Institutions, Governance, and Economic Performance in Post-Socialist ...

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in Post-Socialist Countries: A Conceptual and Empirical Approach ... This paper focuses on the political economy of policy reform in post-socialist countries.

Institutions, Governance, and Economic Performance in Post-Socialist Countries: A Conceptual and Empirical Approach Joachim Ahrens and Martin Meurers* Abstract. This paper focuses on the political economy of policy reform in post-socialist countries. It investigates the impact of institutions on economic transformation processes and seeks to develop and empirically test a concept of governance that will strengthen policy reforms and make them sustainable. By arguing that effective policy reforms require an adequate politico-institutional foundation, this study aims at complementing the Washington Consensus that was formed by the Bretton Woods organizations and the US Treasury in the 1980s.

JEL codes: H1, H7, O1, P5

1. Introduction: Limits of the Washington Consensus

During the first decade of transition, foreign economic advisors and international organizations such as the IMF and the EBRD urged the governments of the post-socialist countries (PSCs) to essentially follow the policy prescriptions inherent in the so-called Washington Consensus, which emphasizes prudent macroeconomic policies, trade and financial liberalization, privatization, and deregulation (Williamson 1990). Basically, it calls for a minimal state that refrains from intervening in the economy. However, many governments were not responsive to those recommendations essentially for political reasons. And even in some of those countries that actually followed that policy advice and initiated bold stabilization-cum-adjustment programs the pursued outcomes did not materialize as quickly as initially expected. After ten years, the economic performance of the PSCs shows a mixed picture. By the end of 1998, only three countries (Poland, the Slovak Republic, and Slovenia) realized a GDP that equaled or slightly exceeded the pre-transformation level. On average, countries in Central and Eastern Europe (CEE) and the Baltics significantly outperformed those of the Commonwealth of Independent States (CIS), in which output has almost continuously declined. But even within these two regional groups, significant differences are to be noted; e.g., the severe economic setbacks in Romania and Bulgaria and considerable growth rates in Kyrgyzstan and the Caucasus (EBRD 1999). The challenges for the next decade of transformation are tremendous. The proposed second generation reforms include enhanced efforts to promote *

University of Goettingen, Department of Economics, Platz der Goettinger Sieben 3, D-37073 Goettingen/Germany email: [email protected] and [email protected] 1

liberalization and to ensure macroeconomic stabilization especially in South-Eastern Europe and the CIS as well as promoting the implementation of privatization policies throughout the region. Furthermore, it has been increasingly recognized that governments need to assume a leading role in institutional change; particularly in complementing private-sector efforts to develop market institutions, in restructuring and possibly liquidating inefficient state enterprises, in strengthening financial sectors, in establishing a market-oriented legal and regulatory framework and implementing social security systems. Besides these economic challenges, political obstacles to an effective transformation are persistent in several countries and need to be eliminated as a precondition to sustained policy reform. This not only refers to modernizing state apparatuses in all PSCs, but also to overcome corruption, political instability and power struggles in countries such as Belarus, Georgia, Russia, and Tajikistan.1 Due to the sobering experiences in numerous transition economies and also in less developed countries (LDCs) and the obstacles to further reform that still exist in most PSCs and LDCs, the policy prescriptions favored by the Washington Consensus have been severely criticized. Essentially, the criticism has centered around four aspects: (1) the focus on inflation has led to macroeconomic policies that may not be the most conducive for long-term growth and has detracted attention from other major sources of instability such as weak financial sectors and ineffective corporate governance; it has also neglected a number of critical policy underpinnings for the emergence and maintenance of a functioning market economy including competition, education, as well as technology policies2; (2) the call for state minimalism neglects the need for government intervention which results from the existence of externalities, scale economies, incomplete markets, and imperfect information. Particularly in PSCs, where market integration is weak and market imperfections exist, market-enhancing government intervention and possibly industrial policies that complement and facilitate private-sector coordination are critical3; (3) apart from one exception (i.e., the protection of private property rights), the consensus view disregards the role of institutions in economic development and transformation; it not only ignores the impact of formal institutional arrangements but also the influence of informal institutions, social capital, and trust on the efficacy

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See EBRD (1999) for a country-specific survey of key reform challenges. See Berglof and von Thadden (1999) with respect to the crucial importance of corporate governance in the course of development and transition, McKinnon (1992) regarding the order of financial liberalization and Stiglitz (1998a,b, and c)for a more thorough discussion of why the prescriptions of the Washington Consensus concerning stabilization and liberalizationits two core areasare incomplete and misguided. See Amsden et al. (1994), Rodrik (1995), Stiglitz (1997), Olson (1997), and Aoki et al. (1997). 2

and feasibility of policy reform and hence economic performance4; and finally (4) the Washington Consensus ignores the interdependence of the economy and the polity. Policy reform is not just a matter for technical experts to get the prices right. The institutional structures underlying economic policy making play a critical role in the direction of policy reform and the implementation of public policies.5 Political factors often prevent authorities from realizing reform programs in PSCs which, for economic reasons, appear to provide sound prospects for accelerating growth and improving living standards. This implies that successful policy reform and economic transformation require a transition of government towards a nexus of institutions supporting a market economy. For these reasons, critics argue that the Washington Consensus is largely insufficient for an effective systemic transformation. Although the four criticisms focus on distinct aspects of the determinants and the efficacy of policy reform in PSCs, they are actually linked by a common underlying thread, i.e. the questions concerning the appropriate role of the state and how to craft effective governance structures in the transition process. Basically, these questions concern a country’s formal and informal institutions and how these affect policy formation and bureaucratic implementation as well as the interconnectedness between public agencies, private business, and civil society. By addressing these questions in a conceptual perspective, this paper seeks to contribute to the emergence of a Post-Washington Consensus which may be suitable to better guide both international organizations and national governments through the complicated terrain of policy reform. Its main argument is that political leaderships and structures, while often part of the problem, are necessarily also part of the solution to creating a more effective and responsive state. An adequate politicoinstitutional structure is an unalterable prerequisite in order to make governments and hence policy reform more effective regardless of whether a government decides to strictly follow the policy recommendations of the Washington Consensus or whether it opts for a more activist role to overcome coordination failures and other market imperfections. The remainder of this paper is structured as follows: The second chapter illustrates the importance of institutions for economic performance by discussing key problems of policy reforms in PSCs. Taking the interaction of the economy and the polity explicitly into consideration, a concept of governance is developed in chapter three, that represents an appropriate institutional foundation of policy reform and that is empirically tested in chapter four. Chapter five provides 4 5

See, e.g., North (1990 and 1995), Raiser (1997), Fukuyama (1999), and Lal (1999). See Weingast (1993 and 1995), North (1995), and Bates (1999). 3

suggestions how governance components could suitably complement the orthodox policy recommendations of international organizations and imply a Post-Washington Consensus.

2. The Failure of Policy Reform in PSCs as a Cause for Poor Economic Performance

At the onset of transition, stabilization-cum-adjustment and privatization policies were undertaken to rapidly establish market-oriented economies in order to solidify transformation, prevent a potential reversal, and avoid an asset stripping of state-owned enterprises. What was overlooked or consciously ignored then was that a functioning market economy requires an adequate institutional infrastructure providing market-preserving and market-enhancing incentives to both policy makers and private business. Instead, policy makers, foreign advisers and international organizations advocated in favor of a minimalist state and aimed at a drastic reduction in the size and scope of government (Amsden et al. 1994, Hare 1997). Institutional problems were viewed as parts of a secondary reform agenda or expected to be automatically overcome by getting the prices and macroeconomic fundamentals right. Moreover, the neglect of institution building and state reform may have been also caused by a surge of anti-statism resulting from the demise of the communist state and the policy prescriptions of neoclassical economics. As Nunberg (1999) found in her cross-country analysis, the restructuring of the core institutions of government has been moderate and reforms have been slow to materialize. Both governments and donor agencies have been hesitant in initiating and supporting programs aimed at enhancing administrative efficiency and making public-private cooperation and coordination more effective. Furthermore, a recent UNDP report concludes that “the ‘shrinking state’ (...) in many parts of the region has contributed to worrying trends in human development, including high rates of poverty, rapidly growing economic and social inequality amounting to socio-economic fragmentation, deterioration in public health and public education, and worrying trends in culture and the long-term health of the environment.”6

