The Political Economy Of Economic Reform In The Pacific

1 The Political Economyof Economic Reformby Ron Duncan1. IntroductionThe policy reforms attempted in developing countries over the past 3 decades have yielded variedresults, with some, such as in East Asia, leading to very good outcomes in terms of economic growth.But, there are many others where it has not been possible to implement reforms or where reformshave achieved poor outcomes. The record in Papua New Guinea (PNG) and the Pacific islandcountries (PICs) has been similar, with good responses to reform attempts in some countries anddisappointing results in others. During this period, ideas about what is important for growth anddevelopment have changed significantly, from the early focus on the notion that the lack ofdevelopment was due to a shortage of capital and the need for transfers of savings from wealthycountries to poor countries, to the subsequent focus on correcting price distortions throughstructural adjustment programs, and to the recent focus on the basic institutions underpinning theeconomic and political performance of countries (for a discussion of the changes in developmentthinking over the past 30 years or so, see Duncan and Pollard 2002).Within the past decade, development agencies have expressed awareness of the need toundertake development assistance only when it is underpinned by a good understanding of the localcontext of the individual countries. However, until recently little emphasis has been placed ongaining this kind of understanding, which presumably relates to an appreciation of a country’seconomic, political, social, and cultural characteristics and the interactions between them. Withinthe communal societies of the Pacific, cultural characteristics are more important than they appear tobe in the more advanced societies. Therefore, increased attention needs to be given to understandingthe cultural characteristics of Pacific economies and how they relate to economic and politicalfactors.Economic reform can mean changing existing institutions, policies, legislation, andregulations. Generally, such change will not be easy, since these elements have been shaped byexisting political, economic, and cultural forces. Hence, understanding the “local context” to provideassistance in the design, acceptance, and implementation of reform also implies some knowledge ofhow to change the status quo.Understanding the economic, political, social, and cultural characteristics of a society andthe interactions between them is broadly the field of political economy. Because of the different

2The Political Economy of Economic Reform in the Pacificaspects of society that are involved, political economy is inevitably a field of interdisciplinary study.Economists, political scientists, lawyers, sociologists, and anthropologists—and perhaps otherdisciplines—can usefully collaborate in developing the needed understanding.This project on the political economy of PNG, PICs, and Timor-Leste therefore draws onthe views of economists, political scientists, sociologists, and others. The Asian Development Bank(ADB) funded the study to increase the effectiveness of the assistance that it provides to thesecountries by improving understanding of their political economy.An increasing amount of research on the political economy of developing countries hasrecently been undertaken. Even more recently, research has been initiated on the political economyof reform processes. However, very little research has been conducted on the political economy ofreform processes in the PICs. This project was established to fill these gaps.2. The Role of Political Economy in Economic ReformAdrian Leftwich’s (2008) definition of what he calls “politics” (but earlier called political economy) isa good description of political economy for our purposes:. all the many activities of cooperation, conflict and negotiation involved indecisions about the use, production and distribution of resources. (p. 6)As Leftwich notes, these activities may be formal or informal, public or private (or a mixtureof both), and undertaken at every level of society, from individual households and businesses to allstrata of government.As a field of study, political economy dates back to at least the 17th century, with writerssuch as Adam Smith, David Ricardo, Thomas Malthus, and later, Karl Marx, being some of its mostinfluential English-language proponents. The field now very broadly refers to interdisciplinarystudies, drawing mainly on the disciplines of economics, politics, and law, to explain howinstitutions, politics, and the economic system interact, whether nationally or internationally, toproduce economic outcomes. Other disciplines such as sociology, anthropology, and humangeography also make contributions to the broad field of political economy.There are many more analytical approaches to the study of political economy than thenumber of disciplines involved, as the practitioners of each discipline usually bring their preferredtheoretical framework to their research. For example, economists doing political economy studiesmay have a classical, neo-classical, neo-Marxian, or new institutional economics view of economicbehavior, while political scientists may use rational choice theory or traditional inductive approaches.The new institutional economics (NIE) approach pioneered by North (1990) has played animportant role in recent studies of the political economy of developing countries with respect toeconomic reform. The NIE approach focuses on the basic institutions and the rules of behavior thatthey establish. These rules provide the incentives to which the various actors involved in the processreact. In this context, institutions may be formal, such as constitutions, electoral systems, andproperty rights, or informal, such as the norms of traditional societies or the behavioral norms ofgroups such as accountants and real estate agents.The recent focus on institutions (used in the broad economic sense) has to a large extentbeen forced upon analysts and development agencies. As Acemoglu (2008) points out,. understanding [by the economics profession] on the importance of institutions hasbeen reached as a result of a large body of theoretical and empirical work. In thepolicy world, it has been reached more painfully, as a result of a long stream of

