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Is There a Local Knowledge Advantage in Federations? Evidence from a Natural Experiment

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Is There a Local Knowledge Advantage in Federations? Evidence from a Natural Experiment Is There a Local Knowledge Advantage in Federations? Evidence from a Natural Experiment by André Schultz Frankfurt School of Finance & Management and Alexander Libman Frankfurt School of Finance & Management and Russian Academy of Sciences In economics the local knowledge advantage is probably one of the key arguments in favor of decentralizing the public sector. However, the empirical investigations of this particular effect have been scarce. This paper tests the existence of the local knowledge advantage in a real world setting. Specifically, it looks at the variation of local knowledge across regions based on the origin and careers of regional politicians, assuming that politicians, who have spent a longer period of their life in a particular region, possess better knowledge of that region than outsiders. In order to avoid the endogeneity problem, the paper investigates how local origin affected the performance of the politicians in a natural experiment environment, studying the responses of regional governors in Russia to the disastrous forest fires in 2010. We confirm that local knowledge improves the performance of the governors. However, in a highly centralized federation like Russia, the effect is conditional on the access to federal resources through close ties to the federal center. Keywords: decentralization, local knowledge, federal connections, exogenous shocks, Russian regions JEL: D73; H77; P26 February 2012 Acknowledgements: The authors are grateful to Ruben Enikolopov, Eberhard Feess, Michael Grote, Sergei Guriev, Henrik Jordahl, Alexander Muravyev, Boris Porfiriev, Adalbert Winkler, Andrei Yakovlev and to the participants of the conferences of the European Economic Association (Oslo, 2011). Higher School of Economics (Moscow, 2011) and New Economic School (Moscow, 2011), as well as of the seminars of the Frankfurt School of Finance & Management (2011) and Moscow State University (2011) for their very valuable comments. This paper was supported by a research grant of the Verein für Socialpolitik/Deutsche Bundesbank. All mistakes remain our own. 2 1. Introduction The importance of local knowledge as one of the main advantages of the federal state belongs to the key insights of the theory of federalism. As Hayek (1945: 524) puts it, “if we agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to people who are familiar with these circumstances...”. Stated otherwise, local governments have a substantial advantage in knowledge of the “circumstances of time and place” and are therefore expected to achieve better economic results in terms of the public policy (Qian and Weingast 1997; Oates 1999; Rodrik 2000; Treisman 2002). Despite the immense importance of this argument, there is almost no empirical research available validating this claim. In fact, it is extremely difficult to devise a reasonable strategy for its empirical investigation. On the one hand, simply by exploring the costs and benefits of federalism in any empirical setting, one is unable to disentangle the “knowledge” benefits from other effects possibly associated with decentralized governance (e.g. inter-jurisdictional competition). On the other hand, it is not easy to measure the knowledge advantage of the regional governments as such. In fact, it is exactly the inability of an outsider (e.g. central government, researcher) to assess local knowledge that makes it so precious. Finally, knowledge is accumulated by individuals and not by “governments”. It is therefore possible that bureaucrats on the local level also suffer from significant information disadvantages. This paper sets out to test for the presence of beneficial local knowledge effects in an empirical setting. For this purpose, instead of looking at the variation of institutions, i.e. of the level of decentralization, and assuming that the latter is associated with the knowledge advantages of the decision-makers, we study the variation of individuals, i.e. decision-makers themselves. It is reasonable to assume that a politician or bureaucrat originating from a particular region has better knowledge of the region than an “outsider”, coming from a different jurisdiction. Thus, if local knowledge does indeed provide better outcomes in terms of public policy, territories of a country governed by politicians of “local origin” or those spending a long period of time in the region should perform better than those governed by “outsiders”. Hence, it is possible to expect some variation of the local knowledge advantage to be present within a federation across different regions, depending on the biographies of the regional politicians. This is exactly the key element of our research strategy, which looks at the performance of the regional governors in the Russian Federation in the late 2000s. Russia seems to be an appropriate empirical playground for this analysis. On the one hand, its regions substantially differ in terms of ethnic composition, religions, economic 3 development, size, topography, climate, natural resources, and geographic location, making local knowledge extremely important for regional policy makers. On the other hand, since 2004 regional governors are appointed by the central government in Moscow. In most federations, where local politicians are elected, it is highly unlikely that complete “outsiders” can win the elections. In Russia it is not unusual that regions are governed by appointees without any past record of experience in that region. In this paper we intend to focus on the local origin of politicians and their tenure duration in the region, which has several advantages. First, this approach is able to disentangle the impact of local knowledge from other aspects of decentralization, because all regions of a particular country are subject to the same rules and institutions. Second, the information on individual biographies of politicians and bureaucrats seems to make the assumption more plausible that they indeed possess substantial “local knowledge”, instead of just “assuming” that all individuals working for a local government have per definition superior knowledge of local circumstances. Clearly, the appointments of regional governors (as well as any other way of selecting regional administrators) can be endogenous to the economic performance of the regions. In fact, a number of recent papers (Zhuravskaya 2010; Reuter and Robertson 2011; Reisinger and Moraski 2011) investigate the role of economic development in the re-appointment decisions of the Russian central government (finding, by the way, that the economic factor plays a minor role as opposed to political loyalty). However, in order to identify the local knowledge effects, this paper uses a natural experiment based on the forest fires in the Russian regions in 2010. In July and August of this year Russia was hit by an unprecedented heat wave with historic record high temperatures, followed by enormous forest fires. The overall economic damage is estimated to have reached 1.5% of the Russian GDP. The regional authorities did play an important role in combating forest fires (not only through their own effort, but also by influencing the allocation of the federal interventions). The fires have been not only unusually strong, but also almost uncorrelated with the forest fires experience of Russian regions in previous years. Thus, it is safe to say that the forest fires of 2010 constituted an exogenous shock which the federal administration could not have taken into account while assigning governors to their territories. 1 Thus, the natural experiment setup should substantially reduce our concerns regarding the endogeneity. While the natural experiment setting and the intra-national variation of local origin among governors provide us with helpful tools to identify the effect of local knowledge, the Russian Federation still poses an additional problem which we have to resolve. Since Russia 1 Szakonyi 2011 and Sobolev et al. 2011 use the exogeneity of Russian forest fires to study the changes of political preferences of Russian population. 4 is a highly centralized federation, the disposable resources of regional crucially depend upon the support of the federal government. The variation of resources caused by often discretionary central interventions is hard to measure and therefore difficult to control for. Under these conditions, it is difficult to disentangle the local knowledge advantage from the effect induced by the various degree of federal support. We deal with that issue by introducing a second important governor-specific characteristic in our analysis. Specifically, we look not only at the level of “local origin”, but also at the presence of “federal connections”. Close ties to the federal government established during the employment in federal institutions should make it easier for regional governors to get support from the federal administration. Based on the above considerations, three possible outcomes are feasible. First, the local knowledge advantage is so powerful that even the best connected governors perform worse than those with an extensive local background and without any federal connections. Second and contradicting the first outcome, a high level of centralization makes local knowledge useless. The variation in performance is determined solely by federal connections. Third, it is possible that local knowledge determines the within group variation
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