A quarterly magazine of the IMF

December 2000, Volume 37, Number 4

Power and Prosperity: Outgrowing Communist and Capitalist Dictatorships

Basic Books, New York, 2000, xxvii + 233 pp., $28/Can$42.50 (cloth).

The late Mancur Olson summed up his life's work in this short but remarkably insightful book. He applies insights drawn from his past work to the vanishing communist world, to the transition from communism to capitalism, and to the poverty of developing countries.

Olson's first insight is that individuals who hold power have an all-encompassing interest in the prosperity of the economy. In an apt metaphor, he describes a "stationary bandit" as better than a "roving bandit." A roving bandit takes everything from his victims; a stationary bandit has an interest in his victims' continuing prosperity and so takes less than 100 percent. By the same token, an unstable autocracy will loot more than a stable autocracy, because the latter has a longer horizon and thus a greater stake in future prosperity. Olson cites empirical work on developing countries that seems to support the hypothesis that long-lived autocracies perform better than short-lived ones. He devotes a fair amount of space to Joseph Stalin, one of history's most notorious stationary bandits. Stalin seized the entire Soviet economy but offset disincentives to future wealth creation by engaging in state-led investment. Olson goes into interesting detail about Stalin's brutally efficient system, which combined state terror with production incentives and helps the reader understand how Stalinist communism endured as long as it did.

But, Olson says, even in a stable autocracy, prosperity is not necessarily ensured for the long term because all autocrats die and create succession crises. Autocrats also have an unfortunate habit of trying to expand their revenues by preying on their neighbors. Democracies almost never go to war with each other—as has been noted many times—and are less likely to expropriate investments or break contracts. Most important, democracies that handle succession in a legal and stable manner create a stronger foundation for future prosperity. Olson points out that virtually all the richest countries are democracies with legal, stable succession processes.

Olson draws on earlier work on the logic of collective action to explain both the collapse of the Soviet Union and the difficult transition of its constituent states to market economies. His now famous insight is that centrally planned economies suffered from the same "sclerosis" as the industrial countries. That is, over time, interest groups organized and diverted resources into their own hands out of the productive economy. In the former Soviet Union, for example, state enterprise managers colluded both with their superiors and with other managers to divert resources into their own pockets. The scale of corruption became so great that the center eventually ran out of resources and the economy imploded.

What about the difficult transition to market economies? Olson draws an interesting contrast between the collapse of fascism (in Germany and Japan after World War II) and that of communism. When fascism collapsed, the victorious Allies swept away all the old collective interest groups and imposed constitutional democracy. In contrast, the collective interest groups of state enterprise managers did not vanish when communism collapsed. These groups have either slowed privatization or retained control of the "privatized" enterprises and continue to divert productive resources to themselves.

If there is a problem with Olson's book, it is that his insights are somewhat contradictory. Stable, long-established democracies have a more lasting interest in future prosperity and thus promote prosperity. Long-term stability, however, leads to interest group sclerosis and is harmful to prosperity. The reader is left with some doubts about the future of the world's stable democracies. Olson offers one ray of hope—that, as the public becomes more knowledgeable, special interest groups will lose their ability to subvert the interests of the larger society. But for his untimely death, I am sure Mancur Olson would have answered this and many other questions for those of us who have long admired his insights.

William Easterly

New Markets, New Opportunities?: Economic and Social Mobility in a Changing World

Brookings Institution Press/Carnegie Endowment for International Peace, Washington, 2000, x + 331 pp., $24.95 (paper).

Nancy Birdsall and Carol Graham have edited a book on the economics of opportunity—the analysis of economic and political systems in which people have more social mobility and thus more access to opportunities, but where upward and downward movements are equally possible. This book looks at the process that produces social inequalities, opportunities, and political behavior, as well as the links between them. This is a topic of mounting complexity, and the editors modestly suggest that their book should be viewed as an exploration of uncharted waters.

Yet the book exceeds expectations for a number of reasons. First, it covers a well-balanced geographical distribution of countries, from Latin America to the newly democratic postcommunist societies of Eastern Europe, with the United States presented as a benchmark case. Second, the various chapters—written by distinguished economists—present rigorous case studies, innovative interpretations, and stimuli for new research.

The book opens with a discussion of the main issues and ideas on the economics of opportunity. It includes a chapter by Joseph Stiglitz, former Chief Economist at the World Bank, criticizing standard welfare economics because, in his view, social justice and the desirability of social mobility and more equal opportunities are inconsistent with this traditional theory. He does not, however, formulate any alternative.

Another section explores the existing evidence on the economics of opportunity and mobility patterns in Latin America and Eastern Europe. One finding is that education both contributes to, and is an outcome of, inequality and mobility patterns. In Latin America, especially, public spending on education was found to increase intergenerational mobility, although it does not seem to have an effect on income distribution in the short run. In Chile, the distribution of income continues to be unequal, despite market reforms, although the incomes of skilled workers have increased dramatically.

