Save Capitalism From Capitalists
Save Capitalism From Capitalists
Save Capitalism From Capitalists
e xc e r p t
the guys with the Adam Smith neckties won. Or so it seemed at the time. But a decade of dislocation everything from the meltdown of the Asian economies to the exposure of rot in Americas corporate boardrooms has illustrated all too clearly that it takes more than faith to make free markets work. For, like communism, capitalism contains the seeds of its own destruction. Hence the timeliness of Saving Capitalism From the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity*, the striking new book by Raghuram Rajan and Luigi Zingales. Rajan, incisnark/art resource, ny
In the early 1990s the great, century-long competition between economic systems ended with a whimper.Communism imploded;
dentally, will have an unusual opportunity to test the merits of his recommendations: he has just been appointed the chief economist and director of research for the International Monetary Fund.
*2003 by Raghumam Rajan and Luigi Zingales. Published by arrangement with Crown Business, a division of Random House Inc.
Peter Passell
67
68
69
when he wrote, People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. Unfortunately, all too often and in all too many countries, the conspiracy enlists the help of the state in enforcing limitations on competition. Marx also understood that capitalists would enlist the state in securing their posi-
petition, and those who lost out, who would be happy if the rules of the game that caused their troubles were changed. The long-term feasibility of free markets rests on reducing the incentives of each of these groups to proceed against the market, and limiting their chances of success if they do proceed. The way to limit the chances of success of vested interests is not to expand the power of the state but to narrow its ability to take in-
70
creasing international competition will create entirely new categories of the distressed. Can the political opposition be contained? Before we describe the looming challenges, it is useful to see an example of how economic institutions can adapt to defuse the incentives of interest groups to coalesce against market forces. Consider the evolution of the U.S. bankruptcy code in the 19th century. The economic role of bankruptcy law is not just to provide a mechanism for creditors to collect their money, but also to offer a form of insurance to debtors, relieving them from some of their burden when it becomes overly oppressive. When a borrower owes so much that he has small hope of repayment, he will have little incentive to exert effort to earn money; any extra dollar earned will simply go to creditors. A modern bankruptcy code provides a mechanism by which debtors can get relief. In providing this exibility, bankruptcy legislation somewhat paradoxically enhances the security of property in two ways. First, it allows creditors to charge up front for the possibility that they will have to offer relief, thus protecting their property. At the same time, it heads off any need for debtors to organize politically, preventing them from arbitrarily wiping out their debts. This further enhances the security of property and the sanctity of contract. Through much of the 19th century, federal bankruptcy laws were enacted in response to harsh business conditions, only to be repealed soon after. But periodically violating creditor rights was no panacea. What guarantee was there that organized debtors would stop at repudiating their current obligations? Could a debtors revolt not spread to questioning other forms of property? To leave relief to concerted political action was tantamount to playing with re. A better solution eventually emerged. As
nancial markets and institutions developed, as information and communications technology, like the telegraph, knit the country together (so that, for example, debtors could not escape the stigma of bankruptcy by going West), as markets for assets improved in liquidity, creditors became better able to monitor their loans and obtain repayment. Some permanent leniency was possible. This is why there was a broad trend in the legislation that was contemplated over the 19th century. The bankruptcy laws that were enacted, albeit for short periods, became progressively friendlier to debtors, encompassing more of them and giving them more relief. The point is that there are solutions that help keep the sphere of markets and the sphere of politics separate while recognizing the imperatives of both. In considering some of the coming challenges, it is important to think of creative ways of managing the implicit tussle between free markets and politics so that one does not destroy the other.
