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Why does capital formation often fail to occur in developing countries? Capital and Collusion explores the political incentives that either foster growth or steal nations' growth prospects.
Hilton Root examines the frontier between risk and uncertainty, analyzing the forces driving development in both developed and undeveloped regions. In the former, he argues, institutions reduce everyday economic risks to levels low enough to make people receptive to opportunities for profit, stimulating developments in technology and science. Not so in developing countries. There, institutions that specialize in sharing risk are scarce. Money hides under mattresses and in teapots, creating a gap between a poor nation's savings and its investment. As a consequence, the developing world faces a growing disconnect between the value of its resources and the availability of finance.
What are the remedies for eliminating this disparity? Root shows us how to close the growing wealth gap among nations by building institutions that convert uncertainty into risk. Comparing China to India, Latin America to East Asia, and contemporary to historical cases, he offers lessons that can help the World Bank and the International Monetary Fund to tackle the political incentives that are the source of poor governance in developing nations.
THE FUTURE IS, by definition, uncertain. But the developed world has many tools to quantify uncertainty and turn it into measured risk: that is, to calculate the probability of many types of events with some certainty. In fact, whole industries have come into existence to calculate risk and help people hedge against it. Reliable information about risk is so pervasive that individuals informally allow with virtually no reflection a whole range of indispensable household decisions to depend on cooperation with complete strangers. Developed countries can also count on social institutions, from private financial and insurance firms, to government welfare programs, to help manage risks, which are beyond the resources of a single household. As a result, people in the developed world respond actively to risk by marketing, developing, and financing new companies and products.
But similar ambitions fail in developing countries. Experts frequently explain this contrast by citing a shortage of capital-the developing world simply cannot generate the funds to break out of its cycle of poverty. The conventional wisdom is that an absence of capital throttlesthe ingenuity of people in developing countries and prevents them from undertaking ventures that would improve their own welfare. Sophisticated economic theorizing equates development with capital accumulation and argues that the difference between the capital required by the country for investment and the capital available to it constitutes a financing gap.
To remedy the shortage, a wide range of multilateral and bilateral institutions-including the International Monetary Fund (IMF), the World Bank, the U.S. Agency for International Development (USAID), and the United Nations Development Programme (UNDP)-dispense aid to the world's deeply troubled and impoverished regions. Nevertheless, the very people targeted to benefit from these organizations' generosity often mistrust their interventions, breeding cynicism instead of hope. Nor have disbursements of a trillion dollars over the past fifty years to needy regions successfully breached the disparity between rich and poor either within one country or among nations. Instead, gaps in wealth between the richest and poorest nations are at historic heights.
But the absence of capital is itself a reflection of other factors. This book attributes the wealth gap between developing and developed countries to the divergence between uncertainty and risk. Uncertainty refers to events about which knowledge is imprecise, whereas risk relates to events that can be assessed with some degree of certainty. Transforming uncertainty into risk is how countries grow rich. Lack of institutions that make managing risk possible is the root cause of the disparity in economic performance between developed and developing countries. Uncertainties grounded in the social and political systems of sovereign states, such as rampant public-sector mismanagement (which people living in developed countries no longer have to face), discourage households from engaging in activities that would harness their skills and capital.
Economic development begins with innovation that produces technological progress; that progress depends on an innovator's willingness to take a journey into the unknown. There is no question of such journeys for people living in developing societies; uncertainty over reaping the benefits of discovery makes such journeys unlikely and thereby keeps the pace of innovation low. Such journeys could only become routine in developing countries as in the developed world if developing-country innovators could assess the risk involved and therefore hedge against it. Without the tools to assess, for instance, the reliability of trading partners and the legal frameworks to form social institutions to cope with market risk, innovation and invention are unlikely.
Measuring the social costs of these impediments to innovation is difficult; underestimating them, easy. When faced with such impediments, most sensible people simply forgo measuring risk and taking calculated chances. They withdraw into the arena where they can avoid uncertainty. Not surprisingly, this means fewer business ventures and also fewer basic risks taken by average households. This inherent conservatism means that both businesses and households only take those risks against which they can self-insure.
Developing-country households need better information about the risks they face and better tools for managing risks. Institutions that make market risk tractable expand the time horizons of economic actors. Developing countries rarely have private or social insurance for unemployment, retirement, workers compensation, intergenerational care, and disaster relief, so that people depend entirely on household savings, whereas either market or social insurance options exist in developed economies for all. If they are secure against basic market risks, households will learn to expand their frame of reference beyond their own endeavors. Once able to calculate the return on investments, they will pool their exposure to market risk by investing in the projects of other households. This is the essential step toward economic growth that people in developing countries are barred from taking. And if households cannot measure larger risks, they cannot take these steps.