In Eastern Europe, young people, especially if they are well educated, are the primary beneficiaries of the transformation from central planning to market-oriented systems because they respond effectively to rapid change, taking advantage of new opportunities and earning higher incomes. Thus, they are the most likely group to favor reforms. The "losers" are older workers who cannot adapt to a system of intensified competition and retirees, whose pensions cannot keep up with inflation.

Without social and political support, market reforms cannot be sustained. To create the necessary consensus for reform in a country, the population must favor reforms. Policymakers should examine the link between, on the one hand, the creation of opportunities resulting from market reforms and the evidence of mobility among self-employed people and, on the other hand, the risk of inequalities and insecurity.

Isabel Sawhill of the Brookings Institution writes about the U.S. economy, in which income distribution has changed very little over time and large inequalities exist. She notes, however, that people appear to cope well because the large inequalities are associated with abundant opportunities. This assertion has never been fully proved, however, and, indeed, there is evidence that opportunities in the United States are no greater than in many other western countries. As people acquire more education, more opportunities become available to them, although in the United States, family background and income patterns also matter, influencing how long an individual goes to school and who goes to college. An effective elementary and secondary education can also expand an individual's opportunities.

All told, the book presents an excellent analysis of the growing interest in social mobility and suggests areas of research for future examination. The editors have done a good job in distinguishing between the economics of opportunity and the politics of public perception and in looking at those countries in which social mobility partially applies or is beginning to emerge. This book fills a gap in the economic literature and should prove useful to economists, sociologists, and policymakers. At the same time, the experiences of transition countries and of their newly market-based economies might be promising areas for continued research.

Bruno S. Sergi

Central Banking in Theory and Practice: A Small State Perspective

Caribbean Center for Monetary Studies, St. Augustine, Trinidad, Trinidad and Tobago, 1998, xx + 303 pp., $25 (paper).

This collection of 15 essays has the unmistakable style of an experienced central banker, which Courtney N. Blackman is, having served three terms as founding governor of the Central Bank of Barbados. Central banks were conceived as apolitical institutions characterized by operational autonomy and a highly educated staff, a tradition of excellence and integrity that involves cordial but frank relations with government political entities, and a role in helping to educate the general public about economics.

The book emphasizes the imperfect market conditions in which central banks operate in small economies, with narrow money and capital markets in which a small number of participants represent a sizable share of the market. This explains the important role of moral suasion in the relationship between a country's central bank and its financial institutions and justifies the central bank's use of direct inter- vention in the conduct of monetary and exchange rate policies, including through reserve requirements, interest rate floors, and exchange restrictions.

The reader will discern Blackman's marked aversion for currency devaluation—recommended, together with fiscal adjustments, at different times for a number of the Caribbean economies by the international financial institutions—and his preference for currency pegs (to the U.S. dollar). The author believes that the exchange rate instability that characterizes small, open economies has a rapid and sizable impact on domestic prices, undermining the public's confidence in the currency and affecting the credibility of the central bank.

He therefore emphasizes throughout the essays the need for a prudent fiscal stance, wage restraint, and limits on the central banks' money-creation powers. Failure to adhere to this approach is reflected in many aspects of Caribbean economic history—the fiscal expansion in Guyana and Jamaica in the mid-1970s, episodes of fiscal strain in Barbados through the 1980s (for example, the pre-electoral increase in fiscal expenditures in 1981 and the sizable tax reductions in 1986), and the collapse of the CARICOM (Caribbean Common Market) multilateral clearing facility as a result of the excessive indebtedness of Guyana, whose severe external imbalances were associated with ambitious public spending.

In Blackman's view, a Caribbean central bank should consider not only the peculiarities of small developing countries—including their development needs and narrow financial markets—but also the prevailing environment, in which the central bank authorities will be perceived as part of the political arena. In practice, central banks in the Caribbean region have enjoyed diverse levels of autonomy, the Eastern Caribbean Central Bank (ECCB) with its quasi- currency board arrangement being perhaps the most independent. In this context, besides some other reforms in central banks (like lengthening the directors' terms in office, making them responsible to the parliaments rather than to the ministries of finance, and introducing legal limits on their financing of the governments), Blackman supports the creation of a Caribbean monetary union with a common currency and free capital movements. Within this union, monetary policy would be managed by a Caribbean federal reserve system with pooled reserves—a larger version of the ECCB. The checks and balances system that would result from the participation of several governments in the decisionmaking process and the need to reach consensus would, in Blackman's opinion, ensure that the system used its money creation powers with skill and restraint.

Overall, this book provides helpful insights on the practices of small developing economies and explores, from their perspective, a number of challenging arguments. It should be noted, however, that the central banks in the Caribbean region have evolved considerably since these essays were completed. They have progressively reduced, and in some cases eliminated, reliance on direct policy instruments, such as reserve requirements, interest rate and credit controls, and exchange restrictions, as they develop domestic or regional money markets, depend more on indirect instruments, and become more integrated with international capital markets. Similarly, the strengthening of the regulatory and supervisory frameworks for the financial sector—especially in the wake of problems in the early to mid-1990s—has made most central banks in the region considerably more independent in the way they conduct monetary policy. But in one important area Blackman's counsel is still particularly apt: it is important to provide appropriate fiscal policy support for monetary policy.

