Divergent Incentives and Economic Reform in Developing Nations
This chapter provides a theoretical account of the diversity of eco- nomic outcomes across federations. In doing so, it brings together two heretofore separate literatures – those on the political economy of market reforms in developing nations and federalism – and con- tributes a new model of how intergovernmental bargaining influences the making of economic policy making in political systems character- ized by the geographic fragmentation of political and economic power.
I contend that the market reform literature has failed to appreciate the importance of subnational politics for the move toward economic liberalization, particularly in cases in which regional leaders respond to constituencies of their own while controlling significant fiscal and policy-making responsibilities. The federalism literature, by contrast, has understudied federal systems in the developing world and paid insufficient attention to the full variety of relationships between the institutions of federalism and economic outcomes, focusing instead on those that are “market-preserving.” Neither literature accounts for the importance of distinctly subnational politics in shaping the political incentives of crucial decision makers, nor for the key factors that affect intergovernmental conflict over major shifts in economic policy.
The political economy of market reform has been a central topic of social scientists for nearly two decades. As an increasingly interde- pendent and globalized international economy has provided incentives for the governments of developing nations to reorient economic pol- icy toward freer, more open markets, researchers have focused on the 17
political conditions for successful economic reform. To date, most re- search has emphasized the importance of international- and national- level variables to explain cross-national variation in the degree of policy liberalization. Although international political economists have accen- tuated the importance of a nation’s integration into the international global economy, comparativists have pointed to the particular role of national institutions and politics. For IPE scholars, exposure to inter- national capital flows (Berger and Dore 1996; Maxfield 1998), the strength and nature of a nation’s export sector (Garrett and Lange 1995; Frieden and Rogowski 1996), the cohesiveness of corporatist institutions (Garrett1998; Iversen1998), and the influence of interna- tional institutions such as the International Monetary Fund and World Bank (Kahler1986, 1992) are all crucial mediators between the exi- gencies of the global economy and the politics and policies of national governments.
Comparativists, by contrast, point to the importance of the dis- tribution of social costs and benefits of the market reform process (Nelson1990), the political vigor and organization of national business communities (Silva and Durand1998; Kingstone1999), the strength of oppositional social forces such as unions (Dornbusch and Edwards 1991; Widner1994), the severity of economic crises (Gourevitch1986;
Williamson 1990; Edwards 1995), the nature of regimes (Skidmore 1977; Stallings and Kaufman 1989), the economic ideology of gov- erning elites (Haggard 1985), and international bargaining position (Remmer1990; Kahler1992) in determining the extent to which na- tions roll back the state in favor of the market. More recent research has tended to focus on the role of national institutions, particularly party systems in the reform process. The degree of party discipline, party system fragmentation, leftist partisan strength, and the balance of partisan forces have all been related to the possibility for success- ful economic reform (Garrett and Lange1991; Geddes1994; Haggard and Kaufman1995; Corrales2000). Others have emphasized the im- portance of the bureaucratic capacity of the state (Haggard 1985;
Na´ım1993; Waterbury 1993), and a favorable institutional context (Przeworski1991; Clague1997) as keys to market reforms.
What unites this disparate array of traditional independent vari- ables is that they ignore subnational and intergovernmental politics.
As a result, most researchers have neglected the issue of market reform at the subnational level and the intergovernmental coordi- nation of economic policies. In decentralized contexts, subnational elected officials often respond to different political incentives than na- tional officials while controlling significant policy levers (May1969;
Watts1996). The politics of market reform, therefore, are often com- plicated numerous times over by the need to trim deficits, privatize subnationally owned enterprises, reform tax codes, and restructure debt on a region-by-region basis. Under these circumstances, the effec- tiveness of national policies as market reform tools is limited, because the conduct of fiscal, monetary, and various other policies are, in part, decentralized to subnational politicians (Treisman1999b, 2000). To the extent that subnational politicians responding to their own elec- toral considerations do not have the same economic policy priorities as national officials, federalism can pose major challenges to the coor- dination of economic policy changes. Thus, most current literature has not accounted for a substantial portion of the market reform story for federal nations such as India, Russia, Nigeria, Brazil, Argentina, and Mexico, to name just a few.
