EUROPEAN F&x%Gmc

ELSEVIER
European Economic Review 41 (1997) 411-442

Alfred Marshall Lecture

The paradoxes of the successful state

Dani Rodrik *
John F. Kennedy School of Government, Harvard Uniuersity, 79 Kennedy Street, Cambridge, MA 02138 USA

Abstract
Three issues are discussed in this paper. First, I argue that it is impossible to understand the East Asian growth miracle without appreciating the importtant role that government policy played in stimulating private investment. Second, I will summarize some of my work on the determinants of policy effectiveness, based on a cross-country comparison of export subsidy regimes, and show that the usual rules of thumb on what makes for good policy (uniformity, transparency, non-selectivity, etc.) are quite useless in predicting which policy regimes perform better in practice. Third, I will provide some evidence that the govem-

ments social insurance role creates a complementarity between states and markets. These three sets of ideas yield a more balanced and nuanced view of the role of the state in
economic B.V. development than has recently become commonplace. 0 1997 Elsevier Science

JEL classification: H5; 01 Keywords: Economic developemnt; The state; East Asia

1. Introduction There is probably no other question in economics that has attracted more attention over the years, from the best minds that the profession has produced, than that of the appropriate role of the state in economic development. Hence anyone proposing to expound on this matter yet again must start with a good dose of humility and modesty. One does well by recognizing that everything that can be

* E-mail: drodrik@ksgl.harvard.edu, 0014-2921/97/$17.00 Copyright PZZSOO14-2921(97)00012-3

Tel.: + 1 617 495-9454,

Fax: + 1 617 496-5747.

0 1997 Elsevier Science B.V. All rights reserved.

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said on the subject has been said at least once, and probably more effectively, by some earlier economist. From this perspective, then, the best that one can do is offer new evidence and new methods to reaffirm old truths. But what are these old truths? The striking thing about the history of thought on the role of the state is that it has little in common with the scientific ideal; it is far from a uniform progression of ideas converging on a more complete set of hypotheses about what the state can and should do to promote development. It resembles instead the swing of a pendulum, from one set of ideas which give primacy to the role of the government over markets to another stressing the advantages of markets over the government - and then back again. Hence the earliest systematic thinking on the role of the state in the economy was undertaken by mercantilists, who advocated pervasive government intervention in industry and trade. Adam Smiths Wealth of Nations was in large part an extended argument against mercantilist beliefs. Smiths advocacy of the power of the invisible hand subsequently became the dominant idea in economics, culminating in the classical gold standard of the late 19th century. The first half of the 20th century, and the interwar period in particular, witnessed a withdrawal from markets, with Fascism, Marxism, and Keynesianism each contributing their distinct ideas about why the state needed to intervene in order to achieve desirable economic outcomes. The three decades following the end of World War II were somewhat anomalous in that there emerged, among the advanced capitalist countries at least, widespread consensus in favor of a hybrid set of ideas - Keynesianism and the welfare state at home, multilateral free trade abroad. The market has reasserted its primacy with the conservative revolution of the 1980s. This back-and-forth shift in ideas about the role of the state can be seen in its most extreme form in the policies of the developing countries themselves. During the 1950s and 1960s most developing countries embarked on developmental policies which gave the state a key role in economic transformation, both through intervention in markets and through the creation of public enterprises. This pattern of policy-making has somewhat misleadingly come to be called importsubstituting industrialization - misleadingly because the policies went far beyond encouraging domestic production of previously imported goods. One consequence of the debt crisis of the 1980s was a dramatic repudiation of these policies throughout Latin America, and parts of Asia and Africa. The policy reforms that ensued were informed by a minimalist conception of the role of the state, with state functions confined to the provision of secure property rights, sound money, adequate primary education, and some infrastructure. The new credo has been nicely summarized by John Williamsons Washington consensus - a set of 10 policy desiderata, heavily weighted towards actions that would reduce the role of

See Krueger (1993, chs. 3-4) for a nice discussion of the origins of these policies excessive faith in government benevolence and abilities that underlay them.

and the

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the government in the economy. The earlier, excessive optimism about what the state would be able to accomplish was replaced by an excessive pessimism. The good news I think, and this is the main message of this lecture, is not only that the pendulum has begun to swing back, but that this time it has a fairly good chance of stopping at some reasonable midpoint before going all the way to yet another counterproductive extreme. I believe we are at the threshold of a serious reconsideration of the role of the state in development, one that will lead to an improved understanding of the role that governments can (and have to) play without the wide-eyed idealism of the 1960s. A combination of factors are pushing us in this direction. First, much of the relevant economic policy community has now moved towards a more nuanced appreciation of the realities of the East Asian development experience - one that recognizes the tremendously important role that active policy played in the early transformations of the Japanese, South Korean, and Taiwanese economies. Whatever one may say about the World Bank (1993) East Asian Miracle report, this study has made it very difficult for any reasonable person to argue that there was little government intervention in East Asian countries, or that these countries grew so fast despite their governments interventions - arguments that one used to hear not infrequently. Developments in formal economic theory have also helped by clarifying the circumstances under which East Asian-type policies could alleviate coordination failures or reduce financial-market imperfections (see for example Krugman, 1993, and Stiglitz, 1994, for summaries). A second development that has taken place is a growing appreciation of the importance of social spending, social insurance and safety nets as necessary counterweights to expanding markets. The equity and social dimensions of policy are now returning to center stage in the wake of the less than thrilling consequences that market-oriented reforms in Latin America and Eastern Europe have produced along those dimensions. One indication of the change is that in a recent updating of his Washington Consensus agenda, Williamson (1996) now includes increased emphasis on targeted social expenditures as one of the key new priorities, adding: It is surely no accident that one of the few Latin American countries that have been reporting an improved income distribution (admittedly starting from a poor base) is Colombia, which has greatly expanded its social spending in recent years (1996, p. 5). Finally, a more subtle change, but conceivably with significant long-term implications, is that economists have started to do their political economy analysis explicitly, rather than implicitly (as has been the norm). This is gradually resulting in a move away from the tendency to view the government in rather simplistic terms as inherently inefficient and, worse yet, as predator. Similarly, naive recommendations that follow loosely from implicit, but unarticulated models of political economy - as in the case of the advocacy of tax and tariff uniformity, for example - are being replaced with more sophisticated institutional approaches. Once one confronts more fully the various constraints under which government