71
people have in the fairness of the market. It is not that people are concerned about disparities in wealth; very few Americans question the enormous amounts earned by superstar athletes like Michael Jordan and Tiger Woods. They can observe Michael Jordans superior talent rsthand, and they are willing to accept that he deserves what he makes. In the boom years, this was also true for corporate America. But corporate disasters like Enron or Global Crossing have un-
dermined the belief that corporate leaders deserve what they make or that nancial analysts really understand the stocks they tout, creating room for envy and resentment. It is in these situations of public mistrust of market forces that foes of free markets nd it easier to coordinate and act. The public resentment in the current economic downturn feeds into a long-standing distrust of markets embodied in the antiglobalization movement. While some of this
72
movement is age-old protectionism in a newage guise, there are also many groups involved that genuinely perceive global markets as unfair. Not all these groups understand what they are protesting. Some long for the things the modern economy appears to crowd out (such as time, friendships, family and conversation) and the things it appears to destroy (such as open spaces and a clean environment). It is change that they fear, and globalization is unfortunately the most visible and
rapid form of change in recent times. More discerning protesters see that the inadequate infrastructure countries have for coping with globalizations adverse consequences, rather than globalization itself, is the problem. But it is easier to make common cause against globalization than to focus on the more mundane task of xing the infrastructure. Already, politicians are responding in the natural way to the downturn by erecting tariff barriers and offering domestic
73
subsidies, a way that is not only shortsighted but also completely oblivious to the lessons of history. The steel tariffs in the United States were followed by a farm bill that substantially increased the level of subsidies available to the agricultural sector. This will inevitably enrage developing countries, which would willingly forgo all the foreign aid developed countries offer if only the developed world would reduce the extent to which it pampers domestic agricultural sectors. Developing countries will respond by being more reluctant to lower their tariff barriers, for unfortunately, history suggests that protectionism is contagious. We are in a dangerous period of hangover, the morning after the ecstasy of a boom. Many feel betrayed by the bust and are demanding action against the markets. Even when the economy picks up, as sooner or later it inevitably will, new challenges are coming that will cause severe dislocation in society. These could be exploited by the few to constrain the market, so it is important to understand what they are.
technological change For centuries, technology has created new products and new ways of making them that render workers and their skills redundant. While the dislocation stemming from technological change is not new, its pace has increased tremendously. Moreover, it is now affecting the professions that have not much changed their way of doing business over the centuries. Because it will affect those who have not yet learned to fear for their jobs, its political impact will be all the more severe. Drafting, for example, used to be a signicant component of an architects job. Computer-aided design software has made this skill all but irrelevant. Older architects now nd themselves at a serious disadvantage rel-
ative to younger colleagues who have been taught to use the software as an integral part of design. Even if older architects do not draft anymore, their ability to supervise and coach their younger colleagues is much diminished. In the race for career advancement, an entire generation has been handicapped. Other jobs are vanishing because customers now have access to information and transactions technology to which only intermediaries had access earlier. Stockbrokers used their privileged access to research reports in order to entice customers into maintaining trading accounts with them in the process, generating large brokerage fees. Now, Internet brokers offer all the research customers need and charge minuscule trading commissions. Travel agents are also nding business increasingly difcult as customers not only have access to the same information they command, but can sometimes get better rates directly from airlines and hotels. This does not mean that all stockbrokers and travel agents will vanish overnight. However, many will not survive, and the ones who do will work very differently from the way they work today. Technology is also having a differential impact within professions. Take our own: teaching in universities. Using new communication techniques, one gifted professor can teach students in many locations around the country. While technology will increase the demand for such superstar teachers, it will reduce the demand for the merely good, and the demand for the mediocre may vanish completely. Not only is technology making certain human skills obsolete quickly, it is creating entirely new sources of distress. As research into genetics progresses, scientists will more easily identify those who are likely to die of particular diseases at a young age. This knowledge
