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Beating the OddsJump-Starting Developing Countries$

Justin Yifu Lin and Célestin Monga

Print publication date: 2019

Print ISBN-13: 9780691192338

Published to Princeton Scholarship Online: May 2020

DOI: 10.23943/princeton/9780691192338.001.0001

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Unpleasant Truths about Institutional and Financial Development

Unpleasant Truths about Institutional and Financial Development

(p.44) 2 Unpleasant Truths about Institutional and Financial Development
Beating the Odds

Justin Yifu Lin

Célestin Monga

Princeton University Press

Abstract and Keywords

This chapter refutes the linear and almost teleological approach in vogue in development economics on political and financial institutions. It briefly discusses the theoretical issues at hand and suggests that policies take into account the requirements of both time and place, which emphasizes the importance of the development level. The chapter acknowledges that institutional development problems are indeed major impediments to economic growth. But contrary to conventional wisdom, it argues that they are often correlated with the level of economic development. Seen from that perspective, the well-known weaknesses in the governance and financial sectors of many poor countries today often reflect their low level of development and the results of failed state interventions and distortions originating from erroneous economic development strategies.

Keywords:   teleological approach, institutional development, economic growth, economic development, poor countries, state intervention, development economics

Thomas Edison, the intrepid American inventor who brought to the world the lightbulb and many other enlightening ideas and held more than a thousand patents, had a simple rule for recruiting his engineers. He always invited the short-listed candidates (whom he assumed to all be technically capable of doing the job at hand) for lunch and carefully observed their behavior. His objective was not to check whether they had sophisticated table manners but rather to try to deduce their decision-making process from their most anodyne acts. A key indicator he monitored was some of his guests’ propensity to add salt and pepper to their dish as soon as the food was brought to them, without even tasting it. That simple, very common, and often unconscious gesture would disqualify any prospective candidate: it revealed an inept tendency to blindly act on one’s instincts and to decide without thinking and checking the evidence.

Many researchers and policy makers working today on institutional development in developing countries may be guilty of the kind of Pavlovian behavior despised by Edison. By simply looking at the current state of institutional development in industrialized countries, they assume they know precisely what it means and how it can be measured. They mechanically compare political, administrative, and financial institutions of countries regardless of their economic development levels. They naturally find gaps between poor and rich countries, and they derive from those a generic reform agenda and policy recommendations that are not based on irrefutable evidence. They also neglect the lessons from the history of very industrialized economies, all of which started their economic development success (p.45) stories with suboptimal political, administrative, and financial institutions. The broad (and somewhat abstract) intuition on the need to improve governance in all countries has strong moral and theoretical foundations: it is the right thing to do to sustain growth, ensure shared prosperity, and build social trust and stable societies. But the conventional wisdom that low-income countries should start their development with the governance institutions of high-income countries is both a non sequitur and a historical fallacy.

This chapter refutes the linear and almost teleological approach in vogue in development economics on political and financial institutions. It briefly discusses the theoretical issues at hand and suggests that policies take into account the requirements of both time and place—the importance of the development level. The chapter acknowledges that institutional development problems are indeed major impediments to economic growth. But contrary to conventional wisdom, it argues that they are often correlated with the level of economic development. Seen from that perspective, the well-known weaknesses in the governance and financial sectors of many poor countries today often reflect their low level of development and the results of failed state interventions and distortions originating from erroneous economic development strategies.

The first part of the chapter deals with the notion of political and administrative institutions through an analysis of the concept of governance. The second part focuses on financial institutions and argues that, contrary to popular belief, third-world countries may not need first-world financial institutions before they reach certain income levels. Instead of posing first-world-type governance and financial institutions as the main prescription and a prerequisite for sustained growth in third-world countries, development economists should design policy frameworks that offer the maximum likelihood of success because they are consistent with comparative advantage and existing firm structure while providing minimum opportunities for rent seeking and state capture. The dynamic development of competitive firms and industries eventually leads to institutional development.

“Underdeveloped” Political Institutions: The Mystery of Governance

Institutional development is generally acknowledged to be the reflection or result of “good governance.” Yet an indication that good governance is (p.46) still a mystery and a difficult concept to assess, measure, and grasp confidently is the observation by A. Premchand (1993), an economist from the International Monetary Fund (IMF)—a serious organization not known for the propensity of its experts to rely on humor—that governance is like obscenity “because it is difficult to define as a legal phrase.”

Perhaps the most comprehensive and authoritative intellectual source on the subject are the Worldwide Governance Indicators (WGI). The indicators are released on a yearly basis by a team of excellent Washington-based researchers and are used widely in academic and policy circles. They define governance as “the traditions and institutions by which authority in a country is exercised. This includes the process by which governments are selected, monitored and replaced; the capacity of the government to effectively formulate and implement sound policies; and the respect of citizens and the state for the institutions that govern economic and social interactions among them.” They identify six dimensions that can measure governance: government effectiveness; regulatory quality; rule of law; control of corruption; voice and accountability; and political stability and absence of violence. That conceptual framework is then given empirical life through the use of data sources produced by a variety of think tanks, survey institutes, international organizations, nongovernmental organizations, and private-sector firms. The WGI are therefore aggregate indices that combine the views of a large number of survey respondents, including those representing enterprises, citizens, and experts in industrial and developing countries.

Such a valiant effort to give meaning to the complex notion of governance is certainly respectable. But the theoretical and philosophical underpinnings of the WGI are highly questionable. First, assessing the quality of the traditions and institutions by which authority in a country is exercised is bound to be a subjective exercise based on value judgments. It is therefore susceptible to being a reflection of ethnocentric—if not paternalistic—perspectives. There is no reason to believe that such an assessment should be performed uniformly in China, Alaska, or Zanzibar. In a world where globalization does not prevent people from seeking to assert their subjectively defined cultural peculiarities, even within old nations that were once thought to be stable and homogenous entities but now are sometimes breaking up,1 one risks falling into the double trap of universalism and relativism. There will always be those who claim that all human societies share the same goals and have adopted global standards and broad principles of (p.47) good governance embodied in internationally agreed covenants. Yet there will also always be the perception that these global standards of good governance are actually evidence of the Westernization of human values under the pretense of “universality.” Both camps have some intellectual legitimacy. That some who reject the good-governance agenda as a hidden attempt to Westernize the world may be defenders of authoritarian practices hidden behind the claim of cultural relativism does not necessarily invalidate all their arguments. After all, even those who are paranoid sometimes have true enemies.

The WGI and other indicators of good governance or democratization do not really help escape the theoretical (universalist-versus-relativist) impasse. Moreover, even if one could come up with an ingredient list that satisfies both the universalists and the relativists, the belief that good governance can be captured quantitatively and measured through subjective perception surveys will remain subject to debate and controversy. Behavioral economics shows that people are often wrong when asked to identify the true constraints that affect even their most important activities and welfare. Econometric analyses show, for instance, that popular survey results such as the World Bank’s Doing Business indicators do not correlate well with the actual constraints on private-sector performance (Bourguignon 2006). In other words, even the most successful businesspeople in the world generally fail to intuitively identify the real obstacles to productivity growth and enterprise development. If that is the case, how confident can one be about perceptions, opinions, self-assessment exercises, or assessments of others’ well-being? Philosophers have struggled to answer these questions satisfactorily at least since Arthur Schopenhauer’s famous essay on the freedom of will.