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policies are made and implemented - the imperfections of information, the multiplicity of interests to which policy must respond, the inability to measure bureaucratic outputs, etc. - one discovers that many bureaucratic arrangements may be constrained efficient, and that in any case improving them usually calls for more than the simple rules of thumb (such as non-intervention, uniformity, simplicity, transparency, and non-discretion) that one finds in the informal literature. A recent monograph by Avinash Dixit (1996) is noteworthy in that it highlights the points made in the previous paragraph especially effectively. Dixit argues that many of the recent formal approaches to political economy can be integrated into a single framework, with transaction costs as the main unifying theme. Hence, the structural shortcomings of bureaucracies mentioned above can be viewed as the transactions costs inherent to politics: imperfect and asymmetric information, inability to monitor effort, opportunistic behavior, multiplicity of principals, time-inconsistency, bounded rationality are among some of the chief forms that such transaction costs take. What is of most interest in the current context is the overall perspective that Dixit feels such an approach brings to the discussion on the role of the state. It is worth quoting him at some length: My starting points are simple to the point of being trite - one must accept that markets and government are both imperfect systems; that both are unavoidable features of reality; that the operation of each is powerfully influenced by the existence of the other; and that both are processes unfolding in real time, whose evolution is dependent on history and buffeted by surprises. Most important, I will argue that the political process should be viewed as a game between many participants (principals) who try to affect the actions of an immediate policymaker (agent). What follows from these observations is orthogonal to, and perhaps destructive, of the whole markets versus governments debate. The equilibrium or the outcome of the game will typically not maximize anything. Any attempts to design, or even identify, the desiderata of a truly optimal system are doomed to failure, and no grand or general results about the superiority of one organizational form over another can be expected. What we can do is to understand how the whole system consisting of markets and governments copes with the whole sets of problems of conflicting information, incentives, and actions that preclude a fully ideal outcome. (1996, pp. 2-3) Note the complete absence here of the normative overtones that characterize the liberal economists (liberal in the European sense) traditional approach to govemments. Once one recognizes that governments cannot be wished away, and that they necessarily operate under multiple political pressures in an environment of incomplete information, the traditional dichotomy of governments versus markets makes a lot less sense. And a simple-minded advocacy of laissez-faire, even if one were to view it as some sort of an ideal. becomes irrelevant.

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Indeed later on, Dixit goes quite a bit further when he discusses how to evaluate the normative (welfare> consequences of government behavior as we observe it in real life. In the context of a model of bureaucratic action in which various transaction costs (informational asymmetries, inability to monitor) are taken into account, he writes: The lack of incentives, and the proliferation of the constraints, are often claimed to be proof of inefficiency of government. Agencies often have to say no. Nothing gets done, or at least [action] requires long delays to ensure that all the constraints have been met. In the model, however, the weak incentives, and the prohibitions or constraints can emerge as a part of a Nash equilibrium. In other words, they may be a reasonable way for the system to cope with transaction costs. I would not claim that what one finds in reality is always a constrained optimum, but at least the results suggests that we should not jump to the opposite conclusion either (1996, p. 107). What is clear, then, is that this new approach to political economy is capable of generating a conception of the state - and of its role in the economy - that is at once less prejudiced about its role and better grounded in theory. This makes for a more pragmatic, case-by-case analysis which is cognizant of the shortcomings under which government agencies make and implement their decisions, yet falls far short of blanket condemnation of the evils of government intervention. In view of the occasion for this lecture, I am particularly happy to point out that Alfred Marshall himself would likely have applauded this transformation. As a key figure in the development of modem economic theory, Marshall obviously believed in the wonders of Adam Smiths invisible hand. At the same time, he thought that many of Smiths followers had oversimplified Smiths own views and had turned them into dogmas, lacking relevance and usefulness to the problems in Marshalls own time. Marshall himself argued for a pragmatic stance on issues of economic policy. He recognized the productive role of government, especially at low levels of development, where he argued governments could make individuals better off by making them do things that they would rather not do on their own. He noted the tendency of mercantilistic regulations and government interventions to be susceptible to corruption and to what we would today call rent-seeking. But at the same time he believed that governments had the capacity to act honestly and in the common good, and indeed that this capacity had greatly expanded since the middle ages. He recognized that policies that restrict foreign trade could do some good if they develop industry and trade in some directions more than they check it in others (1923, p. 740). Indeed, he agreed with the analyses of Mill and List on the benefits of temporary protection for infant industries. He was also a fan of Jean Baptiste Colbert, the 17th century French statesman and the embodiment of the spirit and practice of mercantilism, because he believed that Colberts policies of regulation and support of domestic industries did much to develop the French economy.

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Marshall disliked dogmas above all, and he was particularly scornful of a no-holds-barred commitment to Zuissezfuire. He complained that Adam Smiths successors often took too narrow-minded views, and converted Smiths views into absolute dogmas. Here is Marshall describing economists of the older generation of his time, and how they came to oversimplify things: Their agreement with one another made them confident; the want of a strong opposition made them dogmatic; the necessity of making themselves intelligible to the multitude made them suppress even such conditioning and qualifying clauses as they had in their own minds (1923, p. 759) I know of no better description being! Marshall continues: of how the Washington Consensus came into

Therefore, although their doctrines contained a vast deal that was true, and new, and very important; yet the wording of these doctrines was often so narrow and inelastic that, when applied under conditions of time and place different from those in which they had their origin, their faults became obvious and provoked reaction. (1923, pp. 759-760) On free trade, specifically, Marshall thought that economists were guilty of overselling the case for free trade, and in so doing they retarded the general acceptance of that part of [the free trade doctrine] which may justly claim to be of universal validity (p. 760). In particular, they exaggerated the benefits of free trade to poor countries, as these countries would not be able to attract advanced industries to themselves were they to follow free-trade policies. He drew a distinction between short-run and long-run comparative advantage. As someone who gave his name to a particular brand of production externalities, he was fully aware that short-run comparative advantage need not maximize long-run well being.

The same spirit that levelled all social distinctions without compromise, and without consideration for special cases or indirect effects, bore fruit in the absolute wording of the economic dogma, Let people make whatever they like and move wherever they like: - for this is the true meaning of Laissez faire and Laissez passer: phrases which have come to be used by politicians in a sense entirely dfferent from that which properly belongs to them; with results most detrimental alike to clear thinking and fair controversy. Laissez faire did not imply that Government shouid abstain inertly from from constructive work: it meant simply that anyone who thought that he could make anything with advantage, whether on old lines or by a new method, should be at liberty to do so. Laissez passer had its chief application to difficulties that did not exist in England. It meant that all the various obstacles to the free passage of goods between the various Provinces of France should be removed. England had realized her Zollverein many centuries before. France got hers at the Revolution: Germany had still to wait for another half century. Laissez passer was however sometimes intrepreted that all frontier duties, even those between different countries, should be abolished: and for that the world is not ready yet. (Marshall, 1923, 742-743)

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In the rest of this lecture, I will focus on three strands of my recent research, which I think are in the spirit of Marshalls objections to the arguments of his contemporaries. First, I will discuss the East Asian miracle, and argue that it is impossible to understand this miracle without appreciating the important role that government policy played in stimulating private investment. Second, I will summarize some of my work on the determinants of policy effectiveness, based on a cross-country comparison of export subsidy regimes, and show that the usual rules of thumb on what makes for good policy (uniformity, transparency, nonselectivity, etc.) are quite useless in predicting which policy regimes perform better in practice. Third, I will provide some evidence that the governments social insurance role creates a complementarity between states and markets. These three sets of ideas have an obvious correspondence to the three factors that I argued above are causing the pendulum to swing back.

2. Reconsidering

the East Asian miracle

There is wide agreement about one key feature of the East Asian miracle: this was a miracle of accumulation rather than of total factor productivity (TFP) growth. The proximate determinant of the high growth rates of most of the countries of the region was a high rate of accumulation of both physical and human capital (Kim and Lau, 1992; Young, 1993, 1994). In South Korea and Taiwan, for example, one observes a striking increase in the investment ratios starting in the early 1960s (see Fig. 1). Consequently, in order to understand why

40

---_-~---_-~-..---_~-----_.

