Righting reform, the gap between rules and public perception

Dani Rodrik, Project Syndicate

Most economists now agree that institutional quality holds the key to prosperity. Rich countries are places where investors feel secure in their property rights, the rule of law prevails, private incentives are aligned with social objectives, monetary and fiscal policies are solidly grounded, risks are mediated through social insurance, and citizens have recourse to civil liberties and political representation. Poor countries are where these arrangements are absent or ill-formed.

Compare Russia and China. In Russia, an investor has in principle the full protection of a private property-rights regime enforced by an independent judiciary. In China, there is no such protection, because private property was not legally recognized until recently, and the court system is not independent.

Yet during the mid-to late-1990s, investors consistently gave China higher marks than Russia on the rule of law. That investors evidently felt better protected in China than they did in Russia is perhaps no surprise to anyone who has observed the evolution of Russia's legal system over the last decade. But the important point is the gap between rules and how they are perceived.

To be effective, a formal legal regime protecting investors' rights requires a non-corrupt, independent judiciary with enforcement power. Setting up such a judiciary is difficult and takes time. So the efficacy of enhancing property rights by rewriting domestic legislation -- changing the formal aspects of the institutional environment -- is naturally uncertain. That seems to have been the trap in which Russia's transition was caught for some time.

How did China evade this trap? The largest boom in "private" investment in China took place (at least until the mid-1990s) in Township and Village Enterprises (TVEs). These were firms in which local governments typically held ownership. Private entrepreneurs were effectively partners with government.

In a system where courts cannot be relied upon to protect property rights, letting the government hold residual rights in an enterprise may have been a second-best mechanism for avoiding expropriation. In such circumstances, the expectation of future profits can exert a stronger discipline on the public authority than fear of legal sanction. Private entrepreneurs felt secure not because the government was prevented from expropriating them, but because, sharing in the profits, it had no interest in expropriating them.

This illustrates a broader point: There is no unique, non- context specific way of achieving desirable institutional outcomes. China could provide a semblance of effective protection of private property despite the absence of formal rights. The Russian experience strongly suggests that the obvious alternative of legal reform would not have been nearly as effective.

We can multiply the examples. For instance, China provided market incentives through two-track economic reform rather than across-the-board liberalization, which is usually the standard advice.

In agriculture and industry, price efficiency was achieved not by abolishing quotas and planned allocations, but by allowing producers to trade at market prices at the margin. In international trade, openness was achieved not by reducing import barriers, but by creating special economic zones with different rules than those applied to domestic production.

The good news is that everything we know about economic development suggests that large-scale institutional transformation is hardly ever a prerequisite for jump-starting growth. True, sustained economic convergence eventually requires high-quality institutions. But the initial spurt in growth can be achieved with minimal changes in institutional arrangements.

In other words, we need to distinguish between stimulating economic growth and sustaining it.

Solid institutions are much more important for the latter than for the former. Once growth is set into motion, it becomes easier to maintain a virtuous cycle with rapid growth and institutional transformation driving each other.

Ricardo Hausmann, Lant Pritchett, and I recently identified and examined more than 80 episodes of growth acceleration -- in which a country increased its growth rate by 2 percent or more for at least seven years -- in the period since 1950.

The surprise was not only that there were so many cases, but that the vast majority seemed unrelated to conventional economic reforms, such as liberalization of trade and prices. To the extent that we can identify growth triggers, they seem to be related to relaxing constraints that held back private economic activity.

Even in the better-known cases, institutional changes at the outset of growth acceleration were typically modest. China's gradual, experimental steps towards liberalization in the late 1970s were similar to South Korea's experience in the early 1960s.

After taking power in 1961, Park Chung Hee's military government moved in a trial-and-error fashion, without recourse to system-wide transformation, experimenting at first with various public investment projects. The hallmark reforms associated with the Korean miracle -- devaluation and a hike in interest rates -- came in 1964 and fell far short of full liberalization of currency and financial markets.

Such instances indicate that an attitudinal change on the part of political leaders towards a more market-oriented, private- sector-friendly policy framework often plays as large a role in boosting economic growth as the scope of actual institutional reform. Such an attitudinal change appears to have had a particularly profound effect in one of the important growth miracles of the last quarter century -- India since the early 1980s.

The trick for policymakers is to identify the binding constraint on economic growth at the relevant moment in time. In South Korea in 1961, the major constraint was the gap between the social and private return on investment. In China circa 1978, the constraint was the absence of market-oriented incentives. In the India of 1980, it was government hostility to the private sector. In the Chile of 1983, it was an overvalued exchange rate.

Of course, it is easier to determine these constraints after the fact. We need to develop a framework for "growth diagnostics" capable of pinpointing where even a little reform can go a long way.

The writer is Professor of Political Economy, John F. Kennedy School of Government, Harvard University.