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United Nations Development Programme (1997:1). This UNDP Report provides a comprehensive stocktaking of institutional and political reforms which have been undertaken in the transition countries since the beginning of the 1990s. 4

The most significant political and institutional problems which have threatened the success of the transition in CEE and the CIS have resulted from7: • • • • • • • • • • • •

the existence of weak states, the capacity and capability of which have been eroded and which are chronically unable to enforce laws, collect taxes, resist pressure from interest groups, and implement coherent market-oriented reforms; a lack of political leadership and credible commitment to policy reform; weak local governments and ill-defined central-local government relations; widespread corruption resulting from excessive bureaucratic interference and regulations; poor and inconsistent public-procurement procedures which are in many instances still based on administrative orders and only partly on market bidding; weak supervisory and regulatory structures for the financial sector; institution failures due to a contradiction of existing laws, lack of law enforcement, and lack of legal transparency; a conflict of formal and informal institutions inducing hysteresis effects; resistance to further reform by the winners of the early reform stages, who assumed substantial political power and seek to sustain a partial reform equilibrium; an underdeveloped civil society; a lack of tradition concerning the consultation and transparent and evenhanded cooperation with interest groups and other affected groups prior to the introduction of new laws and policies; a lack of experience of explaining the needs for, and the rationale of, policy reform to the population at large.

Given these obstacles to effective policy reforms, most policy makers, academics, and donor agencies have gradually recognized that the systemic transformation is an incremental and continuous process. After ten years of transition the need for institution and capacity building eventually comes to be understood to be a conditio sine qua non for the consolidation of prior reform achievements and the initiation of further reforms. Meanwhile, some advanced PSCs countries have made significant progress in changing the nature and the structure of their state apparatuses. This primarily holds for privatization and the reorientation of those policies which are on the front line of policy reform.8 Particularly, the transformation process has been strengthened in those countries which have the prospects of acceding to the European Union (EU). For EU membership will be only granted if the transition countries are able to meet EU standards and norms with respect to the institutional foundation of their economic, legal and political systems. In particular, prospective members need to implement the aquis communautaire, that includes numerous institutional components which are critical for a functioning market economy. By adopting institutional arrangements, that are consistent with EU standards, the governments of these countries tie their own hands and improve their policy making structures, so that arbitrary policy changes become less likely. Moreover, the power of vested 7

For a comprehensive and thorough discussion of these obstacles to economic transformation see, e.g., Amsden et al. (1994), Hellman (1998), Pejovich (1994), Voigt and Kiwit (1995), World Bank (1996), and EBRD (1999).

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interests to influence domestic policy making will be reduced and hence the predictability of public policies enhanced. The institutional integration of the Central European countries has been essentially based on the so-called Europe Agreements, which grant the transition countries associate status in economic and political terms.9 They help enhance the credible commitment to policy reform and make public policies transparent and predictable, because non-compliance may imply a loss of benefits resulting from the Europe Agreements and postponement or even denial of EU membership.10 To date, most CEE countries have achieved substantial progress in institutional reforms concerning the trade and foreign exchange regime, privatization, and the legal system, while the reform progress in areas such as corporate governance, competition policy, and financial markets is still modest or diverse (EBRD 1999). In contrast to the economic and political progress in CEE, however, stands the poor performance of the CIS countries, notably Russia. In particular, low capacity and capability of all branches of government have been critical obstacles to progress in most areas of reform. The restructuring of the state is still at its very beginning, and reforms have been impeded by a lack of accountability mechanisms and an unstable and non-transparent policy framework (World Bank 1996). The recent crisis in the Russian Federation, that constituted a considerable setback in economic transition, arose largely from a failure of political institutions (including the inability to collect taxes, to implement administrative and financial sector reform, and to enforce laws). In this respect, the EBRD (1998:iv-v) concludes “that the way in which markets are liberalised and state enterprises are privatisedthat is, the nature of the early transition decisionscan have important implications for the capacity of governments to enforce the rule of law, to promote competition and to regulate effectively. Liberalisation that leaves large profits to be earned from flawed markets and favouritism in privatisation that places industry and finance in the hands of vested interests with powerful political connections can create serious obstacles to further advances in market-oriented reform.” From the beginning of the transition process, Russian authorities have failed to shield policy making from manipulative and strong vested pressure groups reflecting the interests of both the old nomenclatura and the new oligarchs. These political bottlenecks induced an open flank of

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These policies include prudent fiscal and monetary policies, exchange rate and foreign trade policies as well as measures aimed at the deregulation of factor and goods markets. The Europe Agreements were signed by the EU on the one hand and Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, and Slovenia on the other hand. Note, e.g., that inter alia for political reasons and persisting institutional deficits the Slovak Republic was excluded from the group of countries which are primarily eligible for negotiating EU membership. The CEE countries belonging to this group include the Czech Republic, Estonia, Hungary, Poland, and Slovenia. 6

policy reform and contributed to the collapse of the financial sector in 1998. To put it in a nutshell, the economic performance of Russia and other CIS countries underlines the necessity of policy and institutional reforms to establish and promote the rules of a functioning market economy. In sum, the modest and uneven progress in meeting the institutional and structural challenges of the next phase of transition reflects the lack of an adequate politico-institutional foundation of policy making in the PSCs, that had been shaped by the early transition policies as well as the countryspecific legacies inherited from the former socialist regimes. To overcome the current deficits in policy reform, a constructive role of governments is required at a time when their capacities are still insufficiently developed and state apparatuses are susceptible to capture by powerful pressure groups. Hence, the unfinished agenda of policy reform in PSCs includes to a significant degree governance-related problems. Especially, institution and capacity building is a pivotal precondition for further stabilization, structural adjustment, and poverty reduction. Major policy lessons implied by these problems include that (1) institutional reforms must not be postponed or delayed if the economic and political gains from liberalization, stabilization, and privatization are to be realized; (2) the causes of poor public sector performance must be addressed before capacity can be rebuilt; (3) the effectiveness of institutional reforms greatly depends on how these reforms take into consideration the historical, social, customary, and religious factors in a given society; and (4) almost all transition countries will need continuous technical assistance to support the crafting of public-sector institutions, norms and rules for private sector development, and the institutions of civil society.

3. How to Craft an Effective Governance Structure: A Conceptual Approach

Today, there is a heightened awareness across both the donor community and national governments that governance is a key determinant of the ability to pursue sustainable economic and social development and transformation. But as yet, an unambiguous and operational definition of the term which could guide the elaboration of reform strategies is missing. Instead, a confusing variety of definitions, that greatly differ with respect to issues, problems, or objectives, can be found in current development debates. While Frischtak (1994: vii), e.g., defines governance capacity “as the ability to coordinate the aggregation of diverging interests and thus promote policy that can credibly taken to represent the public interest” and Bratton and van der Walle (1992: 30) interpret governance as 7

“an interactive process by which state and social actors reciprocally probe for a consensus on the rules of the political game”, Hydén (1992: 7) views governance as “the conscious management of regime structures with a view to enhancing the legitimacy of the public realm.” The term is often used as a buzz-word in political discussions. Some users of the term either do not offer any definition or seek to incorporate too many aspects so that the underlying concept turns out to be useless for the purposes of policy reform.11 Some definitions prove to be completely redundant, e.g., if governance is perceived as good government.12 The recent literature on obstacles to structural adjustment addresses several critical elements for a suitable conceptualization of the term, but does not explicitly refer to the notion of governance.13 Several scholars interpret governance as an end in itself, while others see it as an analytical frame or as a means to promote sustainable development (Kjaer 1996). Some approaches seek to conceptualize the term by addressing aspects which are critical from the perspective of policy reform, but the underlying definitions are vague and hardly operational for practical matters. The World Bank (1992: 1), e.g., defines governance as “the manner in which power is exercised in the management of a country’s economic and social resources for development.” This leads to the qualification that ‘good governance’ is synonymous with sound development management. A more operational definition, that will be suitable to improve the practice of policy making in PSCs, may be derived from conceptual considerations, which address key issues of policy reform. In this context, three distinct concepts may be suitable. The first conceptual approach views democratization as indispensable to sustained economic reform and transformation. Effective governance then corresponds to a democratic order, that keeps government small and ensures that economics dominates over politics. Under the premise that democracy may provide a remedy against a big and potentially corrupt government, democratic institutions and processes are regarded as effective devices to secure emerging markets. However, the concept of democracy seems to be too broad for a proper operationalization of the term. Furthermore, the hypothesis that democracy will automatically foster economic growth and development is empirically not well supported.14 Hence, one may agree with Frischtak (1994: 12-13), who states