Fig. 1. Investment/GDP

ratios.

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these countries did so well we must first understand why private entrepreneurs suddenly decided to go on an investment binge during the 1960s. First, it helps to debunk some myths about the East Asian experience. 2.1. Myth #I: East Asia did well because it followed orthodox policies

A myth which endures in some quarters is that the East Asian countries managed to raise their investment rates by following the precepts of what later came to be called the Washington Consensus. This is true in a most limited sense. The point is best made by comparing each of these precepts with what the South Korean and Taiwan governments actually did. The comparison is shown in Table 1. The table contains the ten core desiderata of the Washington Consensus, along with my own summary comments on the degree of compliance exhibited by Taiwan and South Korea in each area. How well did South Korea and Taiwan do according to this list? Judging by the number of the prescriptions these countries did or did not follow, we would have to award South Korea a score of about 5 (out of lo>, and Taiwan about 6. Both countries managed fiscal expenditures and revenues rather well, avoiding macroeconomic stop-go cycles and high inflation. They also consistently maintained unified exchange rates (Taiwan since 1961 and Korea since 1964) and competitive parities for the most part. But the rest of the scorecard is less spectacular. Taiwan welcomed DFI, but Korea much less so. Korea repressed interest rates and made heavy use of subsidized credit; Taiwan did not do so, but did give priority to public enterprises in credit allocation. Neither country significantly liberalized its import regime until the 1980s. Both countries heavily interfered in the investment decisions of private enterprises. And far from privatizing public enterprises, both countries actually increased their reliance on such enterprises during the crucial decade of the 1960s. In short, where South Korea and Taiwan followed the orthodox path most closely was in maintaining conservative fiscal policies and competitive exchange rates. 3 This accounts for their ability to avoid protracted periods of macroeconomic instability, particularly in the crisis-ridden decade of the 1980s. On this point there is very little disagreement among economists. Compare, for example, Turkeys experience with fiscal and exchange-rate policy with Koreas or Taiwans. In Turkey, public-sector deficits have been consistently large since the late 1970s and the real exchange rate has gone through wild gyrations as a consequence of policies that alternate between targeting the exchange rate on inflation and

By contrast, it is striking how many Latin American countries have come within reaching distance of completing the items on the Washington consensus in a period of no more than a few years during the 1980s. Mexico, Bolivia, and Argentina, to cite some of the more distinguished examples, have undertaken more trade and financial liberalization and privatization within five years than the East Asian countries have managed in three decades.

Table 1 The Washington south Korea Taiwan Yes, generally Yes Yes Yes

consensus

and East Asia P

Elements of the Washington

consensus

1. 2.

2 S? $ F a b B rll

3. Yes Yes Yes

4. 5.

Fiscal discipline Redirection of public expenditure priorities towards health, education and infrastructure Tax reform, including the broadening of the tax base and cutting marginal tax rates Unified and competitive exchange rates Secure property rights Yes, generally

6. I. 8.

Deregulation Trade liberalization Privatization

9. Limited until the 1980s

10.

Elimination of barriers to direct foreign investment (DFI) Financial liberalization

Yes (except for limited time periods) President Park starts his rule in 1961 by imprisoning leading businessmen and threatening confiscation of their assets. Limited Limited until the 1980s No. Government established many public enterprises during 1950s and 1960s. DFI heavily restricted

Limited Limited until the 1980s No. Government established many public enterprises during 1950s and 1960s. DFI subject to government control Limited until the 1980s

Ir 2 g 2 e 7 6

Source: Rodrik (19%a,b).

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PSBR (X d GDP)

ID

p
__C___r

$j

ff
-

$j
,-

g
-

i3

Fig. 2. Sources of macroeconomic

instability in Turkey.

targeting it on external competitiveness (Fig. 2). I would hazard the guess that at least two percentage points of the long-run growth differential between Turkey and the East Asian countries is due to the difference in macroeconomic policies. In the area of microeconomic interventions, however, the East Asian experience has diverged from the orthodox path. It is impossible to tell a neat story here about how Korea and Taiwan avoided the evils of government intervention while a country like Turkey fell prey to them. The differences were in the details. While we have some clues about which of these details must have mattered (see below), there is also much that remains murky. 2.2. Myth #2: East Asia made the transition to high growth/high investment by increasing substantially the profitability of exporting relative to producing for the home market This is one of the most widely held beliefs about the East Asian model, and constitutes the chief reason why outward orientation is such a central element of todays orthodoxy. The facts are considerably more subtle, and at variance with the received wisdom. It is true that there was less anti-export bias overall in South Korean and Taiwanese policies during the 1960s than in most other developing countries. And as I will discuss further in Section 3, it is also true that East Asian governments exhibited a commitment to exports that was lacking in other regions.

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The phenomenal increase in exports that both economies generated could perhaps not have taken place otherwise. However, it is difficult to ascribe the increase in exports to the export incentives alone, or even in large part to them, for one simple reason: the export booms were not accompanied by any sizable increase in the relative profitability of exporting. In other words, the change in actual incentives around the time of the export take-off was quite modest. Therefore, while the low anti-export bias was surely an enabling factor, it is difficult to believe that it played a fundamentally causal role. The point is best made visually. Fig. 3 shows how the relative price of exports has moved in four countries that have experienced export booms, South Korea and Taiwan, along with Chile and Turkey. As the timing of the booms differ across the countries, I have aligned their series according to the year in which the boom took place. So year 1 is the first year of the export boom in each country, year 2 is the second year, and so on. I have deliberately not indicated which series belong to which countries. Suppose we ask on the basis of this evidence which of these four countries are the ones that experienced the most rapid and sustained increase in exports. Most economists would point to countries A and B, which are the countries with large changes in relative prices in favor of exports. But they would be wrong. In fact, A and B are Turkey and Chile, while C and D are Korea and Taiwan. While Turkey and Chile did experience export booms (the former during the early 1980s and the latter during the late 1980~1,their export performance was undistinguished compared to that in South Korea and Taiwan. At the same time, as

-2

-1

2 5381

3 nlaive

4 0 start

5 of export

6 boom

lo

11

Fig. 3. Relative price of exports in four countries experiencing

export booms.