The relationship between perceptions of good governance and effective political and administrative institutions, on the one hand, and economic performance, on the other, is certainly not as simple as much of the existing economic literature would suggest. In fact, there are fundamental discrepancies between indicators of what is perceived as good governance and indicators of actual economic performance. These discrepancies also reveal fundamental issues of subjectivism and ethnocentrism that are reminiscent of the “orientalism” analyzed by Edward Said (1978) and tackled by several African researchers (Ela 1990; Monga 2015).

A good illustration of the problem can be found in countries’ corruption scale rankings, always one of the key pillars of the good governance agenda. (p.48)

Unpleasant Truths about Institutional and Financial Development

Figure 2.1. Corruption in the world: A dichotomy of good and evil?

Source: Transparency International (2014).

It is puzzling to look at the world map of corruption, the typical and most representative indicator of governance quality. Figure 2.1, from Transparency International surveys, basically shows that the world is divided into two country categories: the highly corrupt countries (in dark grey and black) and the least corrupt ones—presumably with good governance (in light grey). It is difficult to look at this map and not give some credit to the argument of some relativists, as it depicts a “good-governance” Western world surrounded by a “bad-governance” non-Western world. Transparency International is a reputable organization that does good work. But its surveys’ visual results, which display a Manichean view of the world, are deeply disturbing.

Given that the fight against corruption is an important part of the good-governance agenda, it is perplexing that corruption has been prevalent throughout human history and still exists, often on a wide scale, even in high-income countries. One simply has to read Robert Caro’s four-volume The Years of Lyndon Johnson (1982–2012), a monumental biography of the U.S. president and a detailed account of a highly corrupt U.S. Senate, or Jack Abramoff’s Capitol Punishment (2011) to realize that corruption is pervasive even in old democracies and that a good-versus-evil dichotomy among countries is highly misleading.

Newspaper headlines, empirical studies, and political biographies regularly document the persistence of corruption in the most unlikely places.

(p.49) In recent years, France gave its former president Jacques Chirac a two-year suspended prison sentence for diverting public funds and abusing public trust. In the United States, four of the past seven Illinois governors were convicted and imprisoned—including Rod Blagojevitch, the first in history to be impeached, who was convicted of numerous corruption charges in 2011, including for trying to “sell” President Barack Obama’s former Senate seat to the highest bidder. Even the holy state of the Vatican was shaken by corruption when the press revealed several confidential letters sent to Pope Benedict by the state’s deputy governor, Archbishop Carlo Maria Vigano, documenting corruption at its administration’s highest level. In Japan—a non-Western, high-income country with old democratic traditions—many high-ranking government officials have been forced out of office throughout the postwar period amid corruption scandals (Mitchell 1996). The problem has extended well beyond the political sphere and into a bureaucracy often considered one of the better managed in the world (Johnson 2001).

Of course, the economic cost of corruption and bad governance may be relatively higher in low-income countries where large fractions of the population remain poor compared with high-income countries. But if corruption—a sign of bad governance—is observed everywhere, a few questions come to mind: What exactly is corruption? Why do some countries seem to thrive despite its prevalence? And what is the real relationship between perceived levels of bad governance and economic performance?

The typical response to the unflattering truths that corruption exists everywhere and no human society can legislate morality is to argue that high-income countries are “less” corrupt than others and their institutions are “stronger”—strength shown by the number of prosecutions. But those elegant arguments are hard to empirically validate. First, it is difficult to rigorously define what corruption means anytime and everywhere, and to measure it comparatively across place and time. Second, many of both the open and hidden transactions between lobbyists and policy makers in the United States, for example, would be considered corruption in other places in the world. Third, aggressive prosecution of corruption is taking place in many low-income countries, yet in those countries such legal actions are paradoxically considered further evidence of terrible governance. A case in point is that of Cameroon, where dozens of politicians and civil servants at the highest levels of power (including a former prime minister, many (p.50) government ministers, the president’s chief of staff, heads of the largest state-owned enterprises, and ambassadors) have been tried and convicted for embezzling public funds. Yet few analysts would consider Cameroon a good-governance country. To the contrary, the more that senior government officials are arrested and sent to jail, the more that experts are convinced that Cameroon is profoundly corrupt.

Defining Corruption: Some Basic Conceptual Issues

The first sign of the inextricable difficulties of corruption analytics—with heavy implications for what the appropriate political institutions in any given country should be—is the vagueness of the definitions that one can find in the literature. The most commonly used definition is the one by A. Shleifer and R. Vishny (1993, 599), who define government corruption as

the sale by government officials of government property for personal gain. For example, government officials often collect bribes for providing permits and licenses, for giving passage through customs, or for prohibiting the entry of competitors. In these cases they charge personally for goods that the state officially owns. In most cases the goods that the government officials sell are not demanded for their own sake, but rather enable private agents to pursue economic activity they could not pursue otherwise. Licenses, permits, passports, and visas are needed to comply with laws and regulations that restrict private economic activity. Insofar as government officials have discretion over the provision of these goods, they can collect bribes from private agents.

The obvious question that this well-established definition raises is that of legality. What if there are no laws in place preventing government officials from making excessive or arbitrary use of their discretionary power? What if some of their actions, while morally and politically wrong and economically costly, are not strictly illegal? Does corruption intrinsically imply illegality? If it does, then the logical inference from the definition is that some practices may be considered “corruption” in some countries or regions and not so in others. This further complicates the assessment of the extent of the phenomenon and the comparative analysis across place and time.

(p.51) Corruption can be disaggregated along several dimensions. First, one must distinguish its prevalence, especially in large countries with decentralized or federal political systems. “Corruption can be widespread at the local government level, even if it is controlled effectively at the central government level. The United States and India provide examples where corruption is much more severe in some states than in others” (Knack 2007, 256). Second, the purpose of improper actions characterized as corruption must also be taken into account. Bribes intended to influence the design and content of laws and regulations (state capture) must be differentiated from those intended to change or circumvent their implementation (administrative corruption). Third, there is a need to distinguish among the actor categories involved in various forms of corruption: when poor people are involved, it is often referred to as petty corruption as opposed to grand corruption, which involves high-level officials and political figures. Fourth, corruption may be of a different scale and nature depending on the administrative agency in which it takes place (schools, customs, health centers, and so on).

Transparency International, arguably the most active nongovernmental organization fighting corruption around the world, has chosen a more focused operational definition of the term: “the abuse of entrusted power for private gain.” The organization further differentiates between “according to rule” corruption and “against the rule” corruption. Facilitation payments, where a bribe is paid to receive preferential treatment for something that the bribe receiver is required to do by law, constitute the first. The second is a bribe paid to obtain services the bribe receiver is prohibited from providing.