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This holds, e.g., if the term good governance is supposed to mean promoting sustainable economic and social development, democratization, participatory development, fostering the enforcement of human rights, and improving environmental standards; see, e.g., Leisinger (1995). This definition simply creates a new term without providing any new conceptualization. What it makes particularly problematic is the use of the adjective good, which only reflects subjective perceptions. See, e.g., Bardhan (1995), Streeten (1993), Boycko et al. (1996), and Martimort (1996). See, e.g., de Haan and Siermann (1995). 8

that “(t)o build attributes to specific political regimes into the very concept of governancequite apart from the fact that these attributes and norms may be worth promoting in their own rightdetracts from the analytical utility and credibility of the concept.” Another, more useful conception, which is closely related to problems of policy reform, views governance as an approach that seeks to introduce abstract, universal principles and rules, their enforcement mechanisms, as well as stable and transparent mechanisms of conflict resolution. This conception refrains from making any normative judgment concerning specific political regimes and rather follows Weber’s (1972/1921) notion of the modern state. Weber proposed that the operation of markets requires a high degree of calculability based on legal rationality, the rational administration of justice, and a relatively insulated, professional, and apolitical bureaucracy (characterized by a functional definition of duties and full-time devotion to administrative tasks), the work of which is not only based on instrumental rationality, but essentially on the development and enforcement of universal legal norms. Similar to Weber, who conceived that his ideal-type of state is most conducive to the functioning of modern capitalist societies, this conception also suggests that its notion of governance is the key to creating an enabling environment for policy making and business activities. The third conception worth noting complements the previous one by adding the dimension of informal institutions (culture, habits, traditions), which shape individual behavior and subjective perceptions, to the governance framework. The policy prescriptions resulting from this approach suggest that both transformation strategies and policies must be compatible with cultural characteristics and that effective governance needs to take the belief systems persisting in society into consideration (North 1995). This line of reasoning adds an important aspect to the discussion on governance, which has been usually neglected by the economics profession. It also implies that, because the transformation process is path dependent, there is no universal model of effective governance to be successfully applied to all PSCs. This conception may be of particular importance for the systemic transformation of PSCs. For as several scholars have argued, the transition towards capitalism may be impeded by informal institutions which evolved in PSCs before and during socialist rule.15 These include, e.g., widespread pro-collectivist attitudes, nationalism, communalism, and habituation to political hierarchy. The philosophical heritage has neither been conducive to individualism nor to performance-contingent rewards nor to a constitutional state. “(P)eople see the gains from exchange

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as a redistribution of wealth within the community rather than as rewards for creating new value“ (Pejovich 1994: 520). Also, many East Europeans did not perceive capitalism as a system based on self-responsibility, self-determination, and competition, but rather as a system automatically providing a great variety of goods and large incomes, the realization of which would neither require reducing ‘socialist’ welfare benefits nor changing the traditional work ethos. Therefore, “the transition process was a crude awakening that capitalism is not merely about being rich“ (ibid.: 522). These factors made the transformation process path dependent and induced hysteresis effects, so that capitalist behavioral norms as postulated by neoclassical reasoning could not emerge in the short run. This also means that creating capitalist institutions by fiat following text-book models will not yield the intended effects and imply acceptance problems as the resurgence of pro-collectivist political parties indicates. Based on the last two of these conceptual approaches, we define governance as the capacity of the formal and informal institutional environment (in which individual actors, social groups, civic organizations and policy makers interact with each other) to implement and enforce public policies and to improve private-sector coordination.

According to this definition, governance is a means to implement and enforce feasible policies. But in its concrete form, a governance structure, i.e. the underlying institutional environment (comprising formal and informal political, economic and social institutions) as realized in a particular country, may promote the transition toward a market-oriented economic order or impede the systemic transformation. A governance structure affects the incentives of politicians, legislators, bureaucrats, and private economic agents alike and determines the terms of exchange among citizens and between them and government officials. Thus, the capacity of a governance structure plays a critical role concerning (1) the formation, implementation, and enforcement of economic and social policies as well as development projects; and (2) private sector development and coordination. With respect to problems of initiating, implementing and sustaining government policies, the political institutions of a country’s governance structure play a dominant role, because they determine how different actors are involved in political processes, what kinds of economic reforms are politically feasible, and how the behavior of individual actors is shaped. Actual governance structures are based on countless formal and informal institutional mechanisms that guide policy making and implementation. Since the number of relevant mechanisms is extremely large, various mechanisms are of different importance in different 15

See, e.g., Mummert (1999), Pejovich (1994), and North (1995). 10

countries, and some of the ‘true’ explanatory variables of governance are unobservable, conceptual and cross-country statistical analyses need to rely on proxy variables to measure the efficacy of a country’s governance structure. In order to systematically find adequate proxies, we seek to reduce the complexity of actual governance structures by identifying four dimensions of governance which reflect the quality of a country’s institutions. Therefore, we start with the premise that rules, which ought to enhance the quality of policy making, need to show distinct characteristics: (1) they must be clearly defined over a sufficiently large domain of possible events and economic agents must be confident that they are properly enforced; (2) political and economic actors must know and understand the rules and be able to recognize whether or not they are observed; (3) the set of rules must be sufficiently flexible to allow for institutional change if preferences, technological conditions, or specific societal needs change over time. This also presupposes the existence of various channels through which individual actors or groups can initiate and contribute to institutional reforms; and (4) institutional safeguards must be in place that hinder powerful political and economic actors to arbitrarily circumvent or change existing rules at the expense of other actors or society as a whole. These four characteristics can be subsumed under four dimensions of governance that comprise predictability, transparency, participation, and accountability. Hence, if one can identify proxies that measure the quality of any given country’s institutions along these dimensions, this would indicate the efficacy of this country’s governance structure. All of these key principles are required for the sound management of public resources, an enabling environment for the private sector and a productive partnership between the public and private sector, that does not degrade into closed circles of influence and privilege. Governance provides the overall perspective from which these principles are derived.16 Capacity building, a term which is often used in combination with governance, refers to the action proposed to achieve these principles and hence provides a useful starting point to identify proxy variables to measure governance quality (see Table 1)17. Confusing these two terms would imply that operationally capacity building work in the narrow sense may be interpreted as governance in the broad sense. Thus, each effort at capacity building would be considered a governance activity implying the

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For a discussion of these principles and the corresponding imperatives for institution building see Root (1996). See Section 4 and the Appendix regarding the selection of proxies for our econometric analysis. Capacity building refers to improvements in the ability of public sector organizations, either singly or in cooperation with other organizations, to perform appropriate tasks effectively, efficiently, and sustainably. It includes three components: (i) institution building (i.e. replacing a less efficient by a more efficient set of rules and functions); (ii) organizational restructuring (i.e. the design of organizational forms better suited to the new set of rules and functions); and (iii) human resource development (i.e. in particular training); see Grindle and Hilderbrand (1995). 11

danger that policy makers do not take the complexity of a governance structure into account, but tend to tackle governance problems in an ad hoc manner. Recent studies on the political economy of policy reform show that the complex coordination and collective-action problems associated with policy reform can be mitigated by politically-crafted self-enforcing governance structures. These structures change transaction costs, reduce information asymmetries, stabilize expectations, and prompt political authorities to sustainably promote economic development.18 Relatively low political transaction costs are necessary in order to facilitate legislative exchange, to better monitor bureaucratic behavior, to improve public sector management as well as the interaction of the various branches of government, business representatives, and social groups. In another respect, however, a governance structure to be

Table 1:

Governance and Capacity Building

Governance

Capacity Building

Accountability

Public Sector Management; Public Enterprise Management and Reform; Public Financial Management; Civil Service Reform; Participation of Beneficiaries and Affected Groups in Projects; Public-Private Interface; Decentralization of Economic Functions and Empowerment of Local Government; Cooperation with NGOs; Legal and Regulatory Reform; Legal Framework for Private Sector Development; Disclosure of Information; Clarity about government rules and regulations; Transparency in political decision making and public policy implementation.

