Lecture 7 Organized Political Corruption

Anticorruption and the Design of Institutions 2010/11 Lecture 7 Organized Political Corruption Prof. Dr. Johann Graf Lambsdorff

Literature • Lambsdorff, J. Graf (2007), The New Institutional Economics of Corruption and Reform: Theory, Evidence and Policy. Cambridge University Press: 81-108. • Myerson, R. (2008), “Perspective on Mechanism Design in Economic Theory”, American Economic Review Vol. 98 (3): 600-602. • Olson, M. (1993), "Dictatorship, Democracy, and Development," The American Political Science Review, Vol. 87(3): 567-576. • Shleifer, A. and R.W. Vishny (1993), ”Corruption.” Quarterly Journal of Economics, Vol. 108: 599–617.

Disorganized Corruption • Businesspeople might sometimes be confronted with many public servants extorting payments. • For example, setting up a new business may require various permits, none of them can be missed. The organization of these multiple payments becomes a daunting task. • Shleifer and Vishny [1993] model this situation: In Russia private investors negotiate with various departments (fire, police, banks ...), each of them requesting a payment in exchange for the speedy approval of a business license. • This leads to the “overgrazing” of the corrupt marketplace.

Disorganized Corruption • The problem is comparable to road bandits. • Optimal income for road bandits requires a limit on their activity, so as to avoid that too many travelers are scared off. • Taking, for example, only 20% of the traveler’s money may be best. • But competition among road bandits destroys this calculus: Any money not confiscated will be taken by others. • In this spirit, investors prefer to deal with only one extortionist. Parker and Hart, June 30 1999

Disorganized Corruption Exercise:Assume that there is a total number of n symmetric departments (i, i=1, 2, ..., n) requesting a percentage (bi) of the investment (X). The costs for dealing with this payment, providing the corrupt service and obfuscating are cbi, 0<c<1. Investments (X) decrease with the total amount of bribes, X=X(b1+b2+...+bn), dX/dbi<0. Each department’s profit (Pi) is given by Pi=biX-cbiX. Let us assume that the departments are controlled by a strong party (a monopoly), which maximizes total income of all departments. In this case, they are all forced to behave symmetrically (b1=b2=...=bn), resulting in Pi=(1-c)biX(nbi).

Disorganized Corruption Profit is maximized in the monopoly case if: After the breakdown of the party the departments start to maximize their income individually, each considering the other departments not to react to their own level of pay-off. Profit maximization is carried out individually by the departments, resulting in: The second term is no longer multiplied by n. Therefore, a higher bi is needed to satisfy the equation. This is what is known as an “overgrazing” effect. The optimum level of total bribes collected (which was determined in the monopoly case) is missed, because individual bribes are too high.

The Economist, May 3rd 2007: “Rules of the road” In many parts of the world, greasing the palms of corrupt officials is a fact of life. For lorry drivers in poor countries, for example, it can be even more commonplace than paying tolls or taxes. The extortionists are often armed police or soldiers, manning roadblocks, who make little attempt to pretend what they do is legal. Yet, although such people may operate outside the law of the land, they do obey the law of supply and demand. That, at least, is the finding of a recent study (“The Simple Economics of Extortion: Evidence from Trucking in Aceh”, by Benjamin Olken and Patrick Barron) of illicit transactions in Indonesia. In a rare attempt at documenting bribery, it shows how crooked officials act as independent monopolists, maximising their profits and employing sophisticated pricing schemes in ways that have an economic logic, as well as a criminal one. The authors studied bribes paid by lorry drivers along two main roads in Aceh, an Indonesian province where separatist guerrillas had long been active. Over nine months in 2005 and 2006, data gatherers accompanied the truckers on 304 trips to and from Aceh, recording more than 6,000 illegal pay-offs at military roadblocks, police checkpoints and weigh stations. During the 637-kilometre (396-mile) trip from Medan to Meulaboh, for example, drivers typically passed through 27 checkpoints and forked out a total of $23 in bribes, representing roughly 13% of the cost of their trip—more, even, than the total wages of those in the truck. In the early stages of each trip, transactions were typically conducted without negotiation—at each stop, drivers simply handed over a few thousand rupiah ($0.50 to $1.00) or a couple of packs of cigarettes. As the trucks neared their destination, however, checkpoint officials demanded increasingly larger sums. At each stop, drivers found themselves with a progressively stronger incentive to avoid hassle and safeguard their cargo, which gave the extortionists greater power over them.