While Transparency International’s definition of corruption is much clearer, it raises another series of problems: First, since bribe payments are not publicly recorded, it is virtually impossible to calculate the financial transactions that they entail. Second, bribes do not always take monetary form: favors, presents, services, and even threats and blackmail are just as common. These factors highlight new issues, such as the strength of the judicial system and its ability to effectively handle complaints at the lowest possible cost; the prevailing cultural and behavioral norms; and so on. Even less quantifiable are corruption’s social costs. “No one knows how much the loss of an energetic entrepreneur or an acclaimed scientist costs a country. Moreover, any estimated social costs in dollars would be inadequate to the (p.52) task of measuring the human tragedy behind resignation, illiteracy, or inadequate medical care.”2 All this explains why it is impossible to measure the true net social and economic cost of corruption, regardless of how it is defined.

In fact, much of the research on governance—regardless of how it is defined—and institutions in general suggests implicitly, if not explicitly, that they are mostly exotic phenomena that can be observed only on a wide scale in countries under a certain income level. Although there is obviously recognition that corruption also occurs in high-income countries, it is treated as an insignificant example of poor behavior by public officials or businesspeople who represent the exception and not the rule. These high-profile, headline-grabbing cases are considered outlier or minority cases (the so-called bad apples) and therefore are either ignored or discounted by mainstream economic research. Nothing could be farther from the truth.

Defining and measuring corruption is a difficult task, not least because it is not always considered a crime but a general classification for a variety of criminal acts, such as bribery, breach of trust, abuse of authority, and misappropriation of public funds. The definitions of these criminal acts differ not only between countries but also within national boundaries. For instance, while all of Japan is subject to one penal code, and therefore a single definition, the United States has fifty different penal codes (one per state) as well as a national (federal) code, resulting in numerous definitions. Moreover, Japan keeps detailed statistics on corrupt acts, whereas the United States has no centralized record keeping for such acts (Castberg 1999).

Still, consider these statistics: between 1987 and 2006, federal prosecutors convicted more than 20,000 government officials and private citizens involved in public corruption offenses in the United States.3 That is an average of 1,000 a year for several decades. The actual number is higher, since these numbers do not include public corruption convictions that result from prosecution pursued by state district attorneys or attorneys general. Also, public officials in any given U.S. state can be corrupt but not charged simply because federal prosecutors do not have the resources or the political will to bring cases and win convictions; such public corruption cases would not be reflected in the Department of Justice’s dataset.

These conceptual difficulties of defining corruption in a rigorous and comparable way across countries explain why social scientists from various disciplines have come up with contradictory theories of corruption and (p.53) mostly inconclusive empirical evidence on its impact on economic growth and political liberalization.

The Changing Perceptions of Corruption and Governance

The dominant view of good governance as a precondition for economic success is therefore misguided. By focusing on the search for the determinants of global governance standards that often reflect particular political, philosophical, and ideological concepts of power, the traditional literature on governance has so far yielded few results. It has failed to offer a set of actionable policies that poor countries could implement to foster inclusive growth in a pragmatic and incentives-compatible way.

In fact, good governance has been an elusive quest. Since the United Nations Commission on Human Rights identified transparency, responsibility, accountability, participation, and responsiveness to the needs of the people as key attributes of good governance (Resolution 2000/64), the fight against corruption has become the most revealing and the most widely discussed aspect of governance. The academic pendulum on the subject has shifted from praising the economic efficiency effects of corruption to stressing its many economic, sociopolitical, and even moral costs to societies.

Initial theoretical work on corruption underlined its positive role in development. Renowned scholars such as Nathaniel Leff (1964) and Samuel Huntington (1968) argued that corruption may allow businesspeople to be more efficient by allowing them to circumvent bureaucratic procedures and therefore avoid the burden of red tape. Similar arguments were made in subsequent studies: F. T. Lui (1985) developed an equilibrium-queuing model to show that corruption allows the queue to be reorganized in a way that leads to an efficient allocation of time, giving those for whom time is most valuable the opportunity to move to the front of the line. The same efficiency argument can be found in D.-H. D. Lien (1986), who even suggested that corruption actually helps ensure that contracts are awarded to the most efficient firms (those that stand to gain the most from the payment of bribes).

A second strand of the literature has attempted to invalidate these previous analyses, arguing, for instance, that beyond possible changes in the order in the queue, bribes may actually allow civil servants to reduce the speed with which they process business transactions in the queue (Myrdal 1968), or that bureaucratic procedures should be seen not only as causes (p.54) of rent-seeking activities but as their consequences (Tanzi 1998). Maxim Boycko and colleagues (1995) also stressed the higher degree of uncertainty and costs due to enforceability problems created by corruption.

Others have argued that even taking at face value the suggestion that the most able economic agents in corrupt societies are also engaged in and benefit from rent-seeking activities, such talent reallocation cannot be economically efficient. Susan Rose-Ackerman (1975), for instance, observed that once corruption is entrenched it becomes so pervasive that it cannot be limited to areas in which it might be economically “desirable.”

A third and most recent strand of research has focused on the negative effects of corruption (and bad governance more generally) on economic growth. K. M. Murphy and colleagues (1993) suggested that increasing returns on rent seeking may eventually crowd out productive investment. P. M. Romer (1994) made a similar point, emphasizing the idea that corruption imposes a tax on ex-post profits, which may reduce the flow of new goods and technology. Paolo Mauro (1995) offered empirical evidence that the prevalence of perceived corruption may negatively affect economic performance and pioneered econometric work on the subject. His conclusions were confirmed by Philip Keefer and Stephen Knack (1997) and Hélène Poirson (1998), who also observed that corruption substantially reduces economic growth rates. Such problems are said to be even worse in countries rich in natural resources—especially those in the developing world—where opportunities for rent-seeking activities are typically very high.

Despite the insights from all these various waves of research, the problems of corruption and governance and their implications for economic development remain unresolved. Empirical demonstrations of the impact of governance on economic growth are often based on subjective perception indices, the limitations of which are well known. Policy makers in developing countries still have few actionable prescriptions for how to design policies to achieve their economic and governance goals. Moreover, a traditional recommendation for improving governance often involves curbing the power of political leaders—some of whom are not democratically selected. Yet the social sciences literature does not provide an incentives-compatible mechanism for political leaders to improve governance and eliminate corruption. For low-income countries, a potentially more fruitful approach to tackling the problem would be to examine the possible determinants of good governance and infer from these determinants which (p.55) policies could limit opportunities for rent seeking that contribute to political leaders’ personal goals.

The Opportunity Cost of the Good Governance Rhetoric

The opportunity cost of the good governance rhetoric and the obsession that low-income countries must have the same political institutions as high-income countries is perhaps well explained through the story of a fake corruption scandal surrounding the visit of the president of Congo to New York in September 2005. He was there to attend the sixtieth summit of the United Nations. His official purpose was to give a fifteen-minute speech to the UN General Assembly; he also had meetings with other political leaders and members of the world business community.