Participation

Predictability Transparency

effective needs to rely on relatively high political transaction costs. This is particularly important in order to prompt policy makers to credibly precommit to abide by the rules of the game and to enhance the incentive compatibility of public policies and economic performance. In order to create credible limits on their own authority, policy makers need to tie their own hands by establishing suitably designed political rules, the revision or transgression of which is associated with high transaction costs. Governance mechanisms which prevent policy makers from acting opportunistically and restrain arbitrary state action include the rule of law, institutional checks and 18

See, e.g., Campos and Root (1996), Qian and Weingast (1997), and World Bank (1997). 12

balances through horizontal and vertical separation of powers, an independent judiciary, and effective watchdog organizations.19 Furthermore, an adequate institutional environment for policy reform needs to provide mechanisms of consensual conflict resolution, enhance political and social stability through transparent rules and processes about how to solve collective problems, and create public trust on the basis of a common sense of legitimate authority.20 Effective governance structures adequately adjust political transaction costs and mitigate the multiple principle-agent problems which are inherent to policy reform. The existence of multi-principle/multi-task agencies embedded in a multiple-level principle agent framework imposes severe restrictions on the formulation and implementation of public policies. These constraints, resulting from imperfect and asymmetric information, difficulties to monitor bureaucratic input and output as well as the activities of private agents, opportunistic behavior, multiplicity of interests, bounded rationality, and time inconsistency, cause political transaction costs. Instead of imposing additional formal constraints on administrative units, as it is often observed in government bureaucracies (Wilson 1989), effective governance structures need to rely on more sophisticated institutional arrangements with powerful incentive schemes and screening, signaling, and monitoring mechanisms, which imply a fusion of interests of politicians, bureaucrats, business, and non-elites. Institutional mechanisms which help improve public policy making may comprise: • • • • • • •

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the introduction of hard budget constraints that help delimit the influence of external actors on government expenditures and measure bureaucrats’ ability in macroeconomic management; meritocratic recruitment and promotion procedures as well as competitive wages for bureaucrats that can attract more talented individuals and increase integrity and professionalism; effective accounting and auditing practices to enhance the financial accountability of policy makers; independent personnel agencies which reduce external pressure on appointments and patronage; statutory boards partitioning the policy space by assigning single policies to special agencies that help monitor civil servants’ performance; anti-corruption agencies which reduce bureaucrats’ propensity to use their specific information for extra-legal activities; and socially connecting an independent bureaucracy through deliberation councils or informal institutions in order to encourage the mutual exchange of information between the public administration and the private sector, enhance the bureaucracy’s flexibility, and support a consensual and transparent process of policy formulation.21 See, e.g., Persson et al. (1997), Weingast (1993), Dixit (1996), and Root (1996). In this respect, see Knack and Keefer (1997), who find in their cross-country analysis that social capital matters for economic performance. Civic norms and trust are relatively strong in societies with relatively high incomes and equal income distribution, with institutions restraining predatory state action, and with educated, ethnically homogenous populations. They argue that in countries, in which interpersonal trust is relatively low, the provision of formal institutional rules monitoring economic exchange is of particular importance. Note, however, that deliberation councils will only be useful if the private sector is sufficiently developed, in order to avoid collusion between the bureaucracy and individual private companies which have assumed monopolistic powers. 13

A governance structure is effective if it ensures that policies and projects conducted by governments are properly implemented and enforced and that private businesses can thrive within a given legal and regulatory framework, which is not subject to arbitrary political interference. From this perspective, effective governance is independent of the basic character of a political system (the regime type), but results from the realization of a strong but limited government; strong in the sense that it is able to credibly precommit itself to policies, which are in the interests of its constituency, and to establish an independent bureaucracy capable of implementing and enforcing those policies; limited in the sense that both the government and the public administration are prevented from confiscating private wealth and held accountable for their activities. Strong but limited governments are based on institutions and incentives that channel the behavior of political decision makers into those activities which are compatible with sustained transformation and prompt private business to carry out long-term investment and provide the authorities with information that is necessary to make viable policy choices.22

4. Empirical Analysis of the Governance Concept

As argued before, effective governance structures should bring up institutions that facilitate the coordination within the public and the private sector and between these sectors. Hence a country with effective governance structures should display a relatively good economic performance in comparison with other countries where such structures are absent. Subsequently, we test this hypotheses for a sample of 25 PSCs, using GDP growth per capita and average FDI per capita (both in US$) during the period of 1993 to 1998 as measures of economic performance. After briefly reviewing recent empirical studies which link market supporting institutions and economic performance, we employ the following estimation strategy: First, we test whether variables reflecting the four components of our governance concept actually have a positive impact on economic performance. This is done by ordinary least squares regressions of growth and FDI on various institutional variables controlling for initial conditions and a macroeconomic stabilization indicator. As elaborated in section 3, our concept of governance relies on conceptual reasoning to grasp components indicating the quality of political and economic coordination and conflict 22

See Weingast (1995), who provides a thorough analysis of the concept of strong but limited government. 14

resolution mechanisms. But we cannot be sure that e.g. indicators of predictability and accountability do measure different features of the underlying mechanisms  in other words predictability and accountability might not constitute an independent category in a governance concept. Therefore in a second step, we investigate on the basis of our data whether it is possible at all to identify different independent components of governance. We apply factor analysis techniques to determine the number of relevant factors for governance and check whether we can trace distinct links to the four categories on which we built our theoretical concept of governance. The growing literature of empirical investigations on the relevance of coordination-facilitating institutions for economic performance can be separated mainly into two methodologies: The first one builds on a study by Barro (1991) who’s pioneering work stipulated the analysis of institutional quality in a macroeconomic context. In his cross-country analysis of long-term growth he included proxies for political stability and established the link to the relevance of institutions by concluding that the significant adverse effect of his proxies (number of coups and political assassinations) on growth reflects the uncertainty of property rights. Three important studies which followed in this direction have been undertaken by Knack and Keefer (1995) and Brunetti et al. (1997b and 1997c). The former employ the data from the International Country Risk Guide (ICRG) and from Business Environmental Risk Intelligence (BERI) and find a significant positive impact of institutions that protect property rights on growth and investment. Furthermore, they find stronger evidence for conditional convergence if growth is controlled for variables representing the quality of institutions.23 The latter use the results of a worldwide business survey to construct several indicators of institutional uncertainty24, which are related to economic growth and investment in LDCs and PSCs. Both complementary studies confirm the positive impact of high institutional quality on growth and investment which prove robust in combination with different additional economic and political variables typically employed in growth analysis (e.g., inflation or political rights). The other main approach capitalizes on the extensive data collection of institutional variables and the regularly updated publication of institutional indicators. Researchers of this strand seek to trace the year by year impact of institutional development on economic performance over time applying mixed time-series/cross-section models while exploiting the typically U-shaped recovery path of transition economies. Prominent representatives of this branch are Fischer et al. (1996), who utilize 23

Unfortunately, both the ICRG and the BERI data sets include data only for a small number of PSCs.