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Fig. 3 makes abundantly clear, exports performed astonishingly well in the latter despite the absence of a significant increase in their relative profitability. Hence, what the evidence points out is that while anti-export bias may have been low in both South Korea and Taiwan, this bias was comparatively low also in the second half of the 1950s at which time exports were going nowhere. Consequently, it is difficult to attribute the take-off in exports in the early to mid-1960s to the change in export incentives per se. 4 2.3. Myth #3: Since the growth of these countries was driven by investment, is no miracle to explain there

This is a myth that Krugman (1994) is responsible for propagating, in an article called (ironically) the Myth of Asias Miracle. There is surely an economic miracle at work when an economy in which saving and investment decisions are made primarily by households and private entrepreneurs goes from investing ten percent of its income to investing 30 percent within 15 years. In a Stalinist command economy, with which Krugman drew a parallel, higher saving and investment rates can be obtained relatively simply, by planners deciding to allocate fewer funds to consumption. But when the same happens in a non-socialist economy, we are left with prima facie evidence of a substantial increase in the private return to investment, the sources of which we must pursue. For the very same reason, the additional investment that takes place is guaranteed to result in high increments of national output - which is not true of a command economy where investment decisions are divorced from profitability considerations. Hence knowledge about the proximate source of high growth helps focus our inquiry for causes; it does not eliminate the need for explanation. 2.4. An interpretation The main puzzles of the East Asian transformation, therefore, turn out to be the following: why did the private return to investment apparently increase so dramatically in the early 1960s and how did it remain so high? Stated as such, at least the first of these puzzles turns out to have a straightforward solution. This is because in both South Korea and Taiwan we can identify distinct changes in policies around 1960 which it would be safe to say enhanced the private profitability of investment. These changes have been discussed in Rodrik (1995a), and I only summarize them here. First, there was a substantial transformation in government priorities during the late 1950s in Taiwan and the early 1960s in Korea. During much of the

4 The more careful accounts written during the 1970s were actually aware of the absence of a significant shift in export incentives around the time that exports took off, so their discussion of these countries experience tended to be much more nuanced. See in particular Frank et al. (1975) and Jones and Sakong (1980).

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1950s economic goals did not particularly rank high with either the Taiwanese or Korean leaderships. In Taiwan, the government was preoccupied with the reconquest of the mainland. In Korea, Syngman Rhees attention was focussed on national consolidation and on political goals. Economic growth was not a priority in either country. By the end of the decade, things were quite different. In Taiwan, it became clear to the leadership that the communist regime was firmly entrenched in the mainland. Government priorities henceforth shifted towards economic goals, resulting in the nineteen-point reform program instituted in 1960. This program contained a wide range of subsidies for investment, and signalled a major shift in government attitudes towards investment. 5 And in Korea, President Park, who took power in a military coup in 1961, could not have been more different from his predecessor. Park gave precedence to economics over politics, and to economic growth over other economic concerns. These priorities were reflected in the amount of time he spent on economic matters and in his support of growth-oriented bureaucrats and businessmen (see Jones and Sakong, 1980, pp. 40-43). Hence, in both countries there was a sharp improvement in the investment climate. In addition to eliminating obstacles to investment, government policies subsidized investment at handsome rates. In Korea, the chief form of investment subsidy was the extension of credit to large business groups at negative real interest rates. Korean banks were nationalized after the military coup of 1961, and consequently the government obtained exclusive control over the allocation of investible funds in the economy. According to Jones and Sakong, the general bank [lending] rate has typically been half of the curb-market rate; and second, the real bank rate has often been negative and generally below even the most conservative estimates of the opportunity cost of capital (1980, p. 104). Another important manner in which investment was subsidized in Korea was through the socialization of investment risk in selected sectors. This came about because the government - most notably President Park himself - provided an implicit guarantee that the state would bail out those entrepreneurs investing in desirable activities if circumstances later threatened the profitability of these investments. In Taiwan, investment subsidies took different forms. Real lending rates were generally positive and credit subsidies were much less important. The most important direct subsidies in Taiwan came in the form of tax incentives. The Statute for Encouragement of Investment (enacted in 1960 in conjunction with the nineteen-point program mentioned above) represented a sweeping extension (Lin, 1973, p. 85) of the prevailing tax credit system for investment. These incentives were further expanded in 1965, at which time specified manufacturing

As Lin (1973, p. 96) puts it, [with] the announcement of the nineteen-point reform program of 1960, the improvement of investment climate became a catchword. The simplification of administrative procedures and the liberalization of regulative measures with regard to economic matters became an official goal.

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sectors (in basic metals, electrical machinery and electronics, machinery, transportation equipment, chemical fertilizers, petrochemicals, and natural gas pipe) were given complete exemption from import duties on plant equipment. Going beyond subsidies, the Korean and Taiwanese governments played a much more direct, hands-on role by organizing private entrepreneurs into investments that they may not have otherwise made. In both cases, we have good case histories of how the government actively took steps to ensure that private entrepreneurs would invest in certain areas. In Taiwan, it was the government that took the initial steps in establishing such industries as plastics, textiles, fibers, steel, and electronics. In Korea, in the words of Amsden, [tlhe initiative to enter new manufacturing branches has come primarily from the public sphere. Ignoring the 1950s . . . , every major shift in industrial diversification in the decades of the 1960s and 1970s was instigated by the state.. . (Amsden, 1989, pp. 80-81). Finally, public enterprises played a very important role in enhancing the profitability of private investment in both countries (perhaps more so in Taiwan than in Korea). They did so by ensuring that key inputs were available locally for private producers downstream. In Taiwan, it was common for the state to establish new upstream industries and then either hand the factories over to selected private entrepreneurs (as happened in the case of glass, plastics, steel, and cement) or run them as public enterprises (Wade, 1990, p. 78). In Korea, the government established many new public enterprises in the 1960s and 197Os, particularly in basic industries characterized by high degree of forward linkages and scale economies (Jones and Sakong, 1980). In both countries, public enterprises were the recipient of favorable credit terms, as well as direct allocations from the government budget. Not only did public enterprises account for a large share of manufacturing output and investment in each country, their importance actually increased during the critical take-off years of the 1960s. Hence investment was greatly subsidized in both countries starting in the early 1960s. But this explanation raises puzzles of its own in turn. First, there is the question of the t$ficiency of the subsidies. In economies with complete and perfect markets, investment subsidies of the kind just discussed would reduce real income, even if they ended up increasing investment. Second, there is the issue of the effectiveness of the subsidies. Many other developing countries have employed similar investment incentive schemes - if not as wholeheartedly and singlemindedly. More often than not, these schemes have proved ineffective in that they ended up financing inframarginal investments and became riddled with rent-seeking activities. So why were South Korea and Taiwan different? Two key initial conditions, in my view, largely shaped the divergent path that these countries (along with others in East and Southeast Asia) took. First, by the late 1950s the East Asian economies had a much better educated labor force than would have been expected on the basis of their income levels. Table 2 shows the evidence for South Korea and Taiwan. To get a sense of the magnitudes, note that while Ghana had a higher

Table 2 Human capital indicators in South Korea and Taiwan: Actual versus levels predicted by per-capita GDP Secondary enrolment ratio, 1960 Act. 0.27 0.28 0.10 0.12 0.17 0.15 Pred. Diff. Act. 0.71 0.54 Literacy rate, 1960 Pred. 0.31 0.36 Diff. 0.40 0.18 Diff. 0.37 0.34

Primary emolment ratio, 1960

Act.

Pred.

South Korea Taiwan

0.94 0.96

0.57 0.62

Source: Authors calculations.