Even as most households struggle, uncertainty does not prevent all members of a society from prospering. Many regimes have an interest in promoting uncertainty because it compels people to accept outcomes that allow only the ruler and a small band of cronies to prosper through secrecy, endogamy, and violence-defeating open, mutual endeavors by unrelated stakeholders. When households face the prospect that autocrats and their cronies will appropriate any gains they might make, the rationality of self-insurance is reinforced: be conservative; trust only those you know-and not all of them. For instance, households may invest in more children instead of in physical or human capital, but faster population growth slows the growth of per capita income.
The disparities in risk management between developed and developing regions place a high cost on international investment and growth and result in the systematic undervaluation of assets in developing countries. It is the mandate of international organizations like the IMF and the World Bank to eliminate global gaps by imparting an anatomy of capital formation during the early stages of economic growth. Their charters permit capital to be lent but prohibit ventures into the politics of member states that are the very source of their capital inadequacy.
By disregarding the political and social roots of poverty, organizations mandated to remedy global poverty may actually perpetuate uncertainty and contribute to the longevity of the governments that violate the rights and ignore the welfare of the people they govern. For example, an autocratic regime may agree to policies it will not enforce to guarantee the infusion of donor funds needed to reward its followers. Regime officials may agree to create institutions the donors advocate but ensure those institutions are diverted from their agreed-upon function once they are created. Since the government's books are rarely open to an independent external audit, donors are unable to track the deployment of donor assistance to monitor compliance. Weak enforcement makes agreements with donors easy to game. In the future, donors, who have pre-announced aid targets, will be back to loan even more money to the same regimes-even if their policy objectives have not been met. After all, donors still have to justify the next year's aid budget.
So here is the conundrum of growth in the developing world: the very people who are in a position to transform uncertainty into risk are those who benefit from the current regime, and the organizations responsible for implementing schemes to foster growth are unable to address the root problem.
It is easy to blame reform failures on a lack of capital accumulation or an absence of domestic institutional capability. But to understand why capability is wanting in one region and not in another, we must examine the incentives of key social actors. Why do coalitions and leaders in one environment govern for prosperity, while in another they secure their own well-being at the expense of the people they lead? Leaders of East Asia's "tiger" economies, for example, built regime legitimacy by creating institutions that upheld their promise to share growth, which helped woo big business with assurances of social cohesion. Such innovations in governance, which implemented broad-based access to the benefits of development, helped East Asia to experience sustained economic growth. In Latin America, by contrast, despite progress in democratization, substantive reduction of poverty and of inequality has not occurred. Leaders and regional elites secure their own welfare with shortsighted policies that undermine domestic economic sustainability. The roads, schools, health care, electricity, and property rights needed to give impoverished citizens control over their own lives are denied as threats to political stability.
This book begins where international organizations' missions end and explores the political arrangements that create incentives for political leaders either to foster growth or to steal their nation's wealth. It postulates that variations in economic performance among nations frequently stem from reversible institutional failures that encourage leaders to ignore the basic needs of all citizens. And it offers a way to break the poverty trap caused by perverse political incentives. Capital and Collusion contrasts the experiences of various regions and nations to ascertain the coalitional foundations of divergent strategies in economic development. It seeks both the causes of and the solutions to the problems of underdevelopment in the politics and social structures of sovereign states. Exploring the frontier between risk and uncertainty, it aims to offer readers a new perspective on the forces driving development in some of the world's fastest-growing regions.
Economic progress in developing nations requires significant and complementary innovations in social and political structures. Creating a political and social framework favorable to economic growth is often the greatest challenge these nations face. Yet developing countries are frequently advised to adopt models of economic institutions that can only succeed once appropriate social institutions exist. Enforceable property rights, for instance, often enjoy the status of being a necessary condition for economic development. The sustainability of the property rights requires social coherence and political accountability, since property rights can be overturned by the forces of social upheaval or confiscated by unchecked political discretion. The influence of the rich can compromise the property rights of the poor. The security of property rights in highly unequal societies is often enforced by military might rather than the rule of law. The property-rights regime is only as stable as the social and political foundations on which it rests.