Midway through the study, after the Indonesian government had signed a cease-fire with the rebels, it began a phased withdrawal of 30,000 troops, leading to the number of checkpoints falling by half. This gave the researchers the chance to see how the extortion market would adjust. As you would expect, the amount lost to bribery decreased—but only by 36%. Fewer stops meant fewer bribes, but this was offset by a rise in the amounts demanded at the remaining checkpoints, whose operators, with entrepreneurial zeal, seized the chance to capture part of the newly liberated surplus. In fact, they behaved just like monopolists, setting their prices so as to maximise their own revenue, without considering the response of the fellow at the next checkpoint, or whether their activities would deter truckers. The result was a textbook example of double marginalisation—when a chain of independent monopolists charges more, but receives less overall than a single monopoly. These results have intriguing implications for stamping out corruption. In theory, a centralised system of bribery is better for both truckers and extortionists than a string of corrupt officials acting independently. Taking out a kingpin may yield splashy headlines, but it can actually increase the total amount paid in bribes if it destroys co-ordination among his henchmen. A better bet, say the authors, is to reduce the number of troops and police officers. That would, indeed, be a novel way of fighting crime.

Disorganized Corruption • Is disorganized corruption better or worse than organized corruption? • This question can be posed more provocative: Should we help extortionists to better organize their illegal business? • Yes: The model predicts that disorganized corruption is worse. • No: Often there exist legal alternatives to the payment of bribes, even for victims of extortion. Disorganized extortion is more costly and induces some actors to prefer the legal alternative. Once corruption is organized, it becomes deeply embedded in a country and widely accepted as the only way for doing business. The model fails in recognizing such legal alternatives such as complaints mechanisms.

Disorganized Corruption This can be illustrated by the following game in extensive form. B requests to a bribe to share a joint surplus of 12. E chooses between paying the bribe or complaining and thus resisting the payment, which yields him a bonus payment of 2 (and a positive social externality of 10, denoted by the logo of “doctors without borders”). Nature then tosses a coin that determines whether the bribe market is organized or disorganized. The latter implies that E and B must share their surplus again with others (the effect of E withdrawing from the market is disregarded here). Complaining is the dominant strategy. But if the risk of a disorganized bribery is deleted, paying the bribe is dominant. The “bad” outcome of disorganized bribery thus has welfare enhancing repercussions. (0; 5) Complain Bribery disorganized (2; 2) N Request Bribe B Pay Bribe E (6; 6) Bribery organized

The Self-Seeking Government • How should we define corruption when the government (the principal) is maximizing only his own interests and disregards public interests? • The term corruption is misplaced when applied merely to a disobedient agent. Instead, the principal’s own self-seeking behavior may be termed corrupt. • ”misuse” is not clearly related to the trespassing of rules, because rules are themselves the result of self-seeking: • Markets are distorted where this profits the principal. • Public resources are allocated to further the principal’s economic interests. • The principal is above any rules and immune to any accusations.

The Self-Seeking Government • Harden [1993: 186-7 and 208-13] reports about the devastating environmental effects of the Turkwel Gorge Dam in Kenya and how it was motivated by overpricing and kickbacks. But feasibility studies did not have to be falsified, they were just forbidden to be carried out in the first place. When the Financial Times published information from a whistleblower, copies of the newspaper were seized at Nairobi Airport. • Inefficiencies that can be detected are there by design. • In contrast to a single agent, the principal (government) can follow its corrupt goals in a much more systematic way. • The principal does not have to circumvent laws and regulations but can design them to serve his own interests.

The Self-Seeking Government • The principal (government) thus takes advantage of his monopoly position. • A common conclusion is that prices are likely to increase. Market restrictions and price increases already occur with corrupt agents. But principals can impose such restrictions in a much more forceful way by making them part of law. • While we may feel desperate about such a ruler, welfare losses are difficult to prove. Imagine a “perfect” kleptocrat. • Welfare losses reduce the kleptocrat’s potential to take away income from the citizenry; a kleptocrat therefore dislikes welfare losses. • A kleptocrat attempts to organize a corrupt system to operate like a tax.