The Political Economy of Economic Reform3reforms around the world that failed mainly because they did not pay sufficientattention to institutions and governance issues.Besides stressing that “institutions matter,” Acemoglu also argued that while institutions dochange, we do not know how to change them; however, “our best hope is to understand whatinternal dynamics of countries drive institutional changes.”In an effort to understand how it may be possible to change institutions, Elinor Ostrom andher research colleagues in the Workshop in Political Theory and Policy Analysis at IndianaUniversity have placed the NIE in an analytical framework they call Institutional Analysis forDevelopment (IAD) to gain an understanding of the behavior of the groups that have an influence,for better or worse, on economic development within a country (Ostrom et al. 2001). The IADframework is based on the assumption that most problems in development result from the inabilityof people to take the necessary collective action. The delivery of public goods and the effectivemanagement of common-pool resources require collective action by society. However, if theestablished incentives, or rules of behavior of the society, provide weak or perverse incentives toindividuals or groups to act collectively for their common good, the delivery of public goods andmanagement of common-pool resources will be adversely affected.As Ostrom et al. (2001) correctly point out, it is difficult, if not impossible, to change thecharacteristics of public goods or services or to change the culture of a society. Trying to change theincentives (institutions or rules) faced by the people involved is usually the only avenue open bywhich to achieve a different outcome. But as they also point out, any transformation of the “rules inuse” needs to take full account of the characteristics of the community and the physical, economic,political, and social circumstances. Most importantly, it must be understood that those presentlyadvantaged by the status quo will resist any changes in the rules that do not benefit them. Further,aid agencies should be careful not to reinforce perverse incentives or to weaken governmentincentives to find better policies and institutions.The purpose of the so-called “Drivers of Change” approach, largely developed by theDepartment for International Development (DFID) of the United Kingdom (UK), is also to assessthe prospects for and constraints on development from a political economy perspective. Thisapproach also draws to some extent on the NIE framework to study the interactions among theeconomic, political, and cultural characteristics of countries by thoroughly examining the society’sinstitutions and the incentives they create.The analytical framework designed by Hausmann, Rodrik, and Velasco (2004, 2005, and2006) to uncover the “binding constraints” to economic growth in developing countries is closelylinked—and could even be considered a precursor—to the study of the political economy of reform.The Hausmann et al. framework focuses on the economic constraints to growth and development.This approach recognizes that there may be many constraints to economic growth in a country butthat some constraints will dominate others; therefore, unless the dominant or most bindingconstraint(s) is overcome, it is useless to attempt to remove others. The framework is similar to theeconomic logic of linear programming, which identifies the most binding constraint as the one withthe highest shadow price or opportunity cost. Therefore, relaxing that constraint will have thehighest payoff. Once it is relaxed, another constraint will become the most binding. The expectedoutcome of this diagnostic approach is a listing of priorities of where to focus economic reformefforts when attempting to establish a favorable environment for investment and growth.

4The Political Economy of Economic Reform in the PacificThe framework Hausmann et al. (2004) suggest for diagnosing the most limiting constraintis in the form of a decision tree. Recognizing that investment is the most critical factor in growth, thepurpose of the decision tree is to identify whether the most binding constraints on growth are factorscontributing to inadequate returns to investment, poor private appropriability of the returns toinvestment, or the high cost of finance for investment. Within each of these categories of possiblelimiting factors is a subset of factors, any of which could be the main obstacle to investment andgrowth.This diagnostic framework has been extended from identifying the economic constraints togrowth as suggested by Hausmann et al. to investigation of the possible underlying causes of thoseconstraints. Recognizing that underlying institutional factors may be the binding constraints togrowth rather than the more obvious proximate factors affecting investment and growth, Sugden(2008) suggests extending the decision tree to include an additional “institutional branch,” ratherthan including institutional factors at the bottom of their decision tree, as do Hausmann et al.Sugden suggests that more emphasis be given to institutional determinants (such as effectiveconstitutions, well-defined and enforced property rights, impartial enforcement of contracts, and lawand order) as underlying causes of poor economic performance than do Hausmann et al. (2005, p.7), who place emphasis on proximate causes. This extension of the framework essentially takes theanalyst to a study of the political economy.Sugden’s “preliminary, subjective assessment” (2008, pp. 234–235) of the importance ofproximate factors and institutional factors in affecting economic performance in PICs is that “onlyCook Islands and Samoa could be thought of as having an institutional environment conducive toeconomic growth,” so that for these countries “the binding constraints are more likely to be at theproximate level.” For Fiji, the Marshall Islands, Palau, Tonga, and Tuvalu, the necessary institutionalenvironment for private investment and economic growth may exist, so that the constraints toeconomic growth are more likely to be proximate constraints on private sector development. For theFederated States of Micronesia, Kiribati, PNG, Solomon Islands, Timor-Leste, and Vanuatu,Sugden’s preliminary assessment is that “the institutional environment is so weak that the bindingconstraints to economic growth are very likely to be found at the underlying level.”However, it could be observed that the existence of some of these obstacles to goodeconomic performance needs to be explained. What explains why an effective constitution is not inplace? What explains why a country is aid-dependent, or why aid is ineffective? It appears that wehave to dig deeply into a country’s psyche to explain these issues.The IAD framework of Ostrom et al. (2001) provides a framework within which theinfluence of the broader institutional or political economy issues on economic performance may beexamined. Therefore, Duncan (2009) and Bulatale and Duncan (forthcoming) have combined theIAD framework with the diagnostic framework of Hausmann et al. (2005) to analyze the possibleeconomic constraints in Kiribati and the broader political economy issues in Fiji that may beinhibiting economic performance. The results of these recent studies of PICs are discussed below.