74
75
76
This is not to say that secretarial wages are determined arbitrarily. Like all prices, they are determined by supply and demand. One factor determining the supply of secretaries is their alternative employment possibilities. Suppose a secretarys alternative is to be a steelworker. There is a world market for steel (provided protectionism does not close it down), so no country can afford to pay its steelworkers much more than what they contribute at the margin to output. U.S. steelworkers are paid much more than Indian steelworkers because U.S. steelworkers are substantially more productive. Therefore, because U.S. steelworkers are more productive, the U.S. secretary is paid more, even though she herself is not more productive. Thus, in the United States, the secretary earns a hefty salary because she controls a scarce factor: specialized labor. But what is scarce here is secretarial labor in the United States, not secretarial labor in the world. And technology is increasingly making it possible for all kinds of labor to be supplied at a distance. As the cost of communication falls, a Chicagoan complaining about his utility bill is just as likely to nd a middleaged woman in Manila on the other end of the line as an American. Not every job will be at risk. But, over time, competition will move to more skilled activities as foreigners learn the local standards. While large rms may still employ partners in big accounting rms to advise them on arcane tax-minimization strategies, the small-business owner may well deal over the Internet with an Indian or a Chinese accountant who has familiarized herself with U.S. laws. A Russian physician may perform an operation over the Internet at a fraction of the cost that a Western European physician would charge. In short, while workers in traded indus-
tries like steel have faced up to foreign competition for decades and have adapted to it, for many in non-traded service sectors, this will be something they have never experienced before. They currently enjoy compensation in excess of what they would earn in a worldwide competitive market. An increase in competition will jeopardize this excess compensation. Hence, like the steelworkers, these new victims of competition will mobilize to try to block it. But unlike the case of trade in physical goods, border controls will be ineffective.
the fear of developed economies Even while developed countries fear competition from cheap, skilled, educated labor from developing countries, the latter fear that their industries could be wiped out by multinationals with global brands. In the same way workers in the developed world see cheap labor in the developing world as an unfair threat (no matter how much this fear is disguised as concern for the working conditions and benets of developing-country workers), owners and managers in the developing world see the better infrastructure in the developed world as unfair. In truth, each side has a source of comparative advantage, which will help it compete. And in a world of open borders, each side can benet from the others strengths the developed world getting access to cheap labor and the developing world getting access to infrastructure. But all this implies dislocation and distress in the short run. And the developing world is even less prepared than the developed world to handle it. In some developing countries, the preconditions for respect for property or for creating market infrastructure have not yet been established. Property is highly concentrated in the form of large feudal landholdings or
77
monopolies, especially in extractive industries. Not only can these countries not cope with volatile, competitive markets, but their dominant political groups have little interest in creating the infrastructure that would allow them to cope. One reason many rms in developing countries are inefcient, despite their access to cheap labor, is that they have been protected against domestic and foreign competition
of the old, venerable business families that strongly oppose opening up the economy. Another serious concern in developing countries is the near-complete absence of a formal safety net for those hurt by competition. In developing countries, transfers and subsidies represent just one-fourth the proportion of the budgets in developed countries. Until the Asian crisis in 1997, even South Korea had little in the way of unem-
78
degree of mutual dependence and specialization is likely to increase; it is arguably harder to change your accountant or the rm that maintains your system software than to change the rm from which you purchase steel. It is also hard to build inventories of services to act as buffers. There is a silver lining to these interdependencies. When, in May 2002, the governments of India and Pakistan started threatening each other with nuclear war, businesses in both countries became alarmed at the possibility that foreign buyers would get scared off by perceptions of increased risk. As a result, they pressured their governments to tone down the rhetoric. These benets notwithstanding, growing global integration is exposing the world to new risks of disruption that have to be addressed.