WHEN RISK IS OPPORTUNITY
Modern market economies provide many opportunities for the evaluation and measurement of risk, especially financial risk. If not for assumptions about the effectiveness of social and political institutions, many options for managing risk would be unavailable. Standard economic theory assumes that markets spread, pool, or assign a price to risk and can, over the long term, reduce, manage and reward it. This is a highly unrealistic expectation in most developing countries given that inadequate information obscures estimates of the economic value of private assets. Whereas developed market economies possess many tools to pool, quantify, measure, and price risk, making it possible for them to reduce risk by reallocating it to those most capable and willing to bear it, the contracting parties in developing societies are prevented by asymmetric information from using the tools common to mature market societies.
Individuals in developing countries do not have the option of taking remedial actions such as checking individual or commercial credit reports to overcome market imperfections and eliminate search costs or alleviate information asymmetries. As a result, they cannot trade many claims or risks. When these inefficiencies are paired with inadequate common knowledge and an absence of shared beliefs about valuation, market participants are rarely able to agree on an optimal contract for risk management. Rather than diversifying their portfolios at market prices, individuals choose to self-insure. As a result, household strategies for managing risk in developing countries vary significantly from those practiced in developed countries.
A framework for capital markets in developing regions must go beyond the emphasis on market risk in financial theory to address the sources of uncertainty embedded in the political and social order. Unlike risk, uncertainty cannot be priced, and it therefore prevents many trades from occurring and may reduce or destroy the value of economic assets. Uncertainty within an economic system is a market breaker; when two parties have widely divergent valuations of outcomes, they will be unable to agree on the terms of trade. Developing nations frequently avoid investments requiring sunk costs in favor of low-value short-term exchanges that discount an uncertain future. Three sources of uncertainty-market, social, and political-prevent the economic calculation of risk and wreck the coordination of market activity.
THE TRINITY OF UNCERTAINTY IN ECONOMIC DEVELOPMENT
Noncompliance with contractual obligations-from private basic business contracts to tax collection by the government-is the most common source of uncertainty within the market system. Calculating returns on investments becomes difficult when individuals are uncertain about contract compliance. Institutions can mitigate uncertainty by monitoring the reputations of individual market participants and using the courts to make opportunistic behavior costly for perpetrators. In developed economies, institutions also provide innovators with capital from sources beyond their families by making it easier to know the probability of default of an individual loan. Applying the law of large numbers, institutions can facilitate the pooling of risk by providing information about the aggregate percentage of all loans that will default. Such institutions, routine in well-functioning market economies, strengthen access to credit and shape risks into catalysts for development, yet they are in short supply in developing countries.
Avoidance and aversion, both a means of survival in the face of uncertainty, are the other side of risk and opportunity. When contract enforcement is weak, people respond by avoiding situations that require trusting a third party as well as the risk of investing in the projects of other households. Unfortunately, both of these actions are at the heart of economic growth. Households that avoid them violate the golden rule of investing, putting all their eggs in the same basket instead of diversifying in favor of a balanced and less volatile outcome. All of us self-insure, but in the face of this uncertainty and immeasurable risk, developing-country households invest their resources in excessive self-insurance. To insure against accidents or economic downturns, households rely entirely on their own resources and on informal networks of interpersonal obligations with neighbors and family members, constraining enterprise growth and avoiding business opportunities that might otherwise produce greater gains to society.
Excerpted from Capital and Collusion by Hilton L. Root Copyright © 2005 by Princeton University Press. Excerpted by permission.
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Tables and Figures ix
PART I: Analytical Perspectives 1
CHAPTER ONE: Risk, Uncertainty, and Social Progress 3
CHAPTER TWO: Social Foundations of Policy Credibility 17
CHAPTER THREE: Politics and Economic Structure: The Economic Logic of Autocracy 35
CHAPTER FOUR: An Amazing Economy of Information: The Financial System 48
PART II: Regional and National Complexity 57
CHAPTER FIVE: Closing the Social Productivity Gap in East Asia 59
CHAPTER SIX: The Price of Exclusion: Latin America's Explosive Debt 89
CHAPTER SEVEN: Why Not India?New Century, New Country 114
CHAPTER EIGHT: Pakistan on the Edge 157
CHAPTER NINE: China's Capitalist Dream: Between Hierarchy and Market 187
PART III: Conclusion 219
CHAPTER TEN: Mobilizing the State as Public Risk Manager 221
CONCLUSION: Uncertainty, Competition, and Collusion in Early Capital
Appendix 1 Data Sources 251
Appendix 2 Variables 252