Questions arose when hotel bill for the president and the fifty-six people in his entourage was leaked to the press. Copies of the bill were headline news all over the world. True, the numbers were grotesque—at least at first sight. They revealed that Denis Sassou Nguesso, the former military man who had ruled Congo from 1979 to 1992 and had been in power again since 1997 after a civil war that left thousands of people dead, had spent $295,000 for an eight-night stay at the Palace Hotel on New York’s Madison Avenue, including some $81,000 for his own suite. He was charged $8,500 a night for his three-story suite, which the hotel advertised as one of a quartet of art deco–inspired triplex suites that are unlike any others in New York City, featuring marble floors, expansive views of midtown Manhattan from 18-foot windows, and spacious, private roof-top terraces. The suite featured a master bedroom with a king bed, two additional bedrooms with two double beds, and six bathrooms. It also had its own private elevator. Media reports noted that President Sassou Nguesso had a whirlpool bathtub and a 50-inch plasma television screen, and that his room service charges on September 18 alone came to $3,500. The total charges for room service during his stay amounted to $12,000.

In their voyeuristic quest for juicy details, journalists tried to determine what cost so much money. But the hotel did not itemize the charges. Reporters were left to speculate about the items available on the room service menu, which included Dungeness crab, truffle crumbles, Scottish langoustines, pan-seared foie gras, braised snails in chicken mousse, and other exotic selections. They also made a big deal of the Congolese mission at the UN paying only a $51,000 deposit by check to secure the rooms, and the (p.56) settlement of the final bill’s balance by a $177,942.96 cash payment, “an extraordinary sum for any hotel guest to be carrying” according to one journalist.4 Presidential aides pulled out wads of $100 notes to settle the bill for twenty-six rooms.

All the more stunning to reporters was that President Sassou Nguesso was at the time the chairman of the African Union, representing the continent’s fifty-three countries, and also negotiating with the World Bank and the International Monetary Fund for the cancellation of a large fraction of Congo’s debt held by the two multilateral institutions on the grounds that the country could not afford to repay them in full. His government was also talking to the Paris and London Clubs, two informal groups of official and private creditors, respectively, whose role is to find coordinated and sustainable solutions to debtor countries’ payment difficulties. It was therefore shocking to political analysts that such a country’s leader would choose to stay at one of Manhattan’s most expensive hotels.

As could be expected, the news was received with shock and anger, especially by people in Congo, who probably would have liked their tax money spent on other priorities. Outraged by President Sassou Nguesso’s apparent extravagance, leaders of nongovernmental organizations and anticorruption movements wrote letters to the World Bank’s president urging him to oppose any debt relief operation for Congo until the country’s leaders could demonstrate better public finance management skill. Global Witness, a well-known anticorruption group, issued a report claiming that Congo’s oil wealth has “for too long been managed for the private profit of the elite rather than for the benefit of its entire population” (Allen-Mills 2008). Not surprisingly, Paul Wolfowitz, then president of the World Bank, was more than inclined to bow to the pressure. It took a forceful response from the office of the executive director for francophone Africa on the board of directors of the World Bank to refocus the debate on Congo’s debt relief back on the real issues at hand.

Let’s step back and look at the situation in the context of normal diplomatic practices. Why the outrage about a hotel bill of a few hundred thousand dollars for a large presidential delegation on an official visit to the United Nations? After all, hotel suites are expensive in New York in September, especially in the small number of luxury hotels where foreign heads of states are forced to reside—for security reasons—when they attend the annual UN meetings. Would those who cried foul about the hotel bill’s amount have preferred that the president of Congo and his entourage (p.57) sleep on the streets of New York or settle in a two-star hotel somewhere in neighboring New Jersey or Connecticut while attending the summit? Hopefully not: even the president of “poor” Congo certainly deserves the same treatment that his peers from “rich” countries receive during their official trips abroad.

Is Incompetence Worse than Corruption?

There are certainly many important economic and even governance issues to be discussed about Congo and other low-income countries. But the focus on the superficial problem of the hotel bill of a sovereign country’s president on an official visit to the United States obscured the real questions of whether the public policies implemented by his government were sound enough to bring strong economic growth and prosperity to his people. While the bill might have been expensive, the only reason it was disclosed to the press was that some of Congo’s creditors had filed lawsuits against the country through U.S. and British courts over business debt repayment. These were all “vulture” investment funds that make profits by speculating and buying up poor countries’ debt at a discount price. Using a judgment from two British High Court judges that found Congolese officials to be “dishonest” about their country’s debt, the vulture fund managers had subpoenaed President Sassou Nguesso’s hotel bill and leaked it to the media as corruption evidence. Yet few newspapers that reported the sensationalist tale of President Sassou Nguesso’s hotel bill devoted time and resources to investigate the even more important story of these vulture investment funds—what they are, how they function, and how poor countries around the world should deal with them.

One fund manager was quoted saying that the president’s hotel suite cost “more per day than the average Congolese makes in a decade.”5 This was probably an exaggeration, but it was beside the point. Would the media have shown the same interest in the story if the hotel bills were run up by a leader from a country with a better reputation? Would these questions have arisen if the president of an industrialized country had spent the same amount of money for a stay in the city? Did anyone calculate the cost for the trip to New York by the U.S. president (including the cost of flying Air Force One from Washington to New York) and compare it to the $30,000 annual income per capita in the United States? Was the problem merely Congo’s intolerable poverty level? Or were the attacks against (p.58) Sassou Nguesso motivated by other factors—ignorance, class prejudice, racial prejudice, and so on?

Perhaps because he had read news reports and briefing memos on issues such as the Sassou Nguesso hotel bill story, U.S. president Barack Obama used his first official trip to Africa (Accra, Ghana, July 2009) to speak out against corrupt leaders:

Repression can take many forms, and too many nations, even those that have elections, are plagued by problems that condemn their people to poverty. No country is going to create wealth if its leaders exploit the economy to enrich themselves or if police can be bought off by drug traffickers. No business wants to invest in a place where the government skims 20 percent off the top or the head of the Port Authority is corrupt. No person wants to live in a society where the rule of law gives way to the rule of brutality and bribery. That is not democracy. That is tyranny, even if occasionally you sprinkle an election in there. And now is the time for that style of governance to end.

Those words were met with polite applause. But many African leaders and intellectuals objected to the speech’s paternalistic tone and the perceived double standards that underlined Obama’s public ethics lecture. Festus G. Mogae, the Republic of Botswana’s former president, sarcastically observed in 2009 that Obama’s critique of African corruption on his first official visit there seemed quite selective:

[Obama] has been to the Middle East, to Turkey, to Russia, to Europe, to Britain—Britain where Parliamentarians have been doing their own thing, Germany where Siemens has been indicted for corruption, Russia, and the Middle East, [places] which are not known for their anti-corruption probity. … So, while it is right and proper that the President should have raised the issue of corruption, the fact that he only raised it when he got to Africa has the effect of perpetuating the misconception that corruption exists only in Africa.

