The Newsletter About Reforming Economies Public Disclosure Authorized July/August/SeptemberTransition 2003 • Volume 14, No. 7-9 http://www.worldbank.org/transitionnewsletter The Road to Prosperity: Saving Capitalism from Capitalists by Raghuram G. Rajan and Luigi Zingales he corrupt version of capitalism—when powerful competitive markets, no one in particular makes huge profits corporations deliberately try to eliminate healthy from keeping the system competitive and the playing field Tcompetition to preserve their privileged position— level. Thus nobody has a strong vested interest in promoting generates economic inefficiencies and social injustice, thereby and defending free markets. Free markets are a public good, undermining political support for the free-market-based system; and like all public goods, have no natural constituency. Public Disclosure Authorized however, an ownership structure that is too dispersed is just as On the contrary, competitive free markets have many ineffective and dangerous. When ownership is correctly enemies. Not only do their ranks include distressed workers distributed, given the right dose of regulations and the who have lost their jobs because of competitive pressures, but alleviation of social costs, a political consensus in favor of markets also large industrialists themselves. Truly free markets create can be achieved. competition, which undermines the position of established firms, forcing them to prove their competence again and As far as most Americans are concerned, capitalism is part of again. Hence a truly capitalist system not only finds that the American landscape. Its emergence was as spontaneous as generating political support is difficult, it also often the grass growing in their endless prairies, and like the encounters explicit opposition among the most influential prairies the only risk it faces is too much human intervention. groups. It should thus come as no surprise that true free According to them, no intervention is the best policy. market capitalism takes root with great difficulty, which is why it is so difficult to export. After the 1994 Mexican crisis, for instance, the World Public Disclosure Authorized Capitalism: Taking It for Granted? Bank decided to help the government improve the financial As the American experience has dominated economic infrastructure. One of the fundamental institutions that was thinking, economists tend to be overconfident about exporting missing was a credit registry, where assets posted as collateral capitalism to other countries. Some think that exporting for a loan could be officially recorded so that any potential American law and institutions is sufficient to make capitalism lenders could be aware of what a borrower had already blossom instantaneously. It worked for the United States, why pledged. In setting up this registry, the World Bank shouldn’t it work for other countries? For this reason, experienced strong resistance from the banks. The banks economics has typically been oblivious to the political already had enough clout and local experience that they preconditions for the development of capitalism. The fall of could get this information regardless of any credit registry. the Berlin Wall and the massive experiments with transition Not only would they not benefit from it, but they would see economies, however, provided a rude awakening. The their competitive position eroded as less established lenders experience of the last decade shows that in order to work, could access that information and compete for business on an capitalism needs more than a good set of laws and equal footing. Thus access to credit was curtailed to support institutions. Above all, it needs political consensus among the the interests of the few. people. Without political consensus free markets cannot This is not an isolated case, and similar examples abound, Public Disclosure Authorized survive. even in the industrial countries. Worldwide large and Once economists recognize this simple truth, then the established firms and financial institutions have the greatest current American optimism about spreading capitalism seems influence on policy, including the setting up of market excessive. Indeed, it is substituted by a moderate pessimism infrastructure. Often they are simply not interested in about the intrinsic fragility of capitalism, not its economic expanding access to everyone, because that would increase fragility (as Marx theorized), but its political fragility. In a competition. No wonder that the interests of free markets are nutshell, the idea is as follows. While everyone benefits from not well served and that the poor around the world see THE WORLD BANK 2 • Transition—The Newsletter About Reforming Economies Why then did capitalism emerge spontaneously in the United States—and before that in England—but is so difficult to establish in other countries? What lessons can we extract What’s Inside from history on what works—and what does not work—in promoting capitalism? Our book, Saving Capitalism from the NEW FINDINGS Capitalists, tries to answer these crucial questions. Investment Climate in China: A Tale of Five Cities 4 Stability and Growth in EU Accession Countries 7 Right Dose of Government UNICEF Social Monitor 2003 Reveals Real Mortality For capitalism to emerge and function a country needs neither Trends in the Caucasus and Central Asia 9 too little nor too much government. To understand why, TALK OF THE TOWN consider the following example. If you wanted to fly Corporate Governance in Russia: The Yukos Case 11 somewhere and the airline industry lacked any overall supervisory authority and no regulations were in place The Yukos Affair—A Debate 12 enforcing safety standards, you would be extremely reluctant Russia’s Unpopular Billionaires on Forbes’s List 14 to fly fledgling airlines. You would prefer the established ones Corporate Management Scrutinized Worldwide 15 that had a good track record and reputation. Thus a complete lack of safety regulations in the airline industry would favor BEST PRACTICE established firms, making entry impossible and killing China’s Knowