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Views at conference: Second-generation reforms call for varied approaches to institution building and growth

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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Sound social, political, and economic institutions are now widely accepted as necessary complements to the sustained implementation of sound macroeconomic policies and the attainment of high-quality growth. Transparency in government and financial activities; good governance; sound legal, regulatory, and supervisory frameworks; and fiscal policy sensitive to the social and economic needs and situation of its citizens—all these elements have been combined under the rubric “second-generation reforms.” Many questions about the reform process remain unresolved: what is the relationship between first- and second-generation reforms; how universally applicable are they and how can country ownership of a program be reconciled with internationally agreed codes and standards, how effective have they been so far, and where do we go from here?

Representatives from academia, government, the private sector, and multilateral institutions tackled these and other questions during a conference organized jointly by the IMF Institute and the Fiscal Affairs Department on November 8 and 9. IMF Managing Director Michel Camdessus provided welcoming remarks, and World Bank President James Wolfensohn delivered the keynote address.

Background and new developments

By the early 1980s, Camdessus said, much of the world had come to realize that macroeconomic stability was not enough to ensure sustained growth. The need to eliminate market distortions and inefficiency provided the motivation for a first generation of reforms.

The acceleration of globalization during the past decade and its long-term implications provided much of the impetus for the second generation of reforms, Camdessus noted. Few would now dispute the need for sound social, political, and economic institutions. For this reason, first- and second-generation reforms should not be seen as sequential. Indeed, the institution building typically associated with the second generation often can and should occur in parallel with the first generation.

Poverty is central to the activities of the World Bank, James Wolfensohn said. If you want stable growth, you must also address the social and poverty issues and related structural issues, thereby creating a “virtuous circle” of sustained, high-quality growth whose benefits accrue to all levels of society.

Second-generation reforms must also address the question of how to build consensus in a society, Wolfensohn said. How a society moves forward, in terms of both reforming its structure and in the program it adopts, must be controlled by the society itself.

Institutions matter, but politics rules

The concentration of political power determines the formulation of institutions that influence the outcome of political decisions, no matter what type of government, according to Robert H. Bates of Harvard University. There is no reason to expect that a particular kind of government will be best in terms of the expected choice of policies.

Political analysts, Bates said, tend to view policies as the result of deliberations from a single entity that chooses policies to facilitate attainment of those objectives. But policies typically emerge from competitive political processes, in which diverse interests advance competing alternatives, resulting either in the victory of one or in a compromise among several. The type of government is immaterial, Bates said, because even within a single-party or totalitarian state, competing interests and internal political conflicts are rife.

In his response, Anthony Lanyi of the University of Maryland suggested that the type of government might be more relevant than Bates had suggested. Most second-generation reforms, because they entail the introduction of transparency and accountability into a country’s political, financial, and social systems and legal and regulatory frameworks, would find more fruitful soil in an environment of political openness.

Building institutions

A market economy relies on a wide array of nonmarket institutions that perform regulatory, stabilizing, and legitimizing functions that are not inherently generated by the market. Therefore, the question before policymakers, according to Dani Rodrik of Harvard University, is no longer “Do institutions matter?” but “Which institutions matter and how does one acquire them?”

How does a developing society acquire functional institutions that will support a healthy, sustainable market-based system? Rodrik said the choice lay between importing wholesale a “blueprint” from the more advanced economies and relying on the expertise of technocrats and foreign advisors or relying completely on hands-on experience, local knowledge, and experimentation. The local knowledge approach relies on mechanisms for eliciting and aggregating local information. The most reliable forms of such mechanisms, Rodrik argued, are participatory political institutions. Democracy, in his view, helped build better institutions for achieving high-quality growth. For that reason, international conditionality might be better targeted at basic political freedoms than at economic performance and adherence to international standards.

Saleh M. Nsouli, Deputy Director of the IMF Institute, expressed concern about Rodrik’s suggestion that international institutions, like the IMF, should move away from economic conditionality toward political conditionality. How far, he asked, can they go in this direction? Also, it would be useful to distinguish between institutions that are applicable across all countries (such as accounting standards) and those that would be more dependent on a country’s individual circumstances (such as capital account liberalization).

Role of the state

The state has a major role in implementing second-generation reforms, Vito Tanzi, Director of the IMF’s Fiscal Affairs Department, said. As societies become more complex, the state must assume additional responsibilities if it wishes to contribute fully to the welfare of individuals. Markets are not efficient when they are distorted by monopolistic tendencies or when essential information is unavailable or too costly. The state, accordingly, has been called upon to regulate markets and provide essential information to market participants. Within this framework, an efficient public sector should achieve the state’s objectives with a minimum degree of market distortion, the lowest possible burden of taxation, a minimal number of public employees, and the smallest possible absorption of economic resources by the state.

Commenting, Hilton Root of the Milken Institute observed that one of the major obstacles facing the modern state is the “misalignment” between the interests of leaders and of the public. He pointed to many parts of the developing world where schemes for equitable income distribution have been undermined by backdoor cronyism. Ameliorating this condition will require, among other things, greater efficiencies in public management, Root said.

Kevin Davis and Michael Trebilcock of the University of Toronto presented a paper on the role played by legal institutions in development. While the field boasts a rich intellectual tradition, “surprisingly little” is known about the relationship between them, they maintained. Existing research does, however, provide a road map for a limited number of important policy initiatives. More attention should clearly be given to reforming those key institutions that are responsible for enacting laws and regulations. Scholars should also be encouraged to pay more attention to how public bureaucracies influence law enforcement and administration.

William Holder, Deputy General Counsel of the IMF’s Legal Department, commented that unraveling these complexities requires a policy-oriented and dynamic approach that views law as a “creative instrument,” both to promote minimum order in society and to achieve the shaping and sharing of other values. He also noted that the IMF has long been involved in identifying, assessing, and advising on national law.

Addressing the social dimensions of growth, Vinod Thomas of the World Bank urged the international community to devote more attention to quality and sustainability issues. At the top of this list should be legal and judicial system reform. In addition, policies should be undertaken that both promote growth and protect the environment. Sustained growth is not possible, Thomas said, without macroeconomic stability, and, hence, it is critical that, as far as possible, the economy be insulated against external shocks.

In his response, Andrew Feltenstein of the Virginia Polytechnic Institute cautioned against relying on untested generalizations, such as “a rising tide lifts all boats.” In reality, robust growth has not always led to uniform reductions in poverty. Similarly, he said, it is difficult to show the causality between social spending and growth proposed in Thomas’s paper.

Civil society and social capital

Building social capital has typically been seen as a task for second-generation economic reform, observed Francis Fukuyama of George Mason University. Unlike economic policies, or even economic institutions, however, social capital cannot be easily created or shaped by public policy.

While states do not have many obvious levers for creating social capital, they can foster it in a variety of ways through education and the provision of public goods, particularly property rights and public safety, Fukuyama maintained. Religion and globalization are also vital sources of social capital. “Everyone is well aware of the ways in which globalization injures indigenous cultures and threatens long-standing traditions. But it also leaves new ideas, habits, and practices in its wake,” he concluded.

Social capital, however, is not a free good, observed Paul Collier of the World Bank. Access to telecommunications technology—such as telephones and computers—is far greater in developed than in developing countries. As a general proposition, open, democratic, political systems that promote freedom of information are richer in social capital than closed, authoritarian ones, he argued.

Sound regulation

Changing state-market relations is not a zero-sum game where markets expand at the expense of the state, said Scott Jacobs of the Organization for Economic Cooperation and Development. What is happening is far more complex. The reconstruction of essential institutional relationships holds the promise of making all players better at what they do.

The international institutions can reduce the risks of mistakes and speed up the learning process by pooling and comparing national experiences, Jacobs maintained. Second-generation reforms in this arena will likely include increasing the flexibility and responsiveness of national governments, reducing the costs of moral hazard, and preserving the effectiveness of the state and the rule of law, he said.