The story of President Sassou Nguesso’s hotel bill illustrates the confusion and fantasies that have too often plagued public policy when the good governance obsession leads to distracting public discourse and focus on the (p.59) wrong development objectives. By devoting attention to valid but less important questions, such stories sidelined the much bigger economic issues of public investment priorities, flawed debt management strategies, and economic policy mistakes throughout the decades that are much costlier to Congo.

Unpleasant Truths about Institutional and Financial Development

Figure 2.2. Governance: The forgotten aspects.

Source: Authors.

Similar stories can be told about many other countries. In the neighboring Democratic Republic of Congo (DRC), the public debate about corruption and good governance was dominated in 2013 by the story of fifteen government officials who pocketed $52 million in mining rents in 2012. Again, that was a valid issue. But the public debate over corruption and good governance never tackled the much bigger problem: that the mining sector represents one-third of the DRC’s GDP but only 10 percent of fiscal revenue. This is a clear indication that something is profoundly wrong with the framework for sharing rents between the state and foreign firms. The DRC receives less than 5 percent of revenues generated by mining firms operating in the country, while the ratio is as high as 60–80 percent in the Gulf countries or other African countries such as Algeria. Honest incompetence and bad economic strategies are neglected, despite their potentially serious consequences on productivity and growth (figure 2.2).

Likewise, the African Union has devoted many resources to promoting the findings of its Report on Corruption released by its commissioner on human rights and administrative justice in 2012, which indicates that an estimated $148 billion is lost to corruption every year. Clearly, such waste deserves publicity and reflection, because these funds, often meant for projects such as schools and hospitals, are diverted into the pockets of corrupt (p.60) public officials. But the sum should be compared to the GDP of more than $2 trillion for the continent and to the much larger sums of money wasted on unproductive public expenditures. Honest policy mistakes that are even costlier than corruption should be part of the governance agenda and appropriately debated.

An Incentives-Compatible Policy Framework for Governance

Most studies on the determinants of good governance go back to arguments similar to those made by either Gary S. Becker (1968) or Anne Osborn Krueger (1974). Becker analyzed corruption as a purely illegal activity and suggested that criminal offenses must be viewed as “economic activities” with external effects and punishment conceived as a form of taxation. From that general framework he conjectured that the probability of committing a crime depends essentially on the penalty imposed and on the probability of being caught. Furthermore, the penalty’s deterrent value depends on the authorities’ willingness and capacity to enforce laws and regulations and also on people’s acceptance of the country’s institutions. This implies that effective corruption enforcement rules and good governance in general can take place only in countries with political stability and transparent rules.

In Becker’s insightful analysis, corrupt agents expend resources to steal, and society, the victim, experiences negative external effects. Using the Pigouvian solution to negative externalities—to introduce fees or taxes on the externality-generating activity—he suggests that prohibition rules combined with fines or other punishment make up such a fee system. Unfortunately, this kind of after-the-fact remedy to corruption may arrive too late. It may be ineffective in countries where the externality-generating activities (that is, corruption) are not easy to identify owing to prevailing social norms and practices or may be costly to curb. In almost all poor countries, the costs of running a well-staffed, well-equipped, and well-functioning national judicial system are often far beyond what the public sector can afford. The problem is compounded in many African countries where corruption is embedded in societal, economic, and power relations (Monga 1996), and virtually all state institutions, including the judicial system, are caught in the low-equilibrium dynamics of what Richard Joseph (1998) called “prebendal politics.”

But “corruption isn’t just something that happens to poor countries” (Glaeser and Saks 2004, 1). If one looks at corruption in historical (p.61) perspective, it is clear that today’s high-income countries also went through the same—or even worse—bad governance episodes that can now be observed in sub-Saharan Africa. In the fascinating book Corruption and Reform (2006, 3), Harvard University’s Edward Glaeser and Claudia Goldin analyze various schemes and patterns of bad governance in the history of the world’s greatest democracy. The results are disconcerting. “Conventional histories of nineteenth-and early twentieth-century America portray its corrupt elements as similar, and at times equal, to those found in many of today’s modern transition economies and developing regions. Nineteenth-century American urban governments vastly overpaid for basic services, such as street cleaning and construction, in exchange for kickbacks garnered by elected officials. Governments gave away public services for nominal official fees and healthy bribes.”

These elements provide a crucial clue to the problems of corruption and governance: that they are endogenous to the economic development level. In other words, low-income countries are by definition places where (perceived) corruption is a problem, and their governance indicators improve with their economic performance. It is unrealistic to expect the Democratic Republic of Congo, a country of less than $200 income per capita, to build governance institutions that are perceived as effective as those of Norway, where per capita income is $80,000.

Figure 2.3 confirms and illustrates that simple historical truth. It shows a clear correlation between the perception of good governance and income growth. If that is the case, then what is crucially needed to fight corruption and improve governance in low-income countries is a development strategy that offers few opportunities for state capture and rent-seeking activities. In other words, the main solution to corruption is to create a policy environment where there are few opportunities and gains for such externality-generating activities. If a government adopts a comparative-advantage-following strategy, firms in the priority sectors will be viable in an open, competitive market, and the government will not need to protect or subsidize them through various forms of distortions. The result will be dynamic growth, fewer rents, and fewer opportunities for rent seeking. By contrast, if the government adopts a comparative-advantage-defying strategy, the result will be just the opposite (Lin 2009).

What does this leave us? If poor governance (at least as measured by perception indicators) is indeed a low-income disease, the obvious way (p.62)

Unpleasant Truths about Institutional and Financial Development

Figure 2.3. Governance performance and GDP per capita: the algebra of mystery.

Source: Lin and Monga (2012).

of achieving good governance is to focus on development strategies and policies that quickly lead to economic growth while minimizing the opportunities for state capture and rent seeking. In sum, “good political governance” is a difficult concept to operationalize, and there is no generic or universal prescription for it. Despite the beautifully formulated language of UN treaties and the official commitment to the good governance agenda by countries from around the world, no international entity or research body has the qualifications to legitimately measure someone else’s governance quality. Good political governance should be an important public policy goal and be set freely by the all countries’ people and leaders. It should not, however, be a precondition for good economic performance. Sustained economic growth, employment creation, and poverty reduction can be achieved even in very poor governance environments. Moreover, good political governance is always an unfinished process.

Good economic governance is also a noble goal, and its general principles can be widely shared across nations and cultures. But operationalizing it is likely to vary widely across place and time. To succeed at this goal, a policy agenda is needed that focuses on using limited state resources strategically and wisely. Focus areas should include setting economic policy to ensure that only activities that are consistent with comparative (p.63) advantage are encouraged; ensuring that government at all levels has the tools, incentives, and discipline to facilitate public-private partnerships in the development of competitive industries; and setting rules of the game that are enduring and effective (transparency, time limits, collective action, and so on).