Likely the most consistent message that emerges from the dizzy- ing cacophony of hypotheses in the traditional market reform litera- ture is that the centralization of power is a prerequisite for successful economic policy change. Researchers widely assert that price liber- alization, the withdrawal of subsidies, privatization of state-owned enterprises, expenditure cuts, tax increases, removal of trade bar- riers, deregulation and various other policies associated with the
“Washington Consensus” of market reforms are overwhelmingly un- popular.1Such policy reforms are assumed to imply significant, imme- diate costs to well-defined groups in society (the losers), while in the short term, the vast majority of society (the winners) have a difficult time appreciating the gains to be had via economic liberalization. Be- cause the benefits from market-oriented measures are thought to accrue only over the medium to long term, early losers have every incentive to organize against reforms at the expense of the diffuse, unorganized,
1For the quintessential statement of the policy reforms associated with the Washington Consensus, see Williamson (1990).
and poorly identified plurality of future beneficiaries (Callaghy1991;
Przeworski 1991; Nelson 1992; Haggard and Kaufman 1995).2 The obvious political problem is how to sustain reforms that require intense sacrifices early on for the promise of future economic improvements.
Regardless of the specific independent variables researchers focus on, the near uniform prescription for this political dilemma is to fuse power. Thus institutional analyses point to the need for a strong, po- litically insulated chief executive to transcend the resistance of vocal losers. As a number of researchers have noted (Haggard and Kaufman 1995; Mainwaring and Shugart1997; Carey and Shugart1998), strong constitutional powers may allow presidents to implement reforms in even the most inhospitable of political environments and thus over- come the gridlock that can plague market reform initiatives. In such
“hyperpresidential” systems, executives can initiate reforms by decree, override legislative opposition to liberalizing initiatives with vetoes, or any combination thereof. Likewise, party system research empha- sizes the advantages of dominant political parties that supposedly are more likely to initiate market reforms because their electoral strangle- hold assures incumbents that the political costs will not forfeit them the next election (Callaghy1991). Echoing the value of centralism and autonomy is the research on bureaucratic capacity, which emphasizes the need for autonomous technocrats shielded from buffeting political pressures (Na´ım 1993; Waterbury 1993). The cult of the technocrat suggests that only politically insulated specialists will be able to de- sign and implement coherent reform policies in the face of widespread political opposition. In all cases, policy change is facilitated to the de- gree that institutions remove the give and take of politics from the reform agenda, for only when committed reformers cum heroic lead- ers are liberated from widespread rent-seeking can market reforms succeed.
Two points are worth emphasizing in light of the supposed benefits of fusing political power. First, recent research suggests that the ben- efits of centralized political power can be overstated. Hellman (1998) and Remmer (1998), writing on different regional contexts, for in- stance, note that strong executives and hegemonic parties are likely to
2For a rethinking of the supposedly unpopular nature of market reforms, see the work of Stokes (2001a,2001b).
represent obstacles to economic policy reform as they are subject to political capture or risk aversion in the face of pending policy change.3 Second, and more important for the question at hand, the debate as to the optimal concentration of political authority to initiate and sus- tain economic reforms has generally not extended to thegeographicor verticaldistribution of power in societies. Federalism as a means to in- stitutionally organize a polity is grounded in the decentralization and fragmentation of political power. It seems quite reasonable to expect that the geographic dispersal of authority across local and regional governments, each with their own constituencies and political incen- tives, will influence economic policy reforms. And such is most likely where those governments have significant public sector responsibilities and when the reforms themselves have unequal geographic costs and benefits.
The Conventional Characterization of Federalism
Unfortunately, the traditional federalism literature, although cognizant of the potential for incongruent policy across levels of government, is not terribly helpful in thinking about the potential difficulty of co- ordinating economic policy across levels of government. By design, federalism institutionally fragments power among politicians at the national and regional level, each with their own distinct interests and each with relative autonomy in some policy spheres. It is in this geo- graphic fragmentation of constituencies that federalism is distinct from unitary variants of the modern state. Indeed, the authors of theFederal- ist Paperssaw the distribution of power into distinct regions as a natural means to check the power of the national government and augment the representation of citizens in each constituent “republic.”4The relative autonomy and influence implied by such institutional arrangements contrast with politically dependent local governments in most unitary
3In the case of Hellman’s research, strong presidents are subject to capture by early reform winners who seek to lock in their gains by stalling further reforms. Similarly, Remmer argues that strong parties elected with overwhelming majorities are likely to be more risk averse and therefore unwilling to initiate economic reforms whose outcomes are uncertain.