15

the cumulative liberalization index (computed by De Melo et al. (1997)) as an indicator of structural reforms. Together with initial conditions and macroeconomic policy variables this indicator significantly contributes to explaining annual growth in 25 PSCs over the period 1992-1994. Havrylysyhyn et al. (1998) extend this analysis for annual growth rates over the period 1991-1998. Starting from a basic specification in which growth is explained by the contemporaneous inflation rate, the contemporaneous and lagged values of a structural reform index and two ‘clusters’ of initial conditions, they gain explanatory power

by including institutional variables representing the

political and legal framework especially when the impact of the institutional environment is modeled to increase over time. A common feature of both methodologies is to document a general influence of institutions on economic performance without explicitly referring to a concept of governance, thus ignoring different dimensions of governance which are necessary to analyze the foundations of consistent and coherent institution building. More recent approaches that seek to overcome this deficit are Campos and Nugent (1999) and Kaufmann et al. (1999) who investigate the concept of governance proposed by the World Bank25. Both link their dimensions of governance to several development objectives (GDP per capita, illiteracy, and infant mortality). Campos and Nugent focus on the relevance of individual dimensions for distinct regions of the world. They fail, however, to separate the institutional variables they employed according to their framework of governance and carry out their analysis with an arbitrary selection of proxies for the governance dimensions. They analyze complementarity or substitutionality between their dimensions by allowing for interactive terms in their regressions of their development indicators. Kaufmann et al. determine six domains, which they assume to represent their concept of governance, and construct an indicator for each domain condensing data by an unobserved component model. Our study seeks to carry on this more elaborate analysis of a governance structure by linking it with the classical exploratory study of growth performance over a longer term. We focus on transition economies, because consistent with the record of the first decade of transition these emerging market economies are especially sensitive to (changes in) institutional quality. We choose

24

25

They form indicators of ‘predictability of rules’, ‘political stability’, ‘property rights security’, ‘reliability of the judiciary’, ‘lack of corruption’, and ‘credibility’ from respondents experiences in doing business. The World Bank’s governance framework from the 1992 Report: Governance and Development identifies four major components: (i) public sector management, (ii) accountability, (iii) legal framework for development and (iv) transparency and information. The framework of Campos and Nugent is quite similar to ours: They see five components to be associated with good governance: (a) accountability; (b) efficiency of the bureaucracy; (c) an appropriate legal framework; (d) transparency; and (e) participation. 16

the period of 1993-1998 for our investigation (due to data deficiencies and) because the most basic liberalization and privatization measures as well as the bottom economic consolidation had been already completed by 1993 in most of the countries. Economic performance in the successive periods should reflect the growth enhancing effects of an (improved) institutional framework promoting market activity. As a second indicator for economic performance and the future growth prospects we selected FDI. This is adequate in the context of transition economies because, on the one hand, there appears to be more uncertainty in overall investment figures in these countries26 and, on the other hand, FDI not only alleviates the transition specific shortage of savings, but also promotes the technology transfer and the restructuring of the economy, which are both indispensable for accelerating the convergence to developed market economies. We considered per capita figures for both growth and FDI to sustain comparability across countries.27 Two critical aspects need to be considered if the cross-country effects of different institutional qualities are to be analyzed. First, there are different starting conditions determining the possible growth path and the potential to attract FDI. These conditions can either matter directly through different qualities and quantities of factor endowments, but they can also influence the emergence of institutions which in turn enter as a secondary effect through different levels of total factor productivity. Second, the ability to conduct smooth macroeconomic stabilization (especially in an environment of rapid institutional change) has an important effect for stabilizing expectations of entrepreneurs and hence promoting investment and the prospects for growth (Fischer et al. 1996). Apart from this, a frequent problem with institutional variables which mostly come from independent surveys is to find a sufficiently large sample of countries that includes scores for all these variables. In our case, the sample size varies between 19 and 25. This indicates that we should abstain from setting up a parsimonious model and should economize on including extra variables in our regressions. Therefore, we limit ourselves in advance to include at most two more variables by which we control for initial conditions and for macro-stabilization.28 Due to its origin from neoclassical growth theory and its frequent use as a stylized initial condition in cross-country growth studies, we choose the log of GDP per capita of the year 1993 as a

26 27

28

In this context, Brunetti et al. (1997c) emphasize the problem of insufficient reliability of investment data. Usually, investment as percentage of GDP is taken. However, per capita values can also be justified when the denominator is seen as a measure for market size. Brunetti et al. (1997c) seek to overcome this problem by subsequently including different control variables into their regressions. Mutual causality of our institutional variables and the initial conditions is another problem which requires to be cautious with including more control variables. 17

control variable for initial conditions29. Moreover, it displays a high correlation with other relevant initial conditions, e.g., the level of education, wealth in natural resources, etc.30 A high level of per capita GDP has theoretically an ambiguous effect on growth and a clearly positive effect on FDI. High initial GDP per capita on the one hand limits the prospects for growth, because it is an indication for an advanced economy with relatively low marginal factor productivity. On the other hand, because it constitutes a relatively advanced economy, it sets up conditions conducive to institutional progress. The log is taken to account for a marginally decreasing relevance of initial conditions. In order to find a suitable variable to capture the effect of successful stabilization, we investigate the significance of budget deficit and inflation reduction in regressions on both growth and FDI (see Table 2). It turns out that the relation of the standard deviation of the inflation rate in the period from 1996-1998 to the standard deviation from 1993-1995 has a strong negative impact on growth and FDI indicating the importance of reducing macroeconomic uncertainty31. In the next step, we subsequently add the institutional variables to our control equation. These variables are drawn from several surveys and data sources: Nations in Transit 1998 by Freedom House (see Karatnycky 1999), the EBRD’s Transition Report, the data from Brunetti et al. (1997a) prepared for World Development Report 1997, and the Corruption Perceptions Index 1999 (Lambsdorff 1999) by Transparency International. From each source, we select those institutional indicators that reflect the four dimensions by which we identify effective governance. There are certainly overlappings across categories of the selected indices, because they have been evaluated for studies which did not intend to identify the four respective categories. In such cases, we assign the indicators to those categories which seem to be dominantly reflected.32

29

30

31

32

Fischer et al. (1996) report a lower output decline for countries with lower initial income per capita. See also Havrylyshyn et al. (1998). De Melo et al. (1997) use factor analysis to determine two sets of relevant initial conditions just prior to reform, for our sample the period 1989-1991. Their two clusters for economic distortion and overall development displayed little explanatory power for growth and FDI in our time period 1993-1998. However, they are correlated with GDP per capita in 1993 with ρ=-0.75 for the economic distortion cluster and ρ=0.37 for the overall development cluster. Havrylysyhyn and van Rooden (1999) mention that initial conditions might rather matter to explain the output decline. They get improved results in their regressions modeling a diminishing effect of initial conditions over time. De Melo et al. (1996) also take the reduction of the inflation rate as an indicator for successful stabilization. They argue that stabilization can have reverse effects on growth in developed market economies. In transition economies, they observe, however, a clear benefit from stabilizing the initial price spike resulting from price liberalization. Fischer et al. (1996) also stress the role of inflation stabilization as a necessary condition for recovery. For the description and classification of the institutional variables, see the Appendix. 18

Table 2: OLS Regressions to assess the indicator of stabilization Dependent Variable: GDP/Capita-Growth 1993-1999 Constant

0.1939***

0.2008***

0.2251***

(4.63)

(4.73)

(4.24)

-0.0195*** -0.0202*** -0.0244***

Log(GDPpc93) Ave. Infl. 1996-99 / Ave. Infl 1993-95 Stdv. Infl. 1996-99

R adj.

-0.1368**

(-3.26)

(-2.84)

(-2.78)

(-1.95)

(-2.70)

0.2045***

0.0301***

0.0304***

0.0339**

0.0284***

(4.73)

(3.54)

(3.52)

(2.52)

(3.09)

-0.0098***







-0.0061







-0.0131***





0.0018



(-3.64)



(-1.57)

-0.0120***







(-2.84)





(-3.36)

-0.0010







(-0.47)





(0.75)

0.0036







(0.17)

/ Stdv. Def 1993-95

2

-0.1766*

(-3.46)

- Deficit 1993-95

No. Of Obs.

-0.1407**

(-3.21)

33

Stdv. Def. 1996-99

-0.0221*** -0.1435***

(-3.12)

/ Stdv. Infl. 1993-95 Deficit 1996-99

Dependent Variable: FDI/Capita average 1993-1999

0.0028 (0.13)

25

25

25

25

25

25

25

25

0.21

0.20

0.17

0.17

0.32

0.34

0.32

0.30

White-corrected t-statistics in parenthesis, *** significant at a 1% level, ** significant at a 5% level, * significant at a 10% level.

