WP/09/194

Political Risk Aversion

Laura Valderrama

© 2009 International Monetary Fund WP/09/194 IMF Working Paper

IMF Institute

Political Risk Aversion

Prepared by Laura Valderrama1

Authorized for distribution by Marc Quintyn

September 2009

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

This paper studies the effect of individual uncertainty on collective decision-making to implement innovation. We show how individual uncertainty creates a bias for the status quo even under irreversible voting decisions, in contrast with Fernandez and Rodrik (1991). Blocking innovation is rooted in the aversion to the potential loss of political clout in future voting decisions. Thus, risk neutral individuals exhibit what we call political risk aversion. Yet individual uncertainty is not all bad news as it may open the door to institutional reform. We endogenize institutional reform and show a non-monotonic relationship between institutional efficiency and the size of innovation.

JEL Classification Numbers: D74, D81 Keywords: Individual uncertainty; Innovation; Dynamic voting; Institutional reform. Author’s E-Mail Address: [email protected]

1 The author is grateful to Timothy Besley, Simon Johnson, Nobuhiro Kiyotaki, John Moore, Raghuram Rajan, Mathias Thoenig, Jérôme Vandenbussche, Thierry Verdier, and Randall Wright for their suggestions, and seminar participants at the London School of Economics, DELTA, Federal Reserve Bank of Cleveland, International Monetary Fund, Paris School of Economics, Copenhagen Business School, Universitat Pompeu i Fabra, Universitat Autonoma, and Universidad de Navarra. - 2 -

Contents Page

I. Introduction...... 3

II. Basic Model...... 5 A. Economic Environment...... 5 B. Technology Choice ...... 7 C. Aggregate Uncertainty ...... 9

III. Institutional Reform...... 10 A. Outside Ownership...... 10 B. Endogenizing Ownership ...... 11 C. Dominated Employee Ownership ...... 12

IV. Efficieny, Innovation, and Labor Mobility ...... 14 A. Partnership Efficiency...... 14 B. Institutional Efficiency...... 16

V. Discussion...... 19 A. How does the model fit the facts? ...... 19 B. Foundations of Individual Uncertainty ...... 20 C. Heterogeneous Investors ...... 21

VI. Related Literature...... 21

VII. Concluding Remarks...... 23

References...... 24

Figures 1. Technological and Institutional Efficiency...... 15 2. Endogeneous ownership ...... 18