4See Federalist Papers Numbers10and46in particular. Ostrom (1987) provides a nice synthesis of the arguments in the Federalist Papers as they bear on federalism.
systems, which in most cases do not have the political resources or institutional representation to consistently influence national policy.
Nevertheless, academics and commentators alike have historically viewed policy fragmentation and the proliferation of sovereigns as an advantage of federalism. Thus, although Riker argued that “the institutional structure of most contemporary federalisms is highly con- ducive to intergovernmental conflicts and the failure to integrate poli- cies,”5 most available literature is overwhelmingly positive in its as- sessment of federalism’s decentralized arrangements. Social scientists assert that federalism enhances national unity and consensus (Lijphart 1977; Elazar 1987), promotes security (Kincaid 1995), protects citi- zens against encroachment by the state (Weingast1995), limits ethnic conflict (Hechter2000; Amoretti and Bermeo2003) and safeguards in- dividual and communal liberty (Friedrich1968). Similarly, researchers attribute significant economic advantages to federal arrangements, sug- gesting that they are uniquely responsive to the dual pressures for both internationalization and localization associated with an increasingly global economy (Elazar 1995; Watts 1996; Newhouse 1997; Doner and Hershberg 1999). As national economies are increasingly inte- grated into international markets, governments are faced with citizens, who at the same time that they are participants in the global mar- ketplace, demand a flexible, responsive public sector. That the case, decentralized and shared governance in a federal context supposedly ensures a more efficient delivery of public goods, limits government intervention in the economy, brings decision making closer to citizens, and encourages the emergence and maintenance of effective markets as a result of the competitive pressures that states and provinces place on national governments (Tiebout1956; Oates1972; Buchanan1995;
Elazar1995; Inman and Rubinfeld1997).
It is exactly these characteristics that have led Weingast and others (Montinola, Qian, and Weingast1995; Weingast 1995) to identify a subset of federal systems as uniquely “market-preserving.” The the- ory of market-preserving federalism is rooted squarely in the work of Tiebout (1956) and others in the fiscal federalism tradition (Oates1972, 1977,1999; Marlow 1988; Ter-Minassian1997), all of whom make several important assumptions. First, decentralized decision making
5Riker (1987:76).
helps to overcome aggregation problems by bringing policy decisions more closely into line with citizen preferences. Second, decentralized government helps electorates discipline local officials, thus solving agency problems and ensuring that local public goods bundles reflect local preferences. Finally, local decision makers are constrained by the ability of individuals and firms to “vote with their feet” – a euphemism for their capacity to move to jurisdictions that offer the most attractive package of taxes and services. These assumptions are well summed up by Peterson (1995), who writes of the United States that, “Local gov- ernments are best equipped to design and administer development pro- grams because their decisions are disciplined by market forces as well as by political pressures.”6 Proponents hold that the resulting com- petition among jurisdictions improves public services, constrains the growth of the public sector, and advances economic efficiency. Al- though significant debate surrounds the validity of these assumptions (Lyons, Lowery, and Dehoog1992; Rodden and Rose-Ackerman1997;
Bickers and Stein1998), they have provided the foundation for decades of theorizing in the fiscal and political federalism traditions.7
Weingast (1995) and coauthors (Montinola, Qian, and Weingast 1995) place these assumptions in a political economy framework, ar- guing that the economic gains theorized by fiscal federalists will only be achieved in contexts where there is a clear delineation between the au- thority of national and subnational officials, subnational governments have principal authority over the economy, the central government po- lices the common market, each level of government is forced to inter- nalize the costs of its own borrowing, and the national government is not so powerful as to be able to alter unilaterally the scope of authority of each level of government. Where such conditions exist, a federation is expected to be market-preserving in the sense that political insti- tutions credibly commit authorities to respect economic and political rights. In the absence of such internal checks on the political system, the state is likely to become leviathan-like, aggressively encroaching on the liberty of its citizens.
6Peterson (1995:18).