Regulatory reform poses a major challenge to reformers, observed Paul Bradburd of Williams College. Firms are traditionally sensitive to changes in regulatory regimes. Effective adaptation on their part will require more, not less, regulatory stability, he said.

According to Lawrence White of New York University, although this decade has witnessed the spread of market-based economic policies, it will be remembered no less for its financial crises. Even in a world that relies much more on markets and less on governmental intervention, sensible financial regulation remains critical.

The proliferation of financial regulations has confused the public, according to Stefan Ingves, Director of the IMF’s Monetary and Exchange Affairs Department. Greater efforts must accordingly be made to clarify these various instruments. A first step might be to focus more attention on “transaction regulations,” which align buyers and sellers in the modern financial marketplace. On a broader canvas, the international community should be encouraged to work toward a new standardization regime.

Culture, institutions, and development

Employing an array of sociological, cultural, historical, and psychological examples, Deepak Lal of the University of California, Los Angeles, suggested that developing countries could “modernize” without “Westernizing.” The danger inherent in second-generation reforms, Lal suggested, is that their advocates assume that economic development and the ability to prosper in a globalized market economy are possible only through the wholesale acceptance of Western values—”global moral crusades,” concerning “so-called human rights and democracy.” What matters for intensive growth, he said, is that the market should be allowed to function.

Responding to Lal, Peter Montiel, Senior Policy Advisor, IMF Institute, agreed that Western values could make no claim to universality, but he questioned Lal’s assertion that they were wholly unrelated to economic prosperity. He also noted that many second-generation reforms addressed the efficient functioning of the market—the one Western institution that the developing world did embrace. As Dani Rodrik noted earlier, it was not the function of the institution that was necessarily in question, but rather finding or creating the institution within a society or culture best suited to carry out that function, Montiel said.

Fads and fashions in economic reform?

The 1990s began with the widespread expectation that achieving sound market-oriented macroeconomic fundamentals was the ticket for the prosperity that had long eluded poor countries, according to Moises Naim, editor of Foreign Policy. The decade, he said, is ending with the more frustrating but also more realistic understanding that sound macroeconomics is not a goal, but just a precondition for prosperity. In the intervening years, theories about economic development have moved through several stages, starting with the so-called Washington Consensus, which focused on restoring macroeconomic balance and crushing inflation, to fuel growth. But at each level of development theory, Naim contended, confusion reigned. Even the seemingly widely accepted Washington Consensus, from its beginnings, meant different things to different people.

In the late 1990s, Naim said, the reform agenda has become broader and infinitely more complex. For most countries, however, the means to attain “utopia”—honest governments, open legislative and transparent regulatory systems, well-trained and well-paid officials, and an official commitment to fight corruption—are themselves utopic goals. These are valid aspirations, Naim noted, but they are overwhelming. The challenge is to use the many lessons accumulated throughout decades of development efforts to create agendas that include specific prescriptions, intermediate stepping-stones, and more manageable goals.

Commenting on Naim’s paper, Ke-young Chu, Senior Advisor in the IMF’s Fiscal Affairs Department, suggested that the definition of institutions be broadened to include not only public and formal institutions but private and informal ones as well. Understanding private and informal institutions would provide the designers of a reform program with ideas for realistic and effective public institutions.

International institutions

A roundtable, chaired by IMF Institute Director Mohsin Khan, focused on second-generation reform from the perspective of regional and multilateral institutions. Participants included Ted Nkodo of the African Development Bank, Faris Bingaradi of the Arab Monetary Fund, Jungsoo Lee of the Asian Development Bank, Ricardo Hausmann of the Inter-American Bank, and Rolph van der Hoeven of the International Labor Organization. All the speakers agreed on the need for second-generation reforms but also recognized that different levels of economic development—often within the regions their organizations represented—and varying social and cultural needs should dictate the pace of reforms as well as the institutional framework adopted to meet specific country needs.

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