The Political Economy of Economic Reform53. Early Studies of the Political Economy of Reform inDeveloping CountriesTwo early political economy research projects on economic reform in developing countries wereBates and Krueger (1993) and Williamson (1994). In the Bates and Krueger project, eight pairs ofeconomists and political scientists examined the history of economic reform in eight developingcountries, some of which had been successful reformers (Chile and the Republic of Korea), somewhich had been reasonably successful (Ghana and Turkey), and others that had little success withreform despite several attempts (Brazil, Ecuador, Egypt, and Zambia). For each country, theresearchers were asked to examine the impact of interest groups on the success of the reforms and theinstitutional context in which the reforms were carried out.In the Williamson project, nine economists (most of whom held key government positions)wrote about the experience of policy reform in developed, developing, and transitioning countries.The economists were asked to focus on how they managed to get the reform programs accepted.Subsequently, a conference was held where political scientists who had been writing on economicreform programs (and most of whom had been involved in the earlier Bates and Krueger project)were asked to comment on the country papers. The country authors were also asked to discuss theapplicability of 13 often-competing hypotheses in explaining when policy reform is possible. Thesehypotheses included the idea that policy reform is most likely following a crisis, when opposition tothe reform is discredited, when the reforming government has won a mandate for change, whenthere is a visionary leader, or when there is an authoritarian or rightist government.The Williamson volume concluded that the evidence strongly supported the hypothesessuggesting the need for a strong political base, for visionary leadership, and for a coherent economicteam. It also concluded that authoritarian or right-wing governments are not necessary for successfulreform. However, there is little in the way of insights provided into the political processes or theinstitutional arrangements that make effective implementation of reform possible (Duncan 1995).The Bates and Krueger volume is somewhat more insightful. In response to the observationthat interest groups appeared to have little or no role in initiating reforms, they suggest that theoutcome of reform is subject to such uncertainty that interest groups’ decisions are influenced moreby ideology than by statements about the incidence or impacts of policies. It is concluded thatbecause of uncertainty about the future size and distribution of the benefits of reform, and the moreimmediate and concentrated nature of its costs, the status quo is likely to be maintained unless thereis a change of government. However, there are exceptions to this finding, such as Mexico. Thestructure of political competition is also examined. For example, in countries with one-termpresidents, such as Mexico, the president may undertake reforms that would not be considered ifrunning for office again. Compare this situation to democracies where the political term is not fixedand leaders struggle to remain in power.Bates and Krueger find that reform efforts lead to the restructuring of interest grouprepresentation and to changes in political institutions. One change that they highlight is thestrengthening of the executive branch of government and of the finance ministry. An important roleof this restructuring is to protect the technocrats within these core ministries from pressure frominterest groups—except, of course, from the pressure of the interest groups that benefit from thereforms. Bates and Krueger also point to the importance of a well-trained team of policy adviserswho are somehow protected from interest-group pressure. This conclusion highlights the importance

6The Political Economy of Economic Reform in the Pacificof education in developing cadres of highly skilled, local advisers, as well as the need to understandcountries’ political, cultural, and institutional systems.4. Recent Research on the Political Economy of ReformFollowing the Krueger and Bates and Williamson projects, there was little in the way of politicaleconomy studies of the factors underpinning economic reform and why some reform attempts fail,until the 1990s’ realization of the importance of institutions in explaining behavior related todevelopment, and of understanding the local context, if development assistance was to be successful.Interest in these issues has led to the extensive use of political economy studies of economic reform indeveloping countries over the past decade. Initially, the studies focused on the interactions betweeneconomics and politics in the reform process. But these studies led to staff frustratio

The political economy of economic reform in the Pacific. Mandaluyong City, Philippines: Asian Development Bank, 2011. 1. Political economy. 2. Economic reform. 3. Pacific. I. Asian Development Bank. The views expressed in this publication are those of the authors and do not necessarily reflect the views