a loss to the principal. Anticipating this, the principal would prefer to cancel the project.  Bribery implies that potentially beneficial contracts are no longer tenable.  Those contracts that require honesty and the absence of corruption will not be sealed when the principal faces an agent who will take advantage of the arising opportunities. The Dilemma of the Maximizer

21. ADI 2012/13 176  The agent will suffer from his own corrupt intention. The agent fails to maximize by being unlimited in his capacity to maximize.  When agents cannot credibly promise to reject side-payments from clients, they are not trustworthy when writing contracts that require the absence of such payments. Principals will be reluctant to offer such contracts in the first place.  An illustrative example on this is provided by Bates [1981]. He argues that in Sub-Saharan Africa peasant farmers avoided corruption by taking refuge in subsistence production. They simply avoided exchange with those who might extort them. The welfare enhancing profits from a division of labor could not be achieved because farmers had no guarantee that they would not be cheated.  It may be worthwhile to construct good-quality roads. But principals may choose to cancel the project if bad quality is expected to result from unavoidable collusive behavior. The Dilemma of the Maximizer

22. ADI 2012/13 177  A fair and efficient tax system is desirable. If tax collectors cannot be kept from taking bribes such a system may fall into disfavor and be terminated by the principal.  The citizenry prefers to vote against tax increases for otherwise useful purposes because administration and politics cannot be kept from embezzling the funds.  Supervisors may be unable to guarantee honest reports that are not influenced by bribes. Their contribution loses value for the principal and they may not be hired in the first place.  Ultimately, those agents who are willing to take bribes must bear the burden of the drop in welfare – they are jobless. The Dilemma of the Maximizer

23. ADI 2012/13 178  In this perspective, a bureaucrat who tries to maximize with a willingness to take bribes fails to maximize.  His actions can be anticipated; his superior (the principal) has no reason to trust in his loyalty.  The agent will not be hired in the first place.  Any new agent must resist the temptation provided by their discretionary power.  If an agent can commit to honesty, he will be preferred and given the job.  Commitment to such a mechanism provides agents with a competitive advantage. The Dilemma of the Maximizer

24. ADI 2012/13 179  Bureaucrats thus often have an intrinsic motivation to resist temptation. They need help in this desire, just as anonymous alcoholics need their peer group to support their integrity. Reform may find support among the bureaucracy, even if it cuts down on the capacity to take bribes.  We have allies everywhere in the fight against corruption. There is honest willingness to contain corruption.  Some economist’s have suggested that corruption is just as natural as self-seeking. I suggest the opposite: the quest for integrity is part of human nature. The Dilemma of the Maximizer

25. ADI 2012/13 180 Discussions 1) Describe the type of corruption that emerges when self-seeking is the actual object of government! 2) How may in this case allocation be distorted? 3) Show that in a static model a “perfect kleptocrat” avoids welfare losses! 4) Why is such a static analysis misleading? 5) What may motivate autocrats to abstain from taking bribes? 6) In how far is abundance of raw materials important for an antocrat’s decision to restrict his actions by liberalizing? 7) Why may maximizing bureaucrat face problems similar to that of the kleptocrat? Explain by use of a principal-agent approach! Appendix