Following the type of policy-oriented approach suggested by Krueger (1974), the empirical literature has identified seven factors as the main causes of corruption:

  • ➔ Trade restrictions, which make the necessary import licenses very valuable and encourage importers to consider bribing the officials who control their issue

  • ➔ Poorly targeted government subsidies that are appropriated by firms for which they are not intended

  • ➔ Price controls whose purpose is to lower the prices of some goods below market value (usually for social or political reasons) but create incentives for individuals or groups to bribe officials to maintain the flow of such goods or to acquire an unfair share at the below-market price

  • ➔ Multiple exchange rate practices and foreign exchange allocation schemes. Differentials among these rates often lead to attempts to obtain the most advantageous rate, although that rate might not apply to the intended use of the exchange, and multiple exchange rate systems are often associated with anticompetitive banking systems in which a particular bank with strong political ties makes large profits by arbitraging between markets.

  • ➔ Low wages in the civil service relative to wages in the private sector, which often lead civil servants to use their positions to collect bribes as a way of making ends meet, particularly when the expected cost of being caught is low

  • ➔ Natural resource endowments

  • ➔ Sociological factors such as ethnolinguistic fractionalization (Mauro 1995)

Given that virtually all governments in the world—including those in successful democratic countries—regularly intervene in their economies and set various types of regulations, the important question is: which (p.64) particular policy circumstances provide the best incentives for good governance? New Structural Economics (Lin 2012a) attempts to articulate a response to this question. Leaving aside the last two factors identified by Krueger, it specifically recommends policies and safeguards to ensure that the essential responsibilities of any state be carried out in a way that mitigates the risks of state capture and rent seeking. It suggests the gradual lifting of trade restrictions, price controls, and multiple exchange rates, recognizing that such interventions and distortions are temporarily needed to protect nonviable firms in sectors that defy comparative advantage. It advocates carefully targeted incentives (of limited amount and time), allocated in a transparent manner to compensate for the externality generated by pioneer firms—even in industries that are consistent with comparative advantage.

Such a framework ensures that corruption opportunities are minimal. It favors government interventions only in industries where firms are viable in open, competitive markets, and whose investment and survival do not depend on protection, large budgetary subsidies, or direct resource allocations through measures such as monopoly rent, high tariffs, quota restrictions, or subsidized credits. In the absence of large rents embedded in public policies, there will not be distortions that become the easy targets of political capture. The likelihood of the pervasive governance problems that are observed in many low-income countries can be much reduced when governments facilitate the development of new industries that are consistent with the country’s changing comparative advantage, determined by the change in its endowment structure.

The goals of most political leaders everywhere are typically to stay in power as long as possible and to have a positive legacy (if their staying in power is not under threat). Most leaders understand that promoting economic prosperity is the best way to achieve these goals. Development policy based on new structural economics, which advises governments to facilitate the entry of private firms into sectors with comparative advantages, can reduce corruption and bring dynamic growth to a country. Good governance will be the result of such a strategy, because there is no need to create rents that subsidize and protect firms in the priority sectors. Therefore it is an incentives-compatible way for political leaders in developing countries, including those in poor countries, to address challenging governance issues.

(p.65) “Underdeveloped” Financial Institutions: The Illusions of Intellectual Mimicry

On the list of the most recurrent obstacles and preconditions to growth and poverty reduction, the next culprit often singled out in the literature as a key constraint to economic development is limited access to finance. As with the challenges discussed earlier, weak institutional development in the financial sector is a major impediment to economic growth, employment creation, and poverty reduction. Because finance plays a substantial role in modern economies, researchers have long debated the relative importance of banks and financial markets in a financial system. The 2008–09 global financial and economic crisis has also led to calls for improving domestic and international financial regulations and supervision.

Money is obviously an indispensable commodity for households and firms. In survey results it also appears to be a major bottleneck for business creation and development. Moreover, bankers and financiers are universally considered villains whose propensity for greed and shortsightedness are such that entrepreneurs everywhere cannot expect their support in their drive for value creation. In her compilation of jokes about them, Anna White (2011) recounts the widely shared belief that “bankers are people that help you with problems you would not have had without them.” She also recounts the story of a man who visits his bank manager and asks, “How do I start a small business?” The manager replies, “Start a large one and wait six months.”

It is not surprising that the generally weak and underdeveloped financial systems that are so prevalent in low-income countries are perceived as prime suspects in the search for impediments to growth and poverty reduction. At least since Adam Smith and Alfred Marshall, there has been much discussion about financial systems’ role in the economy. Joseph Schumpeter, Alexander Gerschenkron, and others pointed to banks as an economic growth engine in industrialized economies. Following the pioneering work of Raymond Goldsmith (1969), Ronald McKinnon (1973), and Edward Shaw (1973), a rich theoretical and empirical literature has advanced the view that the amount of credit the financial sector can intermediate is an important economic performance determinant. It is almost conventional wisdom that finance is not simply a development by-product but an engine propelling growth. Economic research on the subject generally concludes (p.66) that a large, well-functioning financial sector with deep and liquid markets can generate the necessary credit to support economic growth and reduce growth volatility.

Here again, while the theoretical case for making such a judgment seems quite strong, empirical analyses offer a much more complex story. The theoretical case is as follows: Economic prosperity, the pursuit and result of improvements in physical and human capital and productivity, depends in theory on the efficient and optimal use of productive assets and on including the largest segments of the population in that process. Effective financial intermediation is therefore essential to the smooth unfolding of that process, as agents with excess savings (whether domestic, like households and firms, or foreign) should be encouraged to provide funding at optimal cost to support investment by firms. The state should also establish the appropriate regulatory framework to ensure that these funds are allocated by the financial system to the most productive use, with risk and liquidity levels that allow firms to create value and operate efficiently. Both savers and investors face risk and uncertainty, and the financial system can help them mitigate it or capitalize on it. Savers are generally unable to select the investment project that best matches their personal risk tolerance—except at high costs—and without pooling their money they cannot take advantage of increasing returns to scale in investments (Stiglitz 1998).

Asli Demirgüç-Kunt and Leora Klapper (2012, 2) sum up the intellectual consensus on financial systems’ capacity to reduce poverty:

Well-functioning financial systems serve a vital purpose, offering savings, credit, payment, and risk management products to people with a wide range of needs. Inclusive financial systems—allowing broad access to financial services, without price or nonprice barriers to their use—are especially likely to benefit poor people and other disadvantaged groups. Without inclusive financial systems, poor people must rely on their own limited savings to invest in their education or become entrepreneurs—and small enterprises must rely on their limited earnings to pursue promising growth opportunities. This can contribute to persistent income inequality and slower economic growth.