aging populations No analysis of the potential future threats to the political viability of free markets can ignore the dramatic effects that the rapidly aging population in developed countries will have on the distribution of resources. In 1970, there were 17.2 million children under age ve and 3.7 million adults over 80 in the United States. By 1995, the gures were 19.6 million and 8.1 million respectively, and by 2040, they will be 25 million and 26.2 million respectively. The United States, with substantial immigration, is not even close to being the most rapidly aging country. By 2010, Japan will have fewer than three working-age adults for each elderly citizen, and by 2050, it will have only 1.5 taxpaying workers per pensioner. At that time, Italy will have fewer taxpaying workers than pensioners. A smaller and smaller working population will have to support a larger and larger group of the non-working. If no change occurs, future working generations will pay ever more
to the elderly while expecting ever less for their own old age. This will set up a clash of interests between the incumbent old and the younger working generation, between those whom democracy renders powerful because of their numbers and organizational power and those whom economics renders powerful because of their control over human capital. Historically, a mismatch between political power and economic power has represented a threat to the security of property rights. Such a threat is possible again in the future. Another source of tension arises from the international distribution of resources. If the productive capabilities of the economy fall as the population ages, goods for consumption will have to be imported. Developed economies will have to invest abroad not in other developed economies, as has been the trend in the past but in younger, developing countries. Developing countries need to build the capacity to absorb these investments in sensible ways. Moreover, if developed countries are to hold signicant quantities of nancial claims on developing countries, they will demand safeguards to ensure that they will not be dispossessed at a later date when they need to cash in those investments. Historically, respect for property rights emerged when owners were sufciently represented politically to make expropriation politically difcult and when expropriation hurt the expropriator in the long run. Clearly, investors from developed countries have had little or no political representation in developing countries, at least since the days of gunboat diplomacy. So whether their rights will be respected hinges on whether, going forward, developing countries will nd it costly to expropriate owners in developed countries. Population aging will force developed countries to be
79
increasingly reliant on respect for property in developing countries. It is in our collective interest that market infrastructure expand worldwide.
international governance We have argued that the cause of markets is aided within a country if its large industrial and nancial rms are competitive, for they will then not have to rely on shackling the free market to survive. Internationally, the cause of free markets is helped if the dominant political power is also an efcient producer, for it then will press others to open up their borders. During the 19th century, England promoted free markets around the world. A similar role has been played by the United States in the post-World War II era. It is periods when the political leadership of the world changes hands or when the dominant political power loses its economic leadership that we are especially likely to face ambivalence about open markets. The United States is still the dominant economy in the world as well as the sole superpower, but neither attribute is immutable. Certainly, with the steel tariffs and the farm subsidies, we see the consequences of U.S. economic weakness in some sectors impinging on its commitment to open borders. What if weakness spreads? Will the United States continue to champion free markets? Of course, the United States is only one country. Competition among different political entities can still further the cause of the market even if a major player jumps ship. The danger here is the growing political integration among countries of the type occurring in Europe. It reduces political competition and makes coordinated antimarket moves more feasible. In its early years, what is now the European
Union was the European Economic Community (EEC) a focused attempt to break down national barriers in Europe to enlarge the market. When it was largely intent on a promarket goal, it was a force for the good, and coaxed many countries to liberalize. In ensuring equal access to foreigners, countries also were forced to level the playing eld for their own citizens, thus fostering the development of competitive arms-length markets. However, as the aims of the European Union have broadened to a common program of governance, its directives could well have the potential of becoming more intrusive and illiberal. Consider an extreme but illustrative case. Suppose after a severe stock market crash, the European Union decides that too many companies brought to market were little more than a dream and a prayer. It decides to tighten the rules under which companies can issue shares on the market, a move incumbents might well support because it starves entrants of capital. Given that these rules would apply immediately in all neighboring country capital markets a new European rm might think of tapping, that potential entrant might be hard-pressed to raise nance under the new rules. By contrast, if a single country tried to impose those rules, it would see the potential entrant go to a neighboring country to raise nance. Thus, the migration of business to friendlier political entities is a very strong disciplinary force for keeping policies marketfriendly. This force is suppressed when neighboring political entities coalesce.