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per-capita income in 1960 than South Korea, the average male worker had only one years education in Ghana versus 5 years in South Korea. This may have made it easier to establish a competent bureaucracy. Even more important, it would also have increased the return to capital, However, in the presence of coordination failures (and possibly other market imperfections), active government policy would have been required to transform the latent profitability of investment into a realized one. The market failures in question are not at all implausible for countries at very low levels of industrialization. A formalization and further discussion of this story is provided in Rodrik (1995a, 1996a). The second respect in which initial conditions in East Asia were favorable was the social cohesiveness that these societies exhibited. This is perhaps best seen in their distribution of income and wealth around 1960, which was exceptionally equal by cross-country standards (see Fig. 4). Equality, and more broadly lack of social and political fragmentation, was conducive to better governance for at least three different reasons. First, these governments did not generally have to contend with powerful industrial or landed interest groups: therefore, policy making and implementation could be insulated from pressure-group politics. Second, the absence of large-scale inequities and deep social cleavages meant that govemments felt no immediate need (and were not under pressure) to undertake redistributive policies; they could concentrate on expanding the pie instead. Third, and related to these, the fact that the top political leadership was free to focus on economic goals meant that it could monitor the bureaucracy closely and make sure that the bureaucrats assisted rather than hindered private entrepreneurship. 6 I will expand on these themes in Section 3 in the context of a specific policy area.

0.7 . I

0.2

I 03 04 0.5 Gini 0.6 coefficient 07 for land, c. 1960 0.6 0.9 1

Fig. 4. Measures of income and land distribution. 1994.)

(Source; From original data in Alesina and Rodrik,

D. Rodrik/ European Economic Review 41 (1997) 41 I-442

42-l

The bottom line is that governments played an important role in East Asia in eliciting and organizing a private investment boom starting in the early 1960s. In this, they were aided by some special initial conditions, which allowed a virtuous cycle to develop. These special conditions, however, render the direct transferability of the East Asian experience to other settings problematic.

3. How to design a good policy regime? Export incentives as a case study Development practitioners and development economists have come to realize that the quality of policymaking is as important a determinant of economic performance as the nature of the policies themselves. Hence, the success of government intervention in East Asia may have been due more to the manner in which it was carried out than to the wisdom in selecting the correct interventions. To put it bluntly, interventions in East Asia were effective in eliciting the desired private-sector response, whereas interventions most every else have been ineffective. In view of the importance of this issue in practice, we can ask: what kind of guidance does economics provide to the actual design of policy regimes, as opposed to the nature of the desirable policies themselves? As pointed out in the introduction, there has been much implicit theorizing on this question. Based loosely on various strands of economic theory, policy-oriented economists have converged on a series of rules-of-thumb which can be summarized as follows: * apply simple and uniform rules, rather than selective and differentiated ones; - endow bureaucrats with few discretionary powers; - incorporate safeguards against frequent, unpredictable alteration of the rules; - keep firms and other organized interests at arms length from the policy formulation and implementation process. These conclusions seem broadly reasonable, and lists like the above are often drawn in policy discussions.

These points have received some indirect empirical support in a number of papers which have found a positive relationship between equality and subsequent economic growth. See in particular Alesina and Rodrik (19941, Persson and Tabellini (19941, Clarke (19931, and Birdsall et al. (1994). In these papers, the initial level of income equality around 1960 is shown to be robustly and positively correlated with growth over the next three decades, controlling for other initial conditions such as per capita income and educational attainment. A related theme is developed by Easterly and Levine (1996). who show that an index of ethnolinguistic fragmentation is negatively correlated with subsequent growth, particularly in countries with poor institutions. Three sets of economic models in particular constitute the backdrop to these rules of thumb: (i) models of dynamic-inconsistency of policy; (ii) models with irreversibilities and hysteresis; and (iii) models of rent-seeking. The correspondence between these models and the actual rules of thumb is weaker that is usually supposed, however, as I will argue below.

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I recently examined export-incentive programs in six countries (South Korea, Brazil, Turkey, Kenya, Bolivia, India) to see whether these recommendations were borne out in actual experience. I was expecting that the evidence on what makes some programs successful and others failures would validate these rules of thumb. I was quite wrong. In fact, these rules were almost perfectly negatively correlated with actual outcomes! The two most successful programs of export subsidization I found, those in South Korea and Brazil, were highly complex and selective, differentiated by firm, subject to frequent changes, gave bureaucrats enormous discretionary powers, and entailed close interaction between bureaucrats and firms. On the other hand, the least successful programs in my sample, those in Kenya and Bolivia, consisted of simple, across-the-board, and non-selective subsidies. I will provide some hypotheses about this puzzling finding later on. But first I summarize some of the evidence. 3.1. South Korea The micro-management of incentives in South Korea has already been noted. Perhaps nowhere was this more notable than in the area of export incentives. Korean exporters had access to a bewildering array of subsidies during the 1960s and 1970s. Direct cash grants were important very early on, but were phased out by 1965, to be replaced by tax and import duty exemptions. Exporters were allowed duty-free imports of raw materials and intermediate inputs up to a limit, with the limit determined administratively, on the basis of firms and industries input-output coefficients plus a margin of wastage allowance. Since the imports acquired under the wastage allowance could be sold in the domestic market, this was a significant subsidy and was consciously used as such. Bureaucrats had virtually unrestricted discretion in setting wastage allowances, and their generosity varied from time to time. Businesses and trade associations regularly lobbied for increased allowances. Subsidized credit to exporters was another significant incentive, and it became particularly important after 1966. Frank et al. (1975, Table 5-5) list no less than twelve different types of preferential loans to exporters that were operative in the 1967- 1970 period. The ability of the South Korean government to elicit the desired response from fiis by a combination of cajoling, arm-twisting, and threats was characteristic of the manner in which the export subsidies were administered. Westphals description of the situation is worth quoting at length: [T]he [Korean] government has not relied solely on market forces acting in response to incentives. It has also used publicly announced, quarterly export targets for individual commodities, markets, and firms. Contact between

The following

draws heavily on Rodrik (1995b).

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government and business in the day-to-day implementation of these targets has been close. Next to the responsible ministers office, an export situation room was established, laid out so that potential export shortfalls could be identified at a glance. A large staff has maintained almost daily contact with major exporters, and it has not been uncommon for the minister to intervene in difficult situations; for example, to obtain immediate customs clearance for inputs being delayed on some pretext. Progress towards targets and the current trade situation have been regularly reviewed at a Monthly Trade Promotion Conference, chaired by the president and attended by ministers, bankers, and the more successful exporters, large and small. The highest export achievements have brought national awards as well as material benefits bestowed through discretionary means . . . [including] additional preferences in the general allocation of credit under a system of government directed bank lending and relaxed tax surveillance under a revenue system that gives government officials considerable latitude in determining tax liabilities. . . Conversely, indolence has been deterred by the perception that discretion could be - indeed, sometimes was - exercised in ways that impose material costs or deny potential benefits in other areas of a firms activity. (Westphal, 1990, pp. 45-46) As this passage makes clear, the bureaucrats issued export targets for specific firms (as well as specific commodities and export markets). Eventually, firms began to set their own targets, but remained constrained by past performance as well as the vigilance of bureaucrats in extracting maximum export performance. The extent to which the governments priorities and resources were organized around export performance is striking. As mentioned in the passage by Westphal above, the monthly trade promotion conferences were chaired by President Park himself, and he often took decisions on the spot. Exports were monitored literally on a daily basis: The head of the export promotion office in the Ministry of Commerce and Industry has at his side a computer printout of progress against targets by industry and by firms. The data is for the preceding day, which is all the more remarkable when it is considered that most developing countries do not have aggregate information on exports for many months. The printout is also broken down by geographic region. If sales in a region are not up to target, the Korean ambassadors there are recalled to find out what the problems are and what can be done to spur Korean sales. And in the foyer of the head office of the Korean Traders Association is a big board tracking the progress of each industry towards its target. The export associations of each industry, the nodes for all information flows on exports, have their own boards tracking progress. So do firms on the shop floors, where workers dressed in uniforms that give all of industry a paramilitary air - keep track