The Self-Seeking Government • He contains low-level corruption among the bureaucracy. • He prevents individuals from ”overgrazing” the market. • He dislikes low quality in public procurement. • He dislikes white-elephant projects. • He attempts to take more from those who can give more. • So, why worry about this type of corruption?

Consumer surplus with maximum price Return from investment Dead Weight Loss Producer surplus with maximum price The Self-Seeking Government Welfare losses due to monopoly price setting Supply Demand 0 sectors

Return from investment Kleptocrats surplus The Self-Seeking Government The kleptocrat can levy the burden equally by price discrimination Supply Demand 0 sectors

The Self-Seeking Government Wizard of ID,Parker and Hart,September 17, 2000

The Self-Seeking Government • Some observers argue that a kleptocrat, also labeled as a predatory regime, tends to squeeze his citizens without pity. • Indeed, a kleptocrat is able to gather large bribes. So why do we fail in proving welfare losses? • It is argued that the “stationary bandit” exercises power consistent with the interests of society, (Olson 1993). • A ruler has an ”encompassing interest” (unlike the predator). • Murphy, Shleifer and Vishny [1993: 413] argue that the problems with corruption are mitigated when corrupt rulers can collect bribes efficiently. Perfecting corruption rather than fighting it is the avenue suggested for reform.

The Self-Seeking Government • Example: One of the grandchildren of President Suharto in Indonesia attempted to make a cut from taxes on beer which was collected by his private company. But as a result tourism in Bali was suffering from a shortage of beer and inflated prices, forcing President Suharto to withdraw the tax. • Counterexample: One illustration of a strong and corrupt government is that of Mobutu in Zaire, an uncontested kleptocrat for decades. But his regime crippled the economy and established a strong example that public welfare bitterly suffers from such regimes.

The Self-Seeking Government • In reality various problems exist for kleptocrats. • They assign property rights to comrades and contestants (rather than to those making best use of resources) in exchange for loyalty. • A flourishing economy may threaten their power. • A short time horizon motivates them to “run with the loot while they can”. • Kleptocrats set a bad precedent for lower level bureaucrats. • But, is an eternal dynasty of uncontested rulers the solution? Wizard of ID, Parker and Hart, May 11, 2000

The Problem of the Kleptocrat • Investments require the committing of resources, hoping that their initial investment will be honored. • Such resources cannot easily be transferred or assigned to different tasks. Railroads cannot be removed, power plants cannot be relocated to different countries. Investors fear for the expropriation of their future revenues. They carry out investments if political promises to honor their revenues are credible. • In a survey of business people in Karnataka, India, it was found that the software industry was less affected by the high level of corruption among the local administration. Compared to the construction and manufacturing industries these units could easily shift assets outside the state because this industry depends less on immovable assets. This lower dependency seems to have reduced extortionate demands for bribes among public officials. For other sectors credibility is essential because investments cannot be redeployed.

The Problem of the Kleptocrat • Corrupt tax collectors can impose an excessive tax burden on investors; corrupt regulators may threaten an arbitrary application of the law; corrupt customs authorities may control trade and demand their cut; corrupt politicians may threaten an unfavorable application or drafting of the law. All these actors may be in a position to appropriate the investor’s future revenues. • We note in passing that investors fear corruption not only due to kleptocrats or politicians who may extort them. Also private contractors are frequently in a position to behave opportunistically and expropriate an investor. Corrupt courts will not help an investor in protecting his property but sell the judgment to the highest bidder.

The Problem of the Kleptocrat • Investors want to rely on binding laws, but corruption motivates rulers to arbitrarily change the law and expropriate resources. • Strong corrupt rulers are motivated only by self-enrichment and face no restrictions. • They cannot credibly commit to effective policies. • Due to kleptocrats' failure to make binding commitments, they are not trustworthy to investors. • Investments will be stopped unless the ruler is effectively limited.