But empirical research tends to show that the relationship between financial development, economic growth, and poverty reduction is much (p.67) more complex and varies depending on many other factors, such as the country’s development level, the financial structure, and existing regulations. Stephen Cecchetti and Enisse Kharroubi (2012, 1) investigate two simple questions: “Is it true [that financial development is good for economic growth] regardless of the size and growth rate of the financial system? Or, like a person who eats too much, does a bloated financial system become a drag on the rest of the economy?” From a sample of developed and emerging economies, they show that the financial development level is good only up to a point, after which it becomes a drag on growth. Focusing on advanced economies, they also show that a fast-growing financial sector is detrimental to aggregate productivity growth.

These findings raise important questions for policy makers. The types of financial institutions, the criteria under which they are established and can expand, the rules governing the specific market in which they operate, and even the major instruments they use to mobilize savings from households and firms into enterprise investment and household consumption, to monitor investments and allocate funds, and to price and spread risk are indeed key elements for policy consideration. They are important because in market economies, financial intermediation carries strong externalities, which can be either positive (such as information and liquidity provision) or negative and even threatening to the entire economy (such as excessive risk-taking behavior, contagions, and systemic financial crises).

The Quest for Appropriate Financial Institutions

There is a vast body of literature analyzing the relative advantages of various banking structures. But taken as a whole, the existing research has not reached consensus on the strengths and weaknesses of various types of financial structures—defined as the composition and relative importance of various financial institutional arrangements in a financial system—in promoting economic growth.6 There also is little consensus among researchers on the important policy questions at hand: the strengths and weaknesses of various types of financial structures and why they may promote economic growth in different country settings. The reasons for these gaps in the literature are the neglect of the specific characteristics of the real economy at each level of development and the corresponding needs in terms of financial structure. Understanding the difference in financial structure and how it is related to economic development is indeed essential and can provide (p.68) policy implications for many countries, especially those developing countries that are making efforts to strengthen their financial system.

Economic research shows that financial markets tend to be more active than banks in countries with higher income per capita (Goldsmith 1969; Demirgüç-Kunt and Levine 2001). The literature has focused on the causal relationship between financial structure and economic growth, that is, whether a market-based or bank-based financial structure is better for economic growth.7 Bank-based structure proponents argue that banks and other financial intermediaries have advantages in collecting and processing information, while financial markets provide much weaker incentives for agents to collect information ex ante and monitor borrowers (or stock issuers) ex post. Thus financial markets are at a disadvantage in alleviating informational asymmetry, and therefore a financial system with a bank-based structure should perform better in allocating resources and promoting economic development (Grossman and Hart 1982).

Not surprisingly, those who favor a market-based structure focus on the problems created by powerful banks. Bank-based systems may involve intermediaries that have huge influence over firms that may damage economic growth (Rajan 1992). In addition, banks tend to be more cautious by nature, and so bank-based systems may stymie economic innovation and impede economic growth. Furthermore, financial markets are often seen as providing richer and flexible risk-management tools for agents while banks can provide only basic risk-management services.

The economic literature that focuses on banking structure tends to examine whether competitive or monopolistic banking structure is better for economic growth. Some authors suggest that monopolistic banks may extract too much rent from firms, pay lower deposit interest rates, and thus lead to more severe credit rationing, which has very negative effects on economic growth. But others argue that monopolistic banks have more incentive to collect information, screen and monitor borrowers, and form long-term relationships with borrowers; therefore investment projects have more chances to get financed. In a competitive banking sector, borrowers can more easily shift between lenders, so banks may have less incentive and less capability to forge such long-term borrower-lender relationships. Such borrower-lender relationships are especially valuable to start-ups and new firms. Empirical results on this topic are far from conclusive. Some studies show a positive relationship between banking concentration and (p.69) stability (Beck, Demirgüç-Kunt, and Levine 2007). Others find that new firms grow faster in economies with a more concentrated banking sector, but old firms benefit from a more competitive banking structure (Petersen and Rajan 1995).

Despite their diverging conclusions, these two main schools of thought actually adopt a similar research perspective. They typically start from an examination of the characteristics of various financial institutional arrangements and then offer a discussion of the possible effects of financial structure on economic development. Researchers adopt this perspective probably because they are interested in studying the effect of financial structure on economic growth. Yet its effect on growth may not be appropriately determined if its examination is separated from the examination of how the financial structure is determined. While the research on banking structure has focused on banking concentration, the important topic of the distribution of banks of different size and its economic significance has been neglected. The well-established fact that small businesses, the dominant form of business operations in developing countries, usually have difficulty obtaining loans from big banks suggests that bank size does matter for the allocation efficiency of the banking sector.

A few studies have examined the mechanisms affecting the determination of financial structure. R. G. Rajan and Luigi Zingales (2003), for instance, apply interest group theory to explain the difference in financial structure in countries at a similar development stage. Others have emphasized the legal system’s importance in determining financial structure, arguing that legally protecting investors and effectively implementing the law are more critical for operating financial markets than for banks. Thus a bank-based financial system will have advantages in countries with a weak legal system. This logic, however, does not explain the following observed facts: the financial development level and financial structure are usually different in countries with a similar legal origin but at different development stages, and the financial structure in the same country changes as the country’s economy develops. In fact, any effective financial development theory should take into consideration the financial structure’s endogeneity when analyzing the relationship between financial structure and economic development.

To sum up, much of the literature adopts a supply-side approach. It starts from an examination of the characteristics of various financial (p.70) arrangements and then discusses the likely effects of different financial systems on economic growth. Financial structure is actually seen as not relevant, and the real economy’s characteristics are ignored. It is important to pursue a radically different demand-side approach, one that starts from the analysis of the real economy’s characteristics and the real economy’s demand for financial services. The reason for such a methodological shift is simple, and a financial structure’s effectiveness should be determined by one important criterion: whether the financial structure can best mobilize and allocate financial resources to serve the real economy’s financial needs.

Redefining Financial Structure and Its Optimality

Empirical research shows that there is virtually no country—even among industrialized ones—where security markets actually contribute a large part of corporate sector financing. A comparative study by Colin Mayer (1990) devoted to the industry financing of eight developed countries and to evaluating these patterns in the context of alternative theories of corporate finance concludes that the average net contribution of their security markets was close to zero and highlights the deficiencies of equity markets. This does not imply that equity markets do not perform an important function. “They may promote allocative efficiency by providing prices that guide the allocation of resources or productive efficiency through reallocating existing resources via, for example, the takeover process. But in terms of aggregate corporate sector funding, their function appears limited. Instead, a majority of external finance comes from banks.” (Mayer 1990, 325).

Two financial structure dimensions critically affect financial systems’ efficiency in performing their fundamental functions in economic development: first, the relative importance of banks and financial markets, and second, the distribution of banks of different sizes. Banks are the predominant type of financial intermediaries in low-income countries. Their mechanisms for mobilizing savings, allocating capital, and diversifying risks are very different from those of financial markets. Therefore the relative importance of banks and markets constitutes the most important financial structure dimension. Among banks there is an obvious distinction between the way in which big banks do business and how small banks operate; this has implications for access to services, especially lending services, by different size firms.

