The Role of Time and Institutional Traps Chapters 6 and 7

1. The Role of Time and Institutional TrapsChapters 6 and 7 Kristin Harris and Anders Hawes

2. The Role of Time ♦♦Market System♦♦ А) Brings a competitive equilibrium model into the economy Б) Individual firms/households make their own decisions В) Firms know more about what they need for inputs and outputs in this system than a faraway ministry would

3. The Role of Time *Time* »Past influences present → obvious » Future influences present → not so obvious (Example on page 87) » Foreign goods now compete with domestic goods » Prices now reflect costs, not policy

4. The Role of Time • Privatization • Overhaul of the entire economy not needed • Needs to have a plan (not as strict as command/control economy) – plan takes time • High-capital industries (usually monopolies) have the hardest time transitioning • Low-capital industries have the easiest time

5. The Role of Time • New-Entry • More desirable for economy to replace old enterprises with new ones • New enterprises can always enter • Causes the best economic growth • Yields higher priority than the privatization of enterprises that were adapted to the former regime

6. The Role of Time • Gradualism • Not everything has to change at once • Needs to be a gradual transition so certain pieces can be stopped or reversed if need be • The whole process requires limited guidance (gov’t)

7. Institutional Traps • Institutional traps can be a major risk to a reform process • Transaction/Transformation costs • Transaction Costs – “costs of an agent’s interaction with partners within a framework of a certain behavioral norm.” (pg. 94) • Institutional Transformation Costs – “costs of transition from one norm to another.” (pg. 95) • These costs can be incurred by both the state as well as indivdual firms • Major articles of these costs on page 95

8. Institutional Traps in Russia • Barter • Tax Evasion • Arrears • Corruption • Foreign Trade-related Economic Stagnation • Institutional Conflict

9. 1992 Price Liberation in Russia • Analysis suggests that price Liberation requires advanced monetary institutions to be already in place to avoid a barter trap. Inflation Soars, causing value of paper money to fall Russia has an unformed, Inefficient Banking system Barter System in Russia Firms begin Barter Transactions (less expensive) Barter Exchange spreads & becomes the norm through “Coordination Effect” Over time, Companies learn to design elaborate `chains of Barter Exchanges (Learning Effect) By this point, it is far too costly to ‘break out’ of the barter exchange system. “Cultural Inertia” & uncertainty results in conservative pressure groups who resist monetary exchange. A HYSTERESIS EFFECT IS NOW IN PROCESS

10. Tax Evasion Government Russian Citizen What am I paying taxes for?!! • Raise Taxes • Slash Social Expenditures I am going to stop paying taxes !! Too inefficient to prevent people from stop paying taxes • Another “Co-ordination effect is created, followed again by a “Learning effect”. • Tax evasion and Bartering are joined through the “Linkage effect”, along with arrears and corruption. • Tax evasion becomes the norm, making it difficult and expensive to get out. A firm also risks being under the tax collector’s scrutiny for the rest of its days. • Modest tax reductions can no longer help as the “Hysteresis effect” is now in place.

11. India plans to overhaul tax systemBy Amy Kazmin in New Delhi Published: August 13 2009 05:11 | Last updated: August 13 2009 16:25 “India’s government is planning a big shake-up of its archaic tax system in a bid to curb widespread evasion as it confronts a sharply widening fiscal deficit amid expanding social welfare programs. The plan, announced by PranabMukherjee, the finance minister, aims to foster greater compliance with tax laws by lowering key corporate and personal income tax rates, simplifying rules and eliminating exemptions blamed for eroding the tax base. Corporate taxes on Indian companies will drop to 25 per cent from 30 per cent. India has long struggled to increase its low tax-to-gross domestic product ratio, the legacy of punitive socialist era tax rates, which have encouraged widespread evasion.”