80
that the necessary infrastructure will remain underdeveloped and the market will be exposed to political backlash during the inevitable cycle of business creation and destruction. The only way out consists of initiatives that can check and balance each other so that the government supports, but does not intrude on, the functioning of the market. In isolation, each proposal may seem benign or even counterproductive. But together, they become a force to foster free markets.
will always apply. But the nexus between economic and political power is of special concern in two situations. If a few incumbents have much of the economic power, they can rely on their own political clout to achieve business ends and will feel little need to establish transparent rules that make markets accessible to all. This is more likely to be a problem in a country that does not have an established market infrastructure because the pressure to create
We cannot wish away the fact that economic power translates to political power. No matter what kinds of campaign nance reforms are enacted, some form of the real-world golden rule he who has the gold makes the rules
it will then be low. More dangerous still than this benign neglect of the market is if the incumbents are incompetent at business, for they may then suppress the competitive market so as to preserve their own positions. The two concerns are not unrelated. The diamond trade in India is dominated by a small community of Palanpuri Jains from Gujarat. For nearly half a century, these traders have worked in secrecy, dealing largely with other members of extended families, to buy, cut, polish and resell diamonds around the world. Working without legal contracts, they have been so effective that nine out of 10 diamonds in the world now pass through India. The reason this system has worked so far in a country with a creaky legal system is that it is based on trust. The community ostracizes anyone who violates the implicit understanding among traders. The problem, however, is that outsiders cannot participate in the system, and insiders have no incentive to create
81
a more arms-length, transparent system; it is easier to build trust when prots are large and trading is conned to a well-known few. The concentration of trading in a few hands can be harmful if the system stops working, as well. And there are signs of this as trade expands and business has to be done with more and more outsiders: a courier recently absconded with $10 million worth of diamonds, and two Bombay traders lost their clients money in stock speculation (they were so ashamed, they committed suicide). But members of the community are not eager to accept modernization and professionalism, however necessary, because these changes will also bring competition. Change is therefore coming slowly, perhaps too slowly. The point: concentration of economic power, even if currently benign, need not remain benign, especially if the privileged few have their own ways of doing business. This suggests two goals of policy: to keep economic power from becoming overly concentrated and to ensure that those who control economic resources are capable of using them efciently. These goals are often, but not always, compatible. For example, it is clear that a policy of subjecting rms to competition from the outside helps keep them efcient. There is little pressure on a protected industry to become competitive, and it will use the windfall profits earned while being protected to lobby for more protection instead of taking the steps necessary to restructure. The Indian Ambassador automobile (a version of the ancient British Morris Oxford) was introduced in 1957 and was sold virtually unchanged until 2002 because it had little domestic (and no foreign) competition during much of its history. Even an allegedly temporary pause in market discipline, such as the recent imposition of steel tariffs in the United States, risks
creating incumbents who will ght to make the barriers permanent. A Political Antitrust Law. Antitrust law has been used to prevent rms from squeezing supernormal prots out of customers. But it is also useful to consider the political version of antitrust law one that prevents a rm from growing big enough to gain the clout in domestic politics to suppress market forces. There are obvious problems in framing such a law precisely, but it has been implicitly in place in the United States for some time especially in nance. The attack on the Second Bank of the United States by Andrew Jackson in the 1830s, the breakup of John D. Rockefellers Standard Oil in 1911, the creation of the Federal Reserve in 1913 to counter the power of the House of Morgan, the Glass-Steagall Act of 1933 to curb the power of the large national banks, and the ongoing case against Microsoft can all be seen as consequences of political antitrust law. Better Corporate Governance. Some of the most important properties in advanced economies are not operated by their owners but rather by professional managers. We refer, of course, to corporations. On the one hand, the separation between ownership and control facilitates a better matching between rms and managers, leading to more efcient rms. On the other, it creates conicts of interest between managers and shareholders, potentially leading to inefciencies. To facilitate a healthy separation between ownership and control, more legal protection should be guaranteed to investors who entrust their savings to somebody else. In addition, appropriate mechanisms, such as independent boards, effective auditors and a vibrant market for corporate takeovers, are essential to ensure that managers are coaxed into maximizing the value of the companies they run, and are quickly replaced when they
82
central saint martins college of art and design, london, uk/bridgeman art library
83
demonstrate their inability to do so. In other words, corporate governance is important not only to enhance value for investors, but also to ensure that incumbent rms welcome (rather than) fear competition. Recent scandals suggest that much needs to be done on this front even in advanced market economies.