Simon Cueva and Samuel Itam

L'économie palestinienne: De la dépendance à l'autonomie

L'Harmattan, Paris, 1999, 157 pp.,FF 90 (paper).

A number of recent publications on the economy of the West Bank and Gaza, including some produced by international organizations and quasi-official think tanks, have tended to gloss over important economic issues related to the peace accords between the Palestine Liberation Organization (PLO) and Israel, perhaps because of an excessive preoccupation with the political sensitivities involved. As a result, recent coverage of thorny topics—such as the economic consequences of the Israeli occupation or of corruption in the Palestinian government—has been largely journalistic and often lacked analytical rigor. This book by Jacques Bendelac is one of the few notable exceptions to this trend. It presents a refreshingly candid and bold yet balanced analysis of the evolution of the Palestinian economy from its beginnings to the present.

In the first part of the book, Bendelac examines the factors that constrained the development of the Palestinian economy during the Israeli occupation and that, over time, distorted its pattern of external trade, skewed its private investment away from growth-generating areas, and weakened its agricultural and industrial sectors. One important constraint to growth was the absence of a level playing field in trade between Israel and the West Bank and Gaza. Unlike Israeli exports to the occupied territories, Palestinian exports of agricultural and industrial goods to Israel were severely restricted. Private activities were also constrained by a nontransparent legal and regulatory environment, inadequate public investment in infrastructure, and the virtual absence of a banking system until the early 1980s. As a result, growth in the West Bank and Gaza was sustained largely by the earnings of Palestinian workers in Israel (mostly from low-skill employment); the development of modern farming and industry was suppressed; and private investment remained concentrated in residential construction.

Bendelac examines next the economic opportunities offered by the peace accords, in particular the trade and development strategy envisaged by the 1994 Protocol on Economic Relations. This strategy had the potential to expand and reorient the West Bank and Gaza's productive base toward agricultural and industrial exports and gradually reduce its dependence on the export of labor. The improved trade environment was expected to induce a boom in private investment and create lucrative domestic outlets for a large stock of savings that had previously been deposited abroad.

In the remainder of the book, Bendelac discusses the disappointing performance of the Palestinian economy following the peace accords, which he largely attributes to recurrent border closures and, to a lesser extent, to government interference in private activities. At the same time, he highlights some improvements in fiscal transparency by the Palestinian Authority since 1996, which he credits in part to pressures and assistance from donors and the IMF.

I would have liked to see a final chapter with policy recommendations less constrained by the straitjacket of the 1994 protocol. Bendelac could have taken a more critical approach to the trade regime envisaged by the protocol, in particular, its failure to directly address important obstacles to external trade. These include, notably, the limited flexibility Palestinians have to determine their import policies and tariff structures, as well as their lack of control over borders and outlets to external markets, including seaports and airports. Other issues that are neglected include the establishment of equitable water rights and a system of fair property settlement for land, as well as the impact on productivity growth of the return of highly skilled diaspora Palestinians.

Overall, Bendelac's presentation of the key impediments to the development of the Palestinian economy is clear, persuasive, and dispassionate. He apportions the responsibility for the dismal economic performance to both the Israeli and the Palestinian authorities. The former get the lion's share of the blame, given the damage done during three decades of occupation and by the intermittent border closures, while the latter's track record, although relatively short (barely six years), is exposed for inadequate fiscal discipline and weak governance. Despite a few deficiencies in the forward-looking policy areas—I would have liked to see a more comprehensive and novel discussion of the economic issues being addressed in the permanent status negotiations—Bendelac's book is an important and timely contribution to the long-standing debate on the future of the Palestinian economy.

Oussama Kanaan

Clarification

In the article "Funding the IMF: The Debate in the U.S. Congress" in the September 2000 issue of Finance & Development, the accompanying box misstated the relationship between the U.S. budgetary process and IMF quota increases. A clarification follows:

In the United States, the periodic quota increase exercises take place within the budgetary process, as they require appropriations by Congress.

The dollars committed by the United States under a quota increase are called by the IMF only as it needs them, in combination with contributions from other creditor countries, to extend credit to borrowing members. As and when dollars are used in transactions, the United States is credited with an equal amount in automatic drawing rights on the IMF, which it considers part of its international reserves and which earn a market-related rate of interest.

Since U.S. transfers of dollars to the IMF involve exchanges by the United States of one monetary asset for another, they do not represent net budgetary outlays, nor do they have an impact on the budget deficit and surplus.

Correction

In the article "Estonia Moves Toward EU Accession" in the September 2000 issue, there was an error in Table 2, "Foreign direct investment in Central and Eastern European countries." The denomination for Column 2, which listed "Cumulative inflows per capita, 1989-98," should have been "dollars," not "million dollars."