430

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of their firms progress toward targets and of that by competitors street. (Rhee et al., 1984, p. 22) The extreme discretion that trade officials had allowed respond quickly to changes in circumstances. 3.2. Brazil

down the

them to be flexible

and

Brazils economy has been so mismanaged since the early 1980s that it is hard to imagine the presence there of an effective program of export subsidies. Yet starting in the second half of the 1960s an extensive set of export incentives was successfully implemented and this led - alongside a crawling exchange rate policy _ to an impressive increase in manufactured exports. It was this export performance that prompted many observers to talk about a Brazilian miracle, until the debt crisis of 1982 and macroeconomic mismanagement turned the economy into a big mess. Following the military coup of 1964, the incoming government, like Parks regime, developed a clear commitment to exports. There was some liberalization of import restrictions, a move (in 1968) to a crawling peg regime to maintain competitiveness, and the development of an extensive and generous system of export subsidies for manufactures. These subsidies included duty and tax rebates, income tax exemption, credit subsidies, and many others. By the latter half of the 1970s the combined value of these subsidies stood close to 50 percent of exports. As in Korea, these subsidy programs were implemented in a highly selective and discriminatory manner. Export subsidization varied greatly from industry to industry, as well as from firm to firm. The effectiveness of these subsidies appears beyond question. In a survey of export subsidies in Latin America, Noguts (1990) lists only the Brazilian case as a success. Fasano-Filho et al. (1987) provide econometric evidence of their importance in export supply decisions. A World Bank study (1983, p. 121) credits the BEFIEX program (discussed below) for stimulating a significant amount of new investments oriented towards world markets. Perhaps most telling of all is that Brazilian manufactured exports expanded at an annual average rate of 38 percent during the 1970s. Among the subsidies employed, one stands out in terms of effectiveness and distinctiveness. This is the BEFIEX program, introduced in 1972. (BEFIEX is the Brazilian acronym for Fiscal Benefits for Special Export Programmes.) This scheme was unusual in that it entailed the signing of long-term contracts (for usually 10 years) by participating firms detailing their export commitments. Aside from these export commitments, firms also had to satisfy minimum local-content requirements in order to qualify for BEFIEX incentives. The contracts were negotiated with the BEFIEX administration on the basis of detailed information on firms activities and strategic plans. The incentives, in turn, typically included

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90% reduction of import duties and the Industrialized Products Tax (IPI) on imported machinery and equipment; 50% reduction on import duties and IPI tax on imported raw materials, parts and components, and other intermediate products; exemption from the similarity test; and income tax exemption on profits attributable to exports of manufactured products (GATT, 1992, p. 104). Between 1972-1985, 316 contracts were signed, mainly with multinational enterprises in the transport equipment and textile and clothing industries. In the automotive sector, GM, Ford, and VW each committed to $1 billion of exports over ten years, Fiat to $550 million, and Mercedes Benz to $500 million (Shapiro, 1993, p. 213; World Bank, 1983, p. 257). The effect of the program in this sector was nothing short of dramatic. Automotive exports rose from virtually nothing in 1972 to more than $1 billion in 1980. Total exports under BEFIEX contracts increased to $8.2 billion by 1990, at which time the program was phased out as part of an overall trade liberalization. According to a GAIT study (1992, p. 1041, BEFIEX-linked exports eventually covered about half of all manufactured exports. To an economist, perhaps the most striking thing about BEFIEX is the apparent absence of gaming between firms and the government. Participation in BEFIEX meant that firms were under legal obligation to live up to their export commitments, irrespective of economic circumstances such as foreign demand conditions or exchange-rate fluctuations. These were tough terms, and firms apparently lived by them. In her study of the Brazilian automotive industry, Shapiro (1993) mentions instances in which multinationals had to make adjustments to their global strategies - by cutting back exports from third countries, for example - so as not to run afoul of BEFIEX export commitments. This must be confounding to economists who generally believe that long-term contracts are not enforceable, especially when the government is on one side, and must come under severe renegotiation pressure in response to unforeseen circumstances. In this instance the Brazilian bureaucrats had the capacity to discipline firms, and were perceived as such. 3.3. Kenya Compared to the Korean and Brazilian programs, the Kenyan scheme of the 1970s was on paper an economists dream: it could not have been simpler, less discretionary, nor more uniform. The Local Manufactures (Export Compensation) Act of 1974 applied a straightforward 10 percent export subsidy to most manufactures. (The rate was increased to 20 percent in 1980.) The only restriction was that the value of imported goods could not amount to more than 70 percent of the

9 The similarity test in the quote refers to the infamous law that prohibited foreign products when similar products were available domestically.

the importation

of

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value of the export. The subsidy was to be paid through commercial banks, after export proceeds were received and after government officials processed the subsidy claims. The effects of the program were imperceptible. Low (1982) interviewed 55 firms and found that only 16 (29 percent) of them had responded by increasing exported output. The plurality of firms (17, or 31 percent) treated the subsidy simply as a windfall, while 7 firms (13 percent) did not even bother to claim the subsidy. Even more telling is Lows calculation that at the aggregate level less than 30 percent of eligible exports actually received the subsidy. A very large number of exporters either did not claim the subsidy or did not get it. What seems to have happened is a bit of both. Government officials processing the subsidy claims exercised such zeal that many applications were rejected on trivial grounds. Low spent a day with these officials and observed two claims being rejected, one because a date had been inadvertently omitted on a form and the other because the quadruplicate instead of the sexduplicate copy of the Export Entry form had been submitted with the claim (1982, p. 297). The officials also took their time. More than a quarter of the firms interviewed by Low expected to wait more than six months after claims had been filed. And since the claims could not be filed before export proceeds were actually received, the total waiting time was even longer than this. The delay and unpredictability explain why many firms did not bother to claim, and why those that did treated the subsidy as a lump-sum payment, not to influence their export decisions. In partial recognition of these problems, the government reformed the program in 1980. The subsidy was raised to 20 percent, coverage of the scheme was expanded to almost all nontraditional exports, and an attempt was made to streamline administrative procedures. Two features of the reform deserve special mention. First, the increase in the subsidy was accompanied by an equivalent 10 percent surcharge on imports. This was intended to de-emphasize fiscal considerations in the implementation of the subsidy, but is also indicative of the incoherence of policy: by the Lemer symmetry theorem, the import surcharge served to offset the effect of the increase in the export subsidy. Second, administrative responsibility for the subsidy scheme was moved from the Customs and Excise Department to the Central Bank, an institution with less stake in revenue and greater reputation for bureaucratic efficiency. It appears that this change served only to move Kenyas export policy from one extreme of incentive-blunting diligence to another of corrupt generosity. An account in The Economist (August 14, 1993, pp. 37-38) relates the scandalous story of a Kenyan firm called Goldenberg. This firm, the sole recipient of a license to export gold and jewellery, apparently received $54 million in export subsidies from the Central Bank (amounting to 5 percent of Kenyas total exports!). Not only was the firm paid a subsidy of 35 percent (rather than 20 percent, as the law requires), but the foreign firms to which Goldenberg claimed to have shipped its exports were either fictitious or had never heard of Goldenberg.

