1. States and markets: complements or substitutes?

2. 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%.

3. 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

4. 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 A national system of capitalism, not a global one –Bretton Woods made the system work by throwing lots of “sand in the wheels” of international commerce and finance Capital controls plus a highly permissive GATT Changing conceptions of market capitalism: capitalism 2.0

5. Why markets need states The institutional prerequisites of markets A typology of institutions Sources of institutional divergence Implications for globalization

6. 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)

7. Institutional prerequisites for markets

9. Game theoretic interpretation of institutional prerequisites (I)

10. Game theoretic interpretation of institutional prerequisite (II)

11. A typology of formal institutions

12. The example of social insurance (I)

13. The example of social insurance (II)

14. More recent evidence “ … we have documented that the association between openness and social spending is positive but has become shallower over time. Extending the specification to indicators of financial development, private financial markets appear to substitute for public redistribution along both cross-country and time series dimensions. In cross-section, not only public redistribution but also private financial market transactions tend to increase with international economic openness, addressing the need for consumption smoothing in the presence of international sources of income instability. Systematically different combinations of public schemes and private contracts are observed in countries characterized by different legal and social traditions. When country-specific intercepts control for such permanent differences, we find evidence of a tendency for globalization to be associated with declining generosity of social spending within each country. The tendency is more pronounced in countries where well developed financial markets absorb a larger proportion of demand for consumption smoothing. As financial markets have become more uniformly well-developed in the OECD, this explains why, in cross-section, public social expenditure has become less positively associated with openness.” -- Bertola and Lo Prete (2008)

15. 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!

16. 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

17. 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

18. 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

19. 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: Redistributive programs should be targeted as closely as possible to the intended beneficiaries. Incentive compatibility: Redistributive programs should minimize incentive distortions. OBJECTIVE Distributive justice and poverty alleviation

20. 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

21. 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

22. Back to our typology of institutions Which one of these exist at the global level? What are the consequences of their non-existence?

23. Implications for global economic governance: Institutional diversity/incompleteness across national settings is a source of transaction costs blocking deep integration… Despite disappearance of formal border barriers, border effects remain strong –“Missing” trade –Small net capital flows Trade: the role of regulatory & jurisdictional discontinuities –Borders are estimated to raise costs by around 40% Capital flows: problems of sovereign risk, moral hazard, and absence of ILLR –Do not exist (or greatly alleviated) within nations –Result in financial instability internationally

24. Therefore, deep economic integration and economic convergence are not possible without institutional harmonization… EU versus NAFTA models One is hard because it entails legal, political integration –Acquis communautaire (>80,000 pages) –European Court of Justice –Significant inter-regional transfers –Growing pains of a quasi-federal political system The other is comparatively easy But only the first model has the potential to achieve full economic integration