The complete setup for our OLS-regressions is as follows: Growth93− 98 i = const + θ1 log(GDPpc93 ) i + θ2 InflRisk i + θ3 InstVari + εi

and

FDI 93− 98 i = const + θ1 log(GDPpc93 ) i + θ2 InflRisk i + θ3 InstVari + εi where by εi ~ N (0, σ i ) we allow for heteroscedastic error terms. The results for the institutional variables in each of the categories accountability, participation, predictability, and transparency confirm the by now acknowledged result that institutions do matter for economic performance and that this can be empirically verified convincingly not only for LDCs but also for transition economies (see Table 3). It furthermore indicates that our hypothesis that the four categories are important ingredients for successful institutions cannot be rejected on the basis of our data. Overall, out of the twelve institutional variables we employed (three in each category) only three fail to be significant at the 10% level either in the equation for growth or in the one for FDI (the variables for Security and Legal System only fail in either of the equations where only Gov. Efficiency fails in both). In many cases the other variables are significant at a 1% level in either one

19

or both of the two equations. By principal component analysis, we also extracted a common factor for each triple of institutional variables in the respective four categories34. The factors for accountability and transparency are at least significant at a 5% level on both growth and FDI, the factors for participation and predictability at least at a 10% level.

33 34

The difference is taken to avoid a resemblance to growth. This comes close to the governance clusters in Kaufmann et al. (1999).

20













Rule of Law

Gov. Officials

Fact. Account

*

***





(1.83)



(2.25)

0.0395**







0.0171*

(-1.90)

-0.0072

*

***

(-3.61)

-0.0238

(4.95)

(-2.99)

-0.0115

***

(-2.88)

-0.0380

(3.28) ***

(2.15)

0.0192**







(-3.35)

-0.0104

***

(-3.94)

-0.0350

(5.13)

***









(-3.36)

-0.0131

(3.52)

0.0304

***

(-2.78)

-0.1407**

***













Public Adm.

Gov. Efficiency

Fact. Particip







***

***





(2.16)



(1.10)

0.0229







0.0206**

(-1.24)

-0.0080

(-3.95)

-0.0211

(4.95)

(-3.29)

-0.0112

***

(-3.28)

-0.0410

(3.68)

(1.79)

0.0181*







(-2.75)

-0.0094

**

***

(-4.38)

-0.0333

(5.85)

***









(-3.36)

-0.0131

(3.52)

0.0304

***

(-2.78)

-0.1407**

25 0.49





(3.40)

0.0169***



*

***

(-3.72)

-0.0126

(1.88)

0.0128

(0.88)

19 0.71



(3.95)

0.0972***





(0.06)

0.0002

(4.03)

0.0332

***

(1.96)

19 0.59

(3.66)

0.0366***







(-2.49)

-0.0097**

(1.30)

0.0132

(-0.39)

***

**







(3.10)

0.0167

***

(-3.57)

-0.0119

(2.32)

0.0151

(0.49)

25 0.49





(3.02)

0.0179***



*

***

(-3.95)

-0.0124

(1.89)

0.0123

(1.02)

19 0.38



(1.38)

0.0260





(-1.64)

-0.0100

(3.08)

0.0395

***

(-2.61)

19 0.48

(2.56)

0.0267**





(-2.20)

-0.0100**

(1.97)

0.0216*

(-1.22)

FDI per capita average US$ 1993-1998 0.0238 0.0556 -0.2009** -0.0795

No. of obs. 25 25 25 19 19 25 25 R2 adj. 0.20 0.46 0.44 0.43 0.50 0.34 0.49 White-corrected t-statistics in paranthesis, *** significant at a 1% level, ** significant at a 5% level, * significant at a 10% level

(2.30)

0.0198

**

(-3.21)

-0.0107

***

(-3.59)



(-2.84)

-0.0120

***

-0.0383

(4.14)

GDP per capita growth US$ 1993-1998 0.3958*** 0.4265*** 0.2068*** 0.2918***

***

(-3.21)

-0.0202

(4.73)

0.2008***

Civil Society

Inf. Risk

Log(GDPpc93)

Const

3.2 Participation

***

(3.12)

0.0152

*

***

(-3.97)

-0.0158

(1.99)

0.0133

(0.64)

FDI per capita average US$ 1993-1998 0.0336 0.0456 0.2290* -0.0241

No. of obs. 25 25 25 19 19 25 25 R2 adj. 0.20 0.40 0.38 0.48 0.50 0.34 0.47 White-corrected t-statistics in parenthesis, *** significant at a 1% level, ** significant at a 5% level, * significant at a 10% level

(1.92)

0.0173



Political Process

-0.0151

***

(-4.68)

-0.0120

***

***

(-2.95)

-0.0396

(3.38)

GDP per capita growth US$ 1993-1998 0.3985*** 0.3896*** 0.3870*** 0.3036***

***

(-3.21)

-0.0202

(4.73)

0.2008***

(-2.84)

InfRisk

Log(GDPpc93)

Const

3.1 Accountability

Table 3: OLS Regressions to Test the Concept of Governance

21

3.3 Predictability ***

GDP per capita growth US$ 1993-1998 0.1931*** 0.1960*** 0.2393*** 0.1844***

-0.2172***

-0.2266**

-0.1132**

(-2.78)

(-2.91)

(-2.90)

(-2.34)

0.0304***

0.0438***

0.0455***

0.0172**

(-3.01)

(3.52)

(3.48)

(3.44)

(2.17)

-0.0162***

-0.0033

-0.0131***

-0.0044

-0.0036

-0.0145***

(-1.23)

(-7.06)

(-0.55)

(-3.36)

(-0.66)

(-0.58)

(-3.71)









0.0410**





0.0146*



Const

0.2008

log(GDPpc93)

-0.0202*** -0.0174*** (-3.21)

(-3.23)

(-2.85)

(-4.40)

Inf. Risk

-0.0120***

-0.0031

-0.0066

(-2.84)

(-0.59)



0.0361**

Judiciary Decisions Security

(4.73)

(5.12)

FDI per capita average US$ 1993-1998

(4.73)

-0.0178**

(6.14)

(4.31)

-0.0304*** -0.0175***

-0.1407

**

(2.53)









0.0083















0.0152*













0.0233 (1.61)







No. of obs. 25 19 19 23 19 25 19 R2 adj. 0.20 0.56 0.41 0.48 0.50 0.34 0.46 White-corrected t-statistics in parenthesis, *** significant at a 1% level, ** significant at a 5% level, * significant at a 10% level

19 0.42

23 0.39

0.0177

*



***

GDP per capita growth US$ 1993-1998 0.2499*** 0.3949*** 0.2141*** 0.3158***

Const

0.2008

Log(GDPpc93)

-0.0202*** -0.0352*** -0.0387*** -0.0271*** -0.0363***

Inf. Risk

-0.0120*** -0.0137*** -0.0125***

(4.73)

(-3.21)

(6.04)

(-4.27)

(3.91)

(-3.32)

( 5.51)

(-3.84)

-0.0085*

(6.67)

(-5.10)

FDI per capita average US$ 1993-1998 -0.0839

0.0447

-0.1303**

(-2.78)

(-1.55)

(0.88)

(-2.73)

0.0304***

0.0084

0.0127*

0.0250***

(3.52)

(0.99)

(1.86)

(3.10)

-0.1407

**

-0.0130*** -0.0131*** -0.0110*** -0.0136***

(-4.60)

(-3.71)

(-1.87)

(-4.52)

(-3.36)

(-3.24)

(-4.10)

(-2.65)



0.0182***









0.0276**





0.0166***











0.0174**













0

-0



(3.66)

0.0368**









(2.68)





0.0290** (2.29)







No. of obs. 25 22 25 25 22 25 22 R2 adj. 0.20 0.55 0.44 0.41 0.61 0.34 0.47 White-corrected t-statistics in parenthesis, *** significant at a 1% level, ** significant at a 5% level, * significant at a 10% level

25 0.53

25 0.44

Fact. Transp

0

(2.76) (2.23)

Gov. on Internet

-0.0103**

(-2.84)

(3.03)

Indep. Media

0

(2.08)

3.4 Transparency

Corruption

-0

(1.89) (1.83)

Fact. Predic t

0.

(2.27) (1.65)

Legal System

-0.

0.0243

***



(3.79)

0.