D. Rodrik / European Economic Review 41 (1997) 41 l-442

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3.4. Bolivia Between 1987 and 1991, Bolivia had an export subsidy program similar to the Kenyan scheme, which also failed for virtually identical reasons. As the authorities never resolved the conflicting objectives of safeguarding revenue versus stimulating exports, the exporters reacted by alternatively ignoring the scheme and badly abusing it. The export subsidy introduced in July 1987 was in principle aimed at reimbursing exports for duties paid in imported inputs (hence the acronym CRA, standing for the initials for Tariff Refund Certificate in Spanish). However, rather than create an explicit drawback scheme which can be an administrative nightmare, the government sensibly set the subsidy at a uniform 10 percent for non-traditional exports and 5 percent for traditional exports. (The top rate was subsequently lowered to 6 percent in August 1990, following a tariff reduction.) Bolivia had recently come out of a hyperinflation, with inflation running at more than 40 000 percent per annum and a budget deficit of more than 20 percent of GDP prior to the stabilization of August 1985. The authorities were naturally more than slightly nervous about the budgetary implications of the subsidy. Partly for that reason, the entry into force of the CRA was delayed. Apparently, no CRA payments were made until 1989, and once payments began to be made, enterprising individuals and firms freely abused the system: there was a famous case of so-called tourist cows (vacas twistas) in which cow herds were led across the Bolivian borders several times, collecting CRA benefits at each crossing. The system was finally scrapped in April 1991, and replaced by a narrower scheme with lower financial benefits. 3.5. Discussion The administration of an export-incentive regime, as many other policies, can be conceptualized as a two-level principal agent game. The bureaucrats operating the system sit at the middle of the chain: they are the agent of the political principals (the president, the parliament, other political organizations), but they also act as the principal for the exporters (the agents) whose behavior they aim to influence. This complicated interaction suffers from all the structural shortcomings discussed by Dixit (1996): there are multiple principals at the top (and hence conflicting objectives for the bureaucrats to fulfill), difficulties of monitoring both the bureaucrats and the exporting firms (and consequently the possibility of opportunistic behavior by both groups), bounded rationality (and hence the inability to write a complete set of contingent contracts). In such a context, it is generically difficult to provide high-powered incentives to (both set of) agents, and therefore the best one can do is strive for constrained efficiency. The case studies above reveal the different ways in which these constraints were addressed (or not addressed) in our countries. The situation is clearest for the

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case of South Korea. The Korean system was able to produce high-powered incentives for both bureaucrats and exporting firms thanks to: - a professional ethic in the bureaucracy (which reduced opportunistic behavior); absence of multiple principals at the apex (President Park was the sole principal); good monitoring (as exports were a key priority, both President Park and the bureaucrats spent an inordinate effort on monitoring); - observable performance criteria. By all accounts, there was clear understanding on the part of Korean firms that good export performance would be rewarded by various kinds of government benefits, while poor performance would bring forth penalties. The Brazilian system as a whole was less well endowed with these advantages, but parts of the bureaucracy (and the BEFIEX program in particular) seems to have benefited from the regimes high priority on exports as well as the presence of a professional ethic (on the latter see Evans, 1995, p. 61). These two factors may have helped alleviate problems arising from the multiplicity of principals and from opportunistic behavior. Kenya and Bolivia, by contrast, had none of these advantages, and therefore fell prey to the full panoply of incentive problems that Dixit (1996) describes so well. Neither the Kenyan nor the Bolivian political leadership clearly sorted out and prioritized their objectives as they embarked on their export subsidy policies. Consequently, their agents (the bureaucrats) vacillated between export goals and fiscal concerns. In addition, the bureaucrats monitoring ability was extremely limited. In both countries, bureaucrats had the ability to stop the private sector from doing something, but not the ability to get it to do something that the bureaucracy desired. lo Why, then, do the simple rules of thumb not help? At the most general level, 1 think the answer is that these rules are not based on fully articulated models of political economy, and therefore apply simplistic solutions to problems that have not been properly specified. Hence, if the problem at hand is simply one of poor monitoring, it may be that uniform and non-selective incentives should be preferred; but if it is one of multiple principals, it is not so clear that the same strategy pays off. If the problem is one of administrative capability, building automaticity into the system may be considerably more effective than asking government officials to administer a simple, as opposed to a complicated, schedule of incentives. After all, if the capacity to administer a selective system is lacking, the capacity to administer a non-selective scheme is likely to be lacking as well. Note also that uniformity in general interferes with the provision of high-powered
l l

Bardhan (1996, pp. 9-10) puts this point well in the Indian context: One high official in New Delhi is reported to have told a friend: if you want me to move a file faster, I am not sure I can help you; but if you want me to stop a file I can do it immediately.

-T---

D. Rodrik / European Economic Review 41 (1997) 41 I-442

435

incentives. The recommendation that bureaucrats keep firms at arms length blunts their ability to monitor the firms. And so on. My point is not that there is a superior set of rules of thumb that should replace the list above. It is rather that the hard work on developing such rules - if indeed they exist - has yet to be done. Doing that work will require specific knowledge about the local context. And it will likely yield ideas on institutional innovations that we can hardly predict ex ante.

4. The complementarity

between states and markets: the role of social

insurance
In their haste to roll back the state, many economists and policy makers have overlooked the fact that the maintenance of social safety nets is not a luxury but an essential ingredient of a market economy. Markets are a wonderful thing, but they also expose households to risks and insecurities that have to be managed in order for the social legitimacy of the market system to be maintained. This has become rather evident in the aftermath of the collapse of the communist regimes in Eastern Europe and the former Soviet Union: the surprising rise in the popularity of former communists in these countries a few years into the transition to markets is as good evidence as any of the insecurities generated by a quick rush to markets in the presence of inadequate social protection. But one can see evidence of a backlash against the market, and globalized markets in particular, wherever one turns: the surprising strength exhibited by Pat Buchanan during the Republican primaries in the U.S., the strikes in Argentina, and (closer to home) the rise of Islamists in Turkey are all linked by the common thread of resistance to global markets. Far sighted policy makers have read the message on the wall, and the social side of government policy is re-entering the picture. Chile was a leader in this, as in many other areas of economic policy. After more than a decade-and-a-half of unadulterated free-market policies, the democratically-elected government of President Aylwin made an increase in social spending one of his administrations key priorities. He raised the minimum wage, increased spending on pensions, social subsidies, basic education and health, and launched debt-relief programs (e.g., for housing debt) for lower-middle income groups. Chile has shown that such things can be done in a fiscally responsible manner. Aylwins social programs were financed by a tax reform (in 1990) which raised corporate and personal income taxes and instituted a VAT (see Marcel and Solimano, 1994). The complementarity between markets and social protection is revealed in some otherwise surprising regularities in the cross-country evidence on the size of government and its relationship to international trade. Fig. 5 shows that there is quite a strong correlation among the OECD countries between government expenditures (as a share of GDP) and exposure to trade: countries that are more exposed to trade have bigger governments. Moreover, this relationship is not confined to