Inheritance Tax on Transfer of Control.
Inheritance is a particular form of transfer of control of assets that typically tends to be inefcient because the receiver has little qualication to manage the assets other than the accident of birth. Imposing serious impediments on how the rich dispose of their wealth would reduce their incentive to create that wealth in the rst place. Inefcient and concentrated control of wealth does, however, impose all kinds of costs on society. That is why an inheritance tax, structured so that the rich are encouraged to transfer passive ownership of productive assets (for example, minority stakes in a portfolio of rms), rather than active control, to their children would make sense. Inheritance taxes may be especially important in developing countries where there is immense concentration of landholdings. Another way to break down the excessive concentration of asset ownership is to make equal inheritance by all children, male and female, the default. Such prescriptions are not new. They can be traced back at least to the British philosopher James Harrington, who had tremendous inuence on William Penn (and thence on the Constitution of Philadelphia), on Thomas Jefferson (and thereby on the Constitution of Virginia), and on Theodore Roosevelt (and thus on federal antitrust legislation).
A Safety Net for the Distressed
are essential to the creative destruction process, but are extremely painful for the people affected. The bigger the cost of adjustment and the larger the numbers of the distressed, the stronger the political demand to intervene. Insure People, Not Firms. While perfectly understandable, this demand for intervention is very dangerous because it can be easily manipulated. To prevent the victims of creative destruction from being transformed into human shields for special interests, we need to provide for them in other ways. One rule, therefore, to prevent the politicization of relief is to insure people directly not through rms. For example, economists generally agree that the best way to provide relief to workers who lose their jobs is to offer them lump-sum payments, perhaps dependent on the duration of their previous employment. Not only does this not interfere with the competitive process, but also it gives workers the right incentive to look for new jobs (they get to keep the payment regardless of how long it takes) while relieving them of the privations of unemployment. Unfortunately, such simple solutions are rarely implemented because they disassociate worker relief from politics. Design Insurance Before the Fact. Governments typically prefer to wait for an event before responding instead of preparing for the uncertain eventuality; not only can the magnitude of the relief required be better gauged after the fact, but also resources do not have to be held in reserve. One reason to design relief in advance is simply that a plan provides people a greater sense of security. Moreover, it eliminates the need for the distressed to organize to obtain relief. Since their collective actions are not likely to be friendly to the market, a plan for relief before the fact eliminates a signicant threat to the markets.
84
This, in fact, is suggested by our brief account of the evolution of U.S. bankruptcy law. Once a exible law was put in place, the need for debtors to organize to press for relief during each recession disappeared. Also, they could obtain relief based on individual circumstances, rather than wait for collective misery to tip the political scales. Relief provided after the fact is not insurance but pure redistribution. As such, it is driven solely by the political power of the parties involved, not by the needs of people. Insure Against Permanent Change. Social welfare programs were designed to ght the last wars notably, temporary dislocation caused by business cycles. Structural change, not cyclical change, is the primary concern now. Peoples most valuable assets are typically their productive skills. To develop exible human capital a worker needs sound health into old age, a basic general education that gives him the ongoing ability to learn rather than lling him with facts with a very short half-life, and an education system that can take him in whenever he needs retraining. In the United States, life expectancy has increased by 29 years since 1900. Yet most people stop formal education early in life, much as they did a hundred years ago. Education is still geared toward that rst job, even though technological change, competition, and greater job mobility mean that for most people, the rst job (or even the rst career) will not be the last. Would it not make more sense to cut back a little early on and have more opportunity for education later? Finally, it should be possible for those with neither the desire nor the ability to make career changes to retire. A viable pension scheme would allow this. Unfortunately, the generations coming of age today, when the risks of structural change are so great, have little rea-
son to feel secure about their pensions. With pay-as-you-go nancing, the aging of populations means that the social security systems currently in place in almost every developed country will prove inadequate. There are few formal systems of insurance in place in developing countries; these countries rely on social networks like extended families and villages to serve as buffers to economic volatility. The silver lining is that the level of government expenditure on social security in many of these countries is still low. So they have the ability to create formal security systems without repeating the mistakes made by developed countries.