Institutional variables seem to be more strongly related to FDI than to growth which is consistent with the notion, that investment more closely reflects economic decision making. The coefficients on the control variable for stabilization policy remain significant in the equations and their values alter only marginally in most cases. The coefficients on log(GDPpc93) generally drop when institutional variables are included35. This reflects the positive impact of initial conditions on successful institution building. While the secondary effect was leveled out in the initial growth equation, it appears when we account for the influence of institutions.36 An exception from these regularities are the variables from the World Development Report 1997: Gov. Officials, Gov. Efficiency, Judiciary and Security which are associated with three out of our four categories. For these variables the indicator of stabilization gets mostly insignificant and the coefficient on log(GDPpc93) rather increases. Further investigation shows that these variables appear to be in fact strongly negatively correlated with the indicator of inflation risk37 which might indicate that these variables are linked to a common factor that also contributes to the performance of macro-stabilization, an aspect we will consider in the following factor analysis of our variables. We now turn to the second empirical question: given that certain categories to assess effective governance matter, can we trace independent sources of performance in these categories which point to independent underlying mechanisms? Or at best, have we already identified independent sources of governance by our categories? The answer can be provided by the analysis of a common factor model for our variables38. We discard the indicator for Gov. Efficiency because of its weak performance in the regressions. Factor extraction on basis of the Kaiser-Criterion leads to two independent sources which account for the variance in our institutional variables. Thus, we fail to identify our concept of governance from the data. The rotated factor loadings indicate that the first factor is correlated with variables of all four categories (see Table 4). Hence, there seems to be one broad factor in the data which accounts for institutional quality in our four categories.

35 36

37

38

Knack and Keefer (1995) record the same effect in their growth regressions. Brunetti et al. (1997b) also recognize ‘peculiarities’ in their growth regressions. As initial conditions they use the log of initial GDP per capita and the log of the mean years of schooling. Both coefficients on the variables remain insignificant throughout and the coefficient on the log of initial GDP per capita even displays the wrong sign. They see their results as a consequence of their country sample and their period of observation ignoring the secondary effect of institutional quality on growth. The correlation coefficient lies around 0.6 for the WDR variables whereas for the other variables it is only slightly different from zero. A Bartlett’s Sphercity Test of the correlation-matrix of our institutional variables yielded a χ2 value of 290, whereas the critical value for α=0.001 with 55 degrees of freedom is about 94. Thus, the null hypothesis that the correlation matrix is an identity is strongly rejected and factor analysis is justified. 23

Table 4: Rotated Factor Loadings39:

Category Accountability

Participation

Predictability

Transparency

Variable

Factor 1

Factor 2

Political Process

0.9500

-0.0479

Rule of Law

0.9630

0.0993

Gov. Officials

0.4490

0.3680

Civil Society

0.9680

0.0928

Public Adm.

0.9870

0.0773

Judiciary decisions

0.0737

0.9520

Legal System

0.8670

0.0399

Security

-0.100

0.9270

Corruption

0.8660

0.0076

Gov. on Internet

0.4880

-0.0353

Independent Media

0.9760

0.1060

Rotation method: Varimax with Kaiser-normalization. Convergence after 3 iterations

The second factor only loads high on two variables that we selected to represent predictability. This gives room for two possible interpretations: The respective variables Judiciary Decisions and Security are both drawn from the WDR 1997 data set, so that possibly only the specific setup of the survey is responsible for a variance across the countries which cannot be found in the other variables40. An alternative interpretation would accept the role of these variables to account for a separate source of institutional quality. With reference to our dimensions of governance, this might point to a fundamental role of the predictability of decisions and actions by government authorities in addition to a broad factor encompassing the quality of the institutional environment in which the authorities are acting. An argument in favor of this hypothesis is the correlation of these variables with the indicator of macrostabilization, which of course also displays features of predictability of government decisions. However, we believe that the evidence for the second interpretation is very weak and rather take the results as a rejection of the existence of independent sources of institutional performance. If we had been successful to extract convincing dimensions of governance a next step would be to double-check the significance of the governance concept by examining whether the independent sources of governance carry over into independent sources of economic performance. If so, both factors should be significant in our regressions, which would indicate that governments even had a policy option to improve on one or the other institutional indicator in order to foster growth. Despite the result that we 39

The factor loadings describe the correlations between factors and variables. The Square-Matrix of the loadings is therefore the implied correlation-matrix of the variables.

24

could not fully conclude our estimation strategy, the indicators we chose in our analysis seem to confirm fairly well our perception about necessary ingredients for ‘effective governance’. We take our results as a failure to interpret our governance concept as capturing various independent dimensions of underlying mechanisms. The reason for this might be, that there either are simply no independent sources of successful governance or that the data we employed to reflect our four categories are too fuzzy to separate different sources for effective institutions.41 However, a conclusion we can draw from our analysis is that investigating complementarity or substitutionality of governance categories (like Campos and Nugent (1999) do) is inadequate as long as independent sources of governance are not established. A starting point for future research on the ingredients to an effective governance framework should be further surveys in which the questions are designed to reflect such ingredients, i.e. that they should reflect broader and rather behavioral concepts to evaluate government performance instead of the conventional objective orientated framework.

5. Implications for International Organizations

Besides the formulation of consistent reform policies and the existence of political leadership, a country’s governance structure represents the set of fundamental mechanisms that determine the outcomes of economic reforms and eventually a country’s path of development. Policy reform and high economic growth rates cannot be sustained without continuing institutional change. Therefore, effective governance needs to be interpreted as a dynamic process that requires a permanent fine tuning and adjustment of institutions and policy solutions to changing technological, social, economic, and political environments. New institutions will only survive and unfold their positive developmental impact if they are supported by individuals and organizations which have a stake in their survival. This requires both a high degree of incentive compatibility of government policies and economic performance as well as the creation of flexible institutional arrangements that constitute a stable economic and political order and permit institutional change. During the 1990s, the view, that the politico-institutional environment has been the primary source of obstacles for sustained economic change, has come to reflect the failures of structural adjustment programs. Problems concerning the adequate institutional design for the formation, implementation, and enforcement of policy reform programs have gradually become seriously analyzed issues in both scholarly debates and the work of international organizations. In particular, multilateral development 40

41

Havrylysyhyn and van Rooden (1999) also notice the different pattern of correlations of the World Bank data and elaborate that the WB indicators are showing a ‘flatter distinction’ between advanced and less advanced countries. Recall that we mentioned above the frequent overlapping of the topics certain questions refer to. 25

agencies as well as the IMF, which have usually demanded LDCs and PSCs to radically implement a package of clear and simple adjustment recipes as a precondition to further lending, have come to realize that their policy recommendations have been deficient and incomplete, but that the necessary change in their programming policies would threaten to overrun their own agenda. Given the governance dimension of policy reform, both the World Bank and the IMF face the dilemma that improving adjustment programs will imply that these organizations take into account that now the nature of political orders of sovereign countries is at stake, any consideration of which would not only exceed their technical expertise but also their mandate. Nevertheless, facing the growing public concern with corruption, misuse of funds, and poor policy making, international organizations have been increasingly urged to give governance issues a higher priority on the agenda of policy reforms. The World Bank had already started at the end of the 1980s to focus on governance problems and their inherent constraints to policy reform (World Bank 1989). In 1997, even the Executive Board of the IMF adopted guidelines concerning the Fund’s role in governance issues (IMF 1997). At present, most multilateral and bilateral donor organizations take the problem of fighting corruption and creating effective governance structures into consideration. But essentially, governance work has been carried out in an ad hoc manner. To date, both the Bretton Woods organizations and the regional development banks have failed to provide a coherent concept suitable to establish an overall governance strategy for a given country that explicitly takes political, social, and cultural side conditions into account and seeks to adequately anticipate future political and social consequences that result from recommended policy adjustment packages. Ignoring these consequences may imply that economically efficient programs may turn out to be counterproductive in practice, if existing governance structures are weak or if non-economic side conditions are inappropriate to effectively implement adjustment policies. Only recently, leading policy makers and economists have begun to call for a new coherent paradigm for economic and social development. Within the donor community, the most prominent proponents of a Post-Washington Consensus have been James Wolfensohn, President of the World Bank, and Joseph Stiglitz, the Bank’s former Senior Vice President and Chief Economist. The World Development Report 1997 was a milestone in revising the political paradigm for development of the World Bank, the starting point of a new, more productive dialogue between the Bank, other political decision makers, academics, and civil society.42 Stiglitz (1996, 1998b), in particular, advocates in favor of developing and using more policy instruments to pursue broader objectives of development including sustainable, egalitarian, and democratic development. He argues that the new paradigm for development should seek to explore ways 42

Although it is difficult to assess the actual impact of the World Development Reports on the World Bank’s operations and policies, it is conceivable that the new tone of the 1997 Report represents the beginning of a newly emerging policy stand.