7Lyons, Lowery, and Dehoog, for instance, challenge the notion that local citizens are even capable of discerning which level of government delivers what services in the United States. The implications for local democratic accountability and theories of fiscal federalism are quite obvious.
As the government budgets of developing and emerging market na- tions continue to be subject to severe constraints, the World Bank and other members of the international financial community have seized on these supposed institutional advantages of decentralization and decentralized institutions to “do more with less” (IDB 1994, 1995;
Shah1994,1998). Paying insufficient attention to the scope conditions outlined in the market-preserving federalism literature, academic and policy proponents have promoted a widespread movement toward de- centralization of government policy in nations as diverse as the United States (Brace 1993), India (Rao and Singh 2000), Mexico (Grindle 1996), Brazil (Stepan2000), and Argentina (World Bank1993,1996).
Thus, just as the standard economic tools of national governments are becoming ever more constrained in a global economy (Frieden 1991), subnational governments are taking on larger roles in the policy- making process (Boeckelman1996; Deeg1996). It is more than a little ironic, therefore, that limited attention is paid to the potential costs of increased taxing and spending authority by regions for market reform efforts. Recent World Bank research (Wallich1994; World Bank1996, 1996b) and a number of independent country studies have recognized the difficulty of coordinating policies across levels of government in se- lected large developing and emerging market economies, such as Russia (Solnick 1999; Treisman 1999c; Shleifer and Treisman 2000), India (Rao1997; Chhibber and Eldersveld2000), Brazil (Shah1991,1994;
Samuels2000), and Argentina (Gibson1997; Jones, Sanguinetti, and Tommasi 2000; Remmer and Wibbels 2000);8 however, researchers commonly have underestimated the generalized nature of the problem and its shared political origins.9
Thus, although there is considerable consensus on several positive effects of federal fragmentation, researchers have paid considerably less attention to the challenges associated with coordinating policy action among decentralized actors, each with their institutionally de- fined, distinct constituencies. In cases in which policy jurisdictions are
8With respect to World Bank research, see Wallich (1994) on Russia, World Bank (1996b) on India, and World Bank (1996) on Argentina.
9For exceptions, see Treisman (1999b), who suggests that decentralized governments may complicate economic reform in diverse contexts and Gibson and Calvo (2000), who suggest the ways in which federalism generates regional coalitions with implica- tions for the phasing of market reform.
either subnational or shared across levels of government, policy re- forms require shared effort by multiple political actors. Yet, with each politician responding to his or her own survival instincts and the re- forms themselves subject to spillover effects, decision makers often have incentives to shirk.10 In the classic Olsonian sense, policy ini- tiatives become subject to intense collective action problems – no ac- tor wants to bear the costs of reform when the benefits will accrue, in part, to other jurisdictions. In many cases, central governments – themselves resistant to economic reforms – exacerbate these collective action problems. Thefollowing sectionoutlines my theoretical ratio- nale for expecting that under fairly common conditions, the incentives of national and regional governments vis- `a-vis economic reforms are likely to diverge and that the conditions for market-preserving feder- alism are, therefore, unlikely to be found in much of the developing world.
Federalism, Market Reforms, and the Challenge of Policy Coordination
Economists have long recognized that the absence of proper insti- tutional protections and incentives can deter economic development (North1981,1990; Olson1982; Williamson1985,1996). From these insights, a growing body of research has emerged that takes institu- tional frameworks as its point of departure. Federalism is an institu- tional arrangement that can create both economic and political incen- tives for subnational and national officials to conflict over economic policy reforms. A precise definition of federalism makes it clear why such collective action problems are particularly likely in such multi- tiered systems. Agreement on the general characteristics of a “com- pound republic” aside, the precise definition of federalism has long preoccupied scholars (Duchacek1970; King1982; Elazar1987; Riker 1987; Watts1996). Indeed, any cursory review of the last fifty years
10Spillovers refer to the fact that the benefits of many reforms can not be contained within regional boundaries. For example, a general government may be under fiscal pressure. In an attempt to address this problem, a region could cut its budget, but given the openness of regional economies, the benefits of the cut would be shared by all regions, none of which have had to bear the costs of the cuts. Thus, fiscal retrenchment is subject to regional spillovers.