(p.71) Banks were long regarded as central to promoting economic growth and poverty reduction. But in the face of widespread corruption and bank failures in the 1970s and 1980s, which were often compounded by financial repression policies, there was disillusionment with their role, most notably in developing countries. As a result, many influential development institutions, such as the World Bank (1989), shifted their policy advice and advocated the use of both security markets and banks in promoting growth. In fact, a central feature of the economic reform and structural adjustment programs designed and implemented in the Washington Consensus framework was the dismantling of the traditional development finance model (based on bank-based systems, directed credit, public development banks, closed capital accounts, capped interest rates, and active monetary intervention) that had been established in developing countries in the postwar era.

Small banks with very limited assets cannot afford to make large loans; they would have to bear much higher risk resulting from concentrated investments. Thus small banks can only make small loans. Large banks are more able to make large loans and achieve better risk diversification. Since the transaction cost for making a loan is, at least to some degree, independent of loan size, large banks understandably prefer making loans to large firms rather than small ones. Large banks tend to stay away from small businesses but rather focus on large businesses, while small banks specialize in lending to small businesses (Jayaratne and Wolken 1999). This specialization suggests that, in addition to the mix of banks and financial markets, the distribution of different size banks can be an important dimension for the understanding of financial structure and economic development. Thus the distribution of big banks and their smaller counterparts can have a substantial effect on the banking sector’s performance.

The new standard financial structure model, which has become conventional wisdom, aims to reflect the imperatives of financial development. It has been influenced by financial market liberalization that is unfolding in the advanced economies, which have moved away from national bank–based systems toward open capital markets—at least until the 2008 Great Recession when the pendulum switched to the other extreme. Conservative governments in the United States and Europe abruptly changed gears and adopted new laws and regulations to rein in financial markets and nationalize banks. (p.72)

Unpleasant Truths about Institutional and Financial Development

Figure 2.4. Stock market capitalization and GDP (left); private credit and GDP (right).

Source: Authors.

The financial sector reforms implemented in developing countries around the world over the past decades were expected to raise savings and investment levels, reduce macroeconomic instability, increase the rate of growth, and create employment. These objectives have generally not been achieved. Instead, there have been several financial crises since the mid-1990s and a general funding decline for large firms in productive sectors, and small and medium-sized enterprises (SMEs) in general, a major problem for sustainable growth and poverty reduction in the long run (FitzGerald 2006).

Recent analytical work by Justin Yifu Lin, Xifang Sun, and Ye Jiang (2013) shows that each institutional arrangement in a financial system has both advantages and disadvantages in mobilizing savings, allocating capital, diversifying risks, and processing information when facilitating financial transactions. Empirical observations reveal that equity markets become more active relative to banks as a country becomes richer, and that small businesses have no access to equity markets and generally have less access to large banks’ loan facilities (figure 2.4).

The explanation for these stylized facts lies in the crucial notion of factor endowment, which itself determines firms’ competitiveness—and thus the profitability of financial institutions supporting them. A financial system’s efficiency in promoting economic growth depends on its ability to allocate financial resources to efficient firms in the most competitive industries (p.73)

Unpleasant Truths about Institutional and Financial Development

Figure 2.5. The dynamics of optimal financial structure.

Source: Authors.

in the economy. In other words, the factor endowment in an economy at each stage of its development determines the optimal industrial structure in the real sector, which in turn constitutes the main determinant of the size distribution and risk features of viable enterprises with implications for the appropriate institutional arrangement of financial services at that stage. Therefore there is an endogenously determined optimal financial structure for the economy at each development stage.

The reason is the following: at each stage of its development, an economy has a specific factor endowment structure (that is, the relative abundance of various factors of production, mainly labor, capital, and natural resources), which endogenously determines its optimal industrial structure at that stage (figure 2.5). Enterprises operating in different industries are distinct in firm size, risk, and financing needs. Thus the real economy’s demand for financial services at some development stages can be systemically different from that of the same economy at other stages. Only when the characteristics of financial structure match those of the economy’s industrial structure can the financial system efficiently perform its fundamental functions and contribute to sustainable and inclusive economic development. Therefore there exists an optimal financial structure for the economy at each development stage. A financial structure deviation from its optimal path will lead to low financial system efficiency and hinder economic development. (p.74) While poor regulation and supervision may cause financial crises, a serious mismatch between the financial structure and industrial structure will reduce efficiency in mobilizing and allocating financial resources.

In developed countries where large capital-intensive firms and high-tech firms dominate the economy, financial systems dominated by capital markets and big banks will be more efficient in allocating financial resources and promoting economic growth. In developing countries where small and less risky labor-intensive firms are the main engines for economic growth, the optimal financial structure will be characterized by the dominance of banks, especially small local banks. The optimal financial structure for any country changes as the economy develops, endowment structure upgrades, and industrial structure changes.

The remaining major challenge is selecting the appropriate policy framework for developing sustainable and effective financial institutions. In this regard, governments have an important role to play. Both the equity market and banks require government regulation and supervision to mitigate inherent moral hazard and reduce the occurrence and severity of financial crises. Although a country’s endowment structure and the resulting optimal industrial structure are the most fundamental force shaping its financial structure, the government’s policy will also affect the actual financial system evolution. In fact, development strategies promoted by governments and related policies are among the most important factors that cause the industrial structure and financial structure to deviate from their optimal structures. If a capital-scarce developing country adopts a comparative-advantage-defying strategy in which the development of capital-intensive industries is the priority, the financial structure will be diverted from its optimal path and channel scarce capital to the government’s priority sectors. The “financial repression” in many developing countries is the result of such a development strategy.

Policy makers in developing countries should be mindful of a particularly costly type of hidden distortion: the one that consists of replicating the financial systems in place in developed countries without fully considering the real economy’s demand characteristics for financial services. Just like perception indicators of good governance, financial development is a function of a country’s economic development level, not a prerequisite to performance.


(1.) The number of sovereign nations that are United Nations member states has grown from 51 in 1945 to 193 in 2014.

(3.) U.S. Department of Justice (2006). A total of 23,550 people were charged and 20,513 were convicted.

(4.) T. Allen-Mills, “Congo Leader’s £169,000 Hotel Bill,” Sunday Times, February 12, 2006.

(5.) Ibid.

(6.) This is a much broader definition than the one typically used in the literature, which usually refers to only one dimension of the problem: the relative importance of financial markets and financial intermediaries. The notion of financial structure can be examined from various angles. For instance, to examine the channels of financial intermediation, the relative importance of financial markets and financial intermediaries will be the focus. In terms of long-term or short-term financing, the composition of monetary markets and capital markets is important. For the discussion of government regulation, the distinction and composition of formal finance and informal finance are relevant. In the banking sector, one may want to analyze the distribution of big banks and small banks. See Lin (2009) for discussion.

(7.) Some authors downplay the importance of distinguishing the financial system as bank-based or market-based and argue that banks and markets provide complementary services. See Merton (1995) and Merton and Bodies (2005).