26

of how to effectively achieve an overall transformation of society. A new development strategy should be less prescriptive, though more comprehensive than the Washington Consensus. It needs to give key development issues comprising education, health and living standards as well as the environment equal priority as GDP growth and capital allocation. Processes and consensus for policy reform need to evolve at all levels of society and should not be imposed in form of abstract prescriptions by outside donor organizations. Nevertheless, the debate on a Post-Washington Consensus is still at the very beginning regarding a discussion on how PSC and LDC governments, social groups, and local non-governmental organizations can be supported in developing and improving the capabilities and institutional capacities needed to successfully pursue policy reform. Stiglitz (1998b) identifies five promising propositions in this regard: (1) (2) (3) (4) (5)

Government interventions should be restricted in areas which are subject to a significant and systematic influence of special interest groups; a crucial government role is to promote competition and to act as a referee in a market economy; in order to improve government performance, political decision-making processes need to become more open and less subject to secrecy; governments need to encourage the provision of public goods by the private sector in order to discipline itself and to convey voice; and political authorities should aim to achieve a balance between the technical expertise of policy making on the one hand and accountability and democratic representativeness on the other hand.

Greater openness, a public-private partnership, and an increasing number of participants providing inputs on policy making are central factors to bring about more balanced signals reflecting societal preferences. They are also critical to ensure that the government and the private sector act in a complementary fashion. Moreover, inclusionary policy making based on consensual processes shows a higher degree of permanence and enhances the feasibility and efficacy of policy reforms. Competitive advocacy processes represent an appropriate means to openly discuss opposing arguments. They advance the consideration of costs and benefits related to specific policies in a more balanced manner. Of course, notions of how to redefine the role of government in economic development and how to make it more effective and accountable need to be incorporated in a new paradigm for development. But how should governance issues be coherently and consistently included in the emerging new paradigm? In this regard, neither the literature on policy reform and development nor discussions among development practitioners have provided an answer. Besides the political sensitiveness of the issue, it is the difficulty of operationalizing any concept of governance which imposes new challenges on the development community. Eventually, turning good intentions into action and developing new adjustment programs that may imply a Post-Washington Consensus are associated with serious problems and challenges: • governance is a politically sensitive area, and donor organizations need to ensure that LDC and PSC governments can assume full ownership of governance-related programs; If its conclusions will (partly) percolate into the actual Bank operations, its influence on sectoral programs and Country Assistance Strategies will be significant. 27

• in order to formulate a consistent governance strategy tailored to the needs of a borrowing country, international development organizations must establish internal consensus building mechanisms to deal with persisting diverse interests and convictions within their management; in addition, they need to seek rules and procedures to overcome external political and commercial pressures on their programming activities; • international development organizations such as the World Bank or the regional development banks need to develop a coherent governance policy on which their operations will be based; • in order to implement this policy, these organizations must develop an adequate technical expertise; • since development agencies perform different roles and have different mandates, a concerted action of multilateral and bilateral agencies seems to be necessary to develop coherent program strategies and to achieve the desired results.

Experiences show that institutions, policies as well as the design of the economic and political order are of utmost importance for successful policy reform. This fact is encouraging in so far as it allows to conclude that less successful countries should be basically capable of overcoming the impediments to development. But this requires that governments of these economies as well as authorities of industrialized countries and multilateral financial organizations are ready to take advantage of existing options to development. The concept of governance developed in this paper as well as related empirical analyses suggest that institution building is critical for a successful systemic change. Our findings also imply that there do not exist independent mechanisms working behind a governance structure, but rather that capacity building measures aimed at different dimensions of governance reinforce each other. Finally, it is to be noted that the relatively abstract nature of our governance concept is inevitable. The establishment of effective governance structures is highly context- and time-specific and subject to path dependency. Therefore no universal model of governance can exist, and the application of best-practices approaches will be limited to a very few technical areas of policy making. Nevertheless, the four fundamental principles of effective governance, identified in this paper, seem to be an appropriate starting point that should guide policy and particularly institutional reforms. Incorporating governance issues into economic adjustment strategies helps develop a Post-Washington Consensus which is suitable to identify politically feasible reform policies and to guide policy makers through the complicated terrain of policy reform.

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Appendix

1. Sample of countries Central and Eastern European Countries as well as the successor states of the Soviet Union. 1 2 3 4 5 6 7 8 9

Albania Armenia Azerbaijan Belarus Bosnia Bulgaria Croatia Czech Rep. Estonia

10 11 12 13 14 15 16 17 18

Georgia Hungary Kazakhstan Kyrgyz Rep. Latvia Lithuania Macedonia Poland Romania

19 20 21 22 23 24 25

Russia Slovakia Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan

2. Description of variables Per capita growth rates are computed from GDP per capita in US$ from the Transition Report 1999 by the EBRD. FDI per capita is computed using the US$ FDI flows from the Transition Report 1999 and the population data is taken from the TransMONNE Database provided by the United Nations Children’s Fund Innocenti Research Centre.43

Accountability: ! ! !

The degree of democracy in the political process examined in “Nations in Transit 1998” by Freedom House (for a reference see Graybow (1998)), which recognizes free and fair elections, the development of a multiparty system and popular participation in the political process. The rule of law is also assessed in “Nations in Transit 1998” by Freedom House which highlights constitutional reform, human rights protection, judiciary and judicial independence and the status of ethnic minority rights. Difficulties with government officials: “If a government agent acts against the rules I can usually go to another official or to his superior and get the correct treatment. – This is true always,....,never ?”Question 18 of an entrepreneur survey conducted by Brunetti et al. (1997a) in preparation for the World Development Report (WDR) 1997.44

Participation: ! ! !

The strength of civil society examined in “Nations in Transit 1998” by Freedom House. The index reflects the growth of non-governmental organizations (NGOs), their capacity and financial sustainability, the legal and political environment in which they function and their participation in the political process. Government and Public Administration Index in “Nations in Transit 1998” Freedom House; examines the power of legislative bodies, decentralization, the responsibilities, election and management of local government, and legislative and executive transparency. Government efficiency in delivering services: “How would you generally rate the efficiency of government in delivering services, now and 10yrs ago ?” Question 25 by Brunetti et al. (1997a). Our variable is computed as a difference between the responses for “now” and “10yrs ago”.

Predictability:

43 44

The database is accessible via http://www.unicef-icdc.it/information/databases/. The data can be downloaded from http://www.unibas.ch/wwz/wifor/staff/bw/survey/index.html. For a detailed description see Brunetti et al. (1997). 29

! !

!

Predictability of judiciary decisions: “Unpredictability of judiciary presents a major problem for my business operations. To what degree do you agree with this statement, now and 10yrs ago ? Question 11 by Brunetti et al. (1997a). Our variable is computed as a difference between the responses for “now” and “10yrs ago”. Security of persons and property: An average of two questions from the WDR-Survey. (1) “Theft and crime are serious problems that can substantially increase the cost of doing business. To what degree do you agree, now and 10yrs ago ?”; and (2) “I am not confident that the state authorities protect my property from criminal actions, To what degree do you agree, now and 10yrs ago ?” We took an average over the two differences between the responses for “now” and “10yrs ago”. Legal Transition Index of 1997 assessed by the EBRD (1998). It evaluates the legal system, i.e. the extensiveness and the effectiveness of commercial legal rules on pledge, bankruptcy, company formation and governance.

Transparency: ! ! !

Corruption Perceptions Index (CPI99) assembled by Transparency International45 which is composed from several sources each referring to the degree of corruption. Independence of the media evaluated in ‘Nations in Transit 1998’ by Freedom House which considers the status of press independence, the emergence of a viable private press and Internet access for private citizens.46 The number of Internet pages about the respective government per one million residents (gov. on internet). Own survey conducted on October 29th,, 1999, using LYCOS as search engine.

All variables are scaled so that a high score indicates a high quality of institutions.

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