The Problem of the Kleptocrat • There are no easy approaches to avoiding adverse welfare effects of corruption. • An organized type of corruption brings about other forms of adverse welfare effects than disorganized corruption. • Changing the type of corruption is not a convincing approach for reform. Hints for Reform

The Problem of the Kleptocrat • Even kleptocratic rulers may have an (apparently very limited) interest to engage in anti-corruption. • This is somewhat comparable to Mafia bosses who attempt to legalize their business in a strategy to avoid the hazards for their offspring. • Totalitarian rulers must seek ways to commit themselves to their announced policies, which opens the door to reform. Hints for Reform

The Problem of the Kleptocrat • Myerson (2008) provides a good model for the credibility problem faced by autocrats. • Assume production, Y, in a country to be determined by capital, K, and raw materials, n, according to Y=(K+n)0.5. • An autocrat may honor the investments and allow a return of rK. The variable r is the country’s discount rate, which would just suffice to keep capital in the country. The autocrat would thus tax (or take as bribes) only the difference, which is (K+n)0.5-rK. The current value of his income would be ((K+n)0.5-rK)/(r+b). The variable b is an additional discount rate due to the autocrat’s exogenous risk of losing power. • An autocrat may also expropriate the capital, which suggests that in future periods capital is no longer provided by international investors (K=0). The current value of his income would then be K+n0.5/(r+b). • The autocrat’s moral hazard constraint is thus ((K+n)0.5-rK)/(r+b) ≥ K+n0.5/(r+b)

The Problem of the Kleptocrat • The ideal capital stock that maximizes ((K+n)0.5-rK)/(r+b) is obtained by the first derivative, (0.5(K+n)-0.5-r)/(r+b) =0  (K+n)-0.5=2r. With r=0.05 we obtain K=100-n. Let, for example, n=12 and we see that the moral hazard constraint is violated. For any K>0 this results, suggesting that only K=0 (n=100) is feasible. • The autocrat may now liberalize his regime, for example by designing constitutional constraints or countervailing powers that limit his capacity to expropriate. The extent of liberalism l, 0 ≤l≤1, reduces his income from expropriation according to (1-l)[K+n0.5/(r+b)]. • There is also a random risk for an honest autocrat to be overthrown, which is 0.05.l. His income from honesty thus reduces to ((K+n)0.5-rK)/(r+b+0.05l), which he seeks to maximize by setting l subject to his moral hazard constraint, ((K+n)0.5-rK)/(r+b+0.05l)≥(1-l)[K+n0.5/(r+b)]

The Problem of the Kleptocrat • This moral hazard constraint is depicted in the figure below, alongside with the isopayoff-curve. • Optimal liberalization is achieved with l=0.504, inviting for capital investments K=52.4

The Problem of the Kleptocrat • In case of n=0 the autocrat’s optimal regime would have l=0 and K=44.2. • Intuitively, a lack of natural resources makes it more costly for the ruler to lose his reputation for protecting capital, and so he can credibly encourage substantial investments even without liberalizing. Examples of such countries may be Singapore, Monaco or Liechtenstein.

The Problem of the Kleptocrat • In case of n=25 the autocrat’s optimal regime would have l=0 and K=0. • Intuitively, a great wealth of natural resources makes the ruler unwilling to accept the additional political risk from liberalization, even though it means that nobody will invest in the nation without liberalization. Examples may be Saudi Arabia and Venezuela.

Appendix Discussions1) Why may a disorganized form of corruption be worse than an organized form, for investors and public servants alike; in how far may independent departments “overgraze the market” when requesting bribes? 2) Describe the type of corruption that emerges when self-seeking is the actual object of government!3) How may in this case allocation be distorted?4) Show that in a static model a “perfect kleptocrat” avoids welfare losses! 5) Why is such a static analysis misleading?6) What may motivate autocrats to abstain from taking bribes?7) In how far is abundance of raw materials important for an antocrat’s decision to restrict his actions by liberalizing?

Exercise:There is a total number of 4 symmetric departments (i, i=1, 2, 3, 4) requesting a percentage (bi) of the investment (X). Costs for providing and obfuscating are cbiwith c=0.5. Investments decrease with the total amount of bribes, a) The departments jointly maximize total income. Determine the resulting investment!b) The departments maximize their income individually, each considering the other departments not to react to their own level of pay-off. Determine the resulting level of investment!c) A powerful kleptocrat may unite the departments, but one type of welfare loss becomes particularly strong and unavoidable. Describe this type of welfare loss!

Lecture 7 Organized Political Corruption