12. Inflationary stock empties companies bank accounts No Bankruptcy laws or restructuring mechanisms in place Arrears Modest tax rate reductions cannot help- Non-payers will continue to avoid taxation, and law-abiding taxpayers will pay less. Buyer only makes partial payment to company Cycle of Sadness !! Supplier does not want to lose clients, so they continue to ship supplies. Company only makes partial payment to supplier • Spreads into a coordination effect & mutual arrears • Strengthened by Linkage effect Result Mutual Arrears blocks the application of bankruptcy laws

13. Corruption • Bureaucrats are offered more money through bribes from the rich than what the state can afford to pay. • Corruption becomes tempting due to the higher payout and the government’s ineffectiveness to prevent it. • “Coordination effect” is again in play, lowering the bribe-taker’s chances of being caught even more

14. Foreign Trade Related Economic Stagnation • A Premature, ill-prepared attempt to liberalize foreign trade leads to an institutional trap. • Protected industries cannot compete in the world market, because their products are of poorer quality. Possible Solutions • Long Term • Add domestic production with subsidies that are gradually removed as modern technology is purchased with the export revenues. • Short Term • Export Raw Materials • Spend export revenues on consumption • Problems • Manufacturing enterprises will close • Mass unemployment • Which would cause • Decline in labor skills • Wider gap in incomes. • High social tensions & social indifference. • Rising crime • And Eventually: • Collapse of national economy once the raw materials were exhausted or world market stopped demanding the raw material.

15. Foreign Trade Related Economic Stagnation… contd • The longer the short-term solution is in effect, the higher the transformation cost to switch to a better norm. • A politically unstable country is more likely to choose the short-term option…. which is what Russia did. • The Lesson: • For proponents of shock theory – it is vital to resist the temptation of choosing the short-term strategy option.

16. Institutional Conflict • Russian institutions tried to create a western-style corporate system, even though U.S. Institutions were so different from Russia’s cultural tradition. • Conflict in transferring institutions from onecultural environment to another can result in • Non-viable institutions (eg. Russia’s bankruptcy law) • Mutant Structures – stable but inefficient structures, a form of institutional trap (eg. Joint-Stock Company)

17. Reform Process and the State Large-scale economic reform can be carried out, but requires: 1)Preparation of the economy for transformation 2) Effective provisional institutions to guide the reforms 3)Proper rate and sequencing of the reforms 4)Consistent discretionary economic policy And MOST important task of the reformative state is- 5) AVOID INSTITUTIONAL TRAPS!! • The Reform Process: • Transitional Rent and Reform Failures • Rate, Preparedness, and Sequence of Reforms • Industrial Policy

18. Transitional Rent and Reform Failures Privilege-generating rental income- limitation posed on the free flow of resources or the level of prices. A margin was made between retail and wholesale and paid as rent to the state budget to be redistributed. However…. Most was stolen by high-ranking officials and shadow dealers So… Limitations were lifted But… Russia wasn’t prepared at that time for such a change, and their losses have been tremendous Some regions continued to collect the rent and firms pocketed the money

19. Rate, Preparedness, and Sequence of Reforms • There are two viewpoints as to how to carry out reforms: 1) Shock Therapy- as quickly as possible. The belief is that reforms are sililar to surgery and have to be carried out as quickly as possible to minimize suffering. 2) Gradually! There are 3 key arguments for the gradualist viewpoint: Government needs to acquire the funds to finance the transformation costs When reforms are too rapid, it is extremely difficult or impossible to make adjustments or correct mistakes Shock liberalization of prices inevitable leads to barter and arrears traps if there is no efficient banking system to avoid inordinate transactions costs

20. Industrial Policy • Industrial Policy should be aimed at protecting select companies from bankruptcy & industries in dire straits. • Important process for the transitional period is the emergence of large corporations, because a large corporation • Can make major investments • Reduces market transactions, taking edge off barter & criminalization problems. • Facilitate tax collection • A long term industrial policy, combined with anti-monopoly measures& proper corporate governance could help overcome institutional traps.

21. Conclusion – Things to consider… • Every reform should be preceded by efforts to forecast & forestall possible institutional traps. • Once an institutional trap is formed, breaking out is very difficult. • To get out, measures should be directed at weakening the stabilizing mechanisms that support the traps (co-ordination, linkage & inertia effects). • If the government is weak or passive, reforms are doomed to failure. • “Naive attempts to imitate economic organizations of more developed countries result in institutional conflict. Wise reform strategies would help economies find their own forms of the invisible hand”. The end (With thunderous applause) !!!