Reduce Incumbents Ability to Affect Governance
Thus far, we have proposed ways of reducing the incentives of incumbents and the distressed to go against markets. We now turn to measures that would reduce their ability to affect governance. Open Goods and Capital Markets. The most effective way to reduce the power of incumbents is to keep domestic markets open to international competition. It is especially important to keep nancial markets open. Countries have little incentive to close their borders to trade and capital ows unilaterally when the rest of the world is open. This is because goods and capital will leak through anyway unless the country goes the totalitarian route of a North Korea. But a mass movement against open borders, even if only in a few large countries, can make it attractive for politicians to close borders. This is the danger posed by the growing antiglobalization protests. Economists have responded to these protests by emphasizing the productivity gains generated by international trade. However, they have generally been lukewarm in their support for the free
85
movement of capital. While we certainly do not dismiss the importance of the efciency gains generated by trade, we emphasize a different argument in favor of openness its capacity to undermine the power of domestic incumbents. A commitment to openness forces incumbents to abandon politics and to focus on the tougher task of defending their positions in the marketplace by becoming more efcient. While openness is clearly benecial for developed economies with sound infrastructure, sudden liberalization can be problematic for underdeveloped economies. Subjecting ill-prepared economies to the gale-force winds of international competition can be harmful because it may wipe out the very constituencies the professional classes, small- and medium-size entrepreneurs, commercial farmers that can push for a market economy. According to some, the right policy for the large developing economy is to limit competition until the institutions necessary for an efcient market economy are in place. But there is a great risk in such gradualism: slowing down the liberalization process may bring it to a standstill. If incumbents know that opening up to competition hinges on improvements in infrastructure and skills, they can block movement on either front. In fact, while gradualists argue that nancial-sector reforms should precede the open capital ows, in practice they seem to follow it. So the dilemma for a reformist government in a developing country is how to create a commitment to increase competition while allowing time for market institutions to be built.
Provide Incentives Through Trading Zones.
force) reforms: offer membership in their trading zones, conditional on progress on market infrastructure development. By using the carrot of the opportunity to trade with a large group of countries (like the European Union or Nafta), they make reform politically appealing for the developing or transition economy. It is impressive how much Turkey is trying to change (with respect to human rights as well as economic structure) in order to qualify for membership in the European Union. There are, of course, countries that do not t naturally into a trade zone. But the broad principle of providing incentives for reform still applies. Developed countries could do a great deal for the cause of markets, both in their countries and around the world, by stopping subsidies to their own farmers and by lowering trade barriers in key goods like textiles. Farmers and small entrepreneurs in developing countries, who have a better chance of growing rich if protectionism in developed countries is reduced, can be a great force for opening markets in their own countries just as their counterparts were in the developed world.
Richer countries, which have come together in free trade zones, have a very powerful instrument to encourage (rather than to
public awareness Throughout, we have argued that organized interests drive government policies. One reason politicians can ignore the public interest with impunity is that they believe the public is unaware of what its interests really are and cannot be bothered to nd out. Our goal is to make more people think like economists do. If they see the benets of free markets, yet understand their political fragility, it will be harder for narrow interest groups to prevail. It will become easier for public-spirited politicians there are some to advance sound reforms. And the world will become a M fairer and better place.
86