D. Rodrik/

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Fig. 5. Relationship

between openness and public expenditures.

the high-income countries. Fig. 6 shows an analogous picture for more than 100 countries, most of them developing: once again we find a striking positive relationship between size of government (in this case government consumption)

1
2

OL

Fig. 6. Partial relation between openness and government income, urbanization, dependency ratio, area, and region).

consumption

(controlling

for per-capita

D. Rodrik/ European Economic Review 41(1997)

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437

and exposure to trade. For this larger sample, I have controlled for other potential determinants of government size. As I have discussed in Rodrik (1996b), this correlation is quite robust and remains strong no matter what additional controls are introduced on the right-hand side of the regression. Furthermore, it turns out that the degree of openness during the early 1960s is a very good predictor of the expansion of government over the subsequent three decades (Fig. 7). To most economists, this regularity should be puzzling. After all, we are trained to believe that governments are inimical to markets and their expansion. However, the evidence captured in these figures offers quite a different perspective on the role of governments, one that is suggestive of a complementarity instead between states and markets. I have argued in Rodrik (1996b) that these cross-country patterns are due to the provision of social insurance by governments to counter the

355
l .

y = 0.3513x R = 0.1619

. .
*.

.
.

.c***

. .

I
0 2 2.5 3

35

4 log(x+mY~,l950-64

45

55

Fig. 7. Relationship between exposure to trade in early 1960s and subsequent increase in government (controlling for initial per-capita income and government consumption share, urbanization, dependency ratio, regional dummies).

438 Table 3 The importance Independent

D. Rodrik/

European Economic Review 41 (1997) 411-442

of exposure to external risk Dependent variable: log of real government consumption as % of GDP (1)

variables

(2)
- 0.002 - 0.909 a 0.015 a

(3) - 0.005 b

(4) -0.005 b -0.012 0.002 - 3.649 b 0.054 b 105 0.528 and

(x+M)/Y

0.003 a

Product concentration in exports ( X + M)/ Y X product concentration in exports Terms-of-trade instability ( X + M)/ Y X terms-of-trade instability N Adj. R2 Other regressors (coefficients regional dummies. a Significant at 99% level; b Significant at 95% level; Significant at 90% level. not shown) 105 0.439 are per-capita

- 3.856 a 0.061 a 105 0.506 GDP, dependency 105 0.535

ratio, urbanization,

effects of exposure to external risk. Societies that are exposed to greater amounts of external risk demand, and receive, a greater government role as partial insulation. The evidence for this hypothesis is summarized in Tables 3 and 4. Table 3 shows regressions where measures of external risk are included explicitly. The independent variable is the share of government consumption in GDP, with a range of additional controls included on the right hand side (listed in the note to Table 3). Column (1) shows that exposure to trade has an estimated coefficient that is statistically significant at the 99% level, when measures of external risk are not otherwise included. The rest of the columns show what happens when such measures are included. Two measures of external risk are included: one is the interaction of exposure to trade with terms-of-trade instability; the other is the interaction of exposure to trade with a Gini-Hirschman index of product concentration on the export side. I2 Note that the first of these is a theoretically appropriate measure of exposure to external risk, as it measures the (unpredictable component of the) volatility in the streams of income associated with foreign trade. Table 3 shows that these measures of external risk are highly significant in statistical terms. Furthermore, once they are included in the regression, the coefficient on exposure to trade actually changes sign. Hence, there is

For a nice illustration of how exposure to external risk can detract from the benefits of trade see Newbery and Stiglitz (1984). I2 The terms of trade instability measure is calculated as the standard deviation of the first log differences of the terms of trade over 1971-1990. See Rodrik (1996b) for sources and more detailed discussion of variable constructions.

Table 4 The effects of openness expenditures variable: log of government Countries with 1985 per capita GDP > $4500 Government consumption Government consumption All countries expenditure (by type) as % of GDP of different types, by income groups Dependent OECD countries

and external risk on government

V $ a $ \ 2 a c1 Government consumption : F Y (5) -0.018 16.484 a 0.183 68 32 0.09 ratio, urbanization, 0.48 (6) -0.004 c - 3.585 a 0.056 a 109 0.51 and regional dummies. Coefficients

Independent

variables

Social security and welfare Social security and welfare (3) - 0.043 c - 35.010 b 0.438 b 25 0.23 per-capita GDP, dependency -4.148 c 0.067 b (4) - 0.006 -0.170 - 134.088 a 1.869 = 19 0.75 other regressors: 0.18 22 - 8.329 0.070 a (2) - 0.005

Social security and welfare

(1)

(x+M)/Y

Terms-of-trade instability (X + Ml/ Y X terms-of-trade

instability

8. r, b Fz. 2 e 5 s c 7 $

Adj. R2

Regressions in columns (5) and (6) include the following on these additional regressors are riot shown. Significant at 99% level; b Significant at 95% level; Significant at 90% level.

440

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strong support for the idea that the cross-country correlation between openness and government size is driven by exposure to external risk. How exactly does government spending (and in particular government consumption) ameliorate external risk? As long as government purchases of goods and services (and government employment) tend to be insensitive to external (and domestic) shocks to the economy, having a large government sector can indeed play the role of a shock absorber. It is of course an empirical question whether the pattern of variances and covariances that obtain in the real world satisfy the required conditions. I have provided some positive evidence on this score in Rodrik (1996b). But perhaps more telling evidence is provided by the regressions in Table 4. The dependent variables in these regressions are spending on social security and welfare and government consumption, and results are shown for sub-samples according to membership in the OECD and income levels. The bottom line is that in the richest countries, and the OECD members in particular, it is spending on social security and welfare that has the greatest sensitivity to exposure to external risk. These are the countries which do have elaborate social safety nets. The majority of the countries in the larger cross-section do not, however, and we see the social insurance role being played in these countries by government consumption instead. I believe that this kind of evidence is quite telling about the role of governments in market economies. It identifies in a particular context, and in an empirically measurable way, the supportive role that governments play in enabling the expansion of markets. None of this is to say that the provision of social insurance requires big government. And certainly I do not mean to imply that deficit spending has a useful role. The point instead is that any reform of the state that overlooks the importance of social insurance risks undermining the market-oriented system that is the ultimate objective of the reform.

5. Concluding

remarks

The phenomena discussed in the preceding pages are paradoxical from the perspective of prevailing orthodoxies in development thinking. But there is nothing surprising about them once we place them in the context of the emerging set of ideas I have briefly discussed in the introduction: Certain government interventions are required to transform poor countries into rich ones. Good public institutions make the task of intervention easier; bad ones more difficult. Markets and states are complements, particularly where social insurance is concerned. These are hardly earth-shattering ideas, and they certainly are not novel. What we need now is the kind of pragmatic, non-dogmatic approach to these issues that Alfred Marshall demonstrated in his own time. With some luck, the pendulum will swing back only so far this time, and we will manage to avoid the counterproductive extremes that came to dominate our thinking in the past.

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6. Unlinked reference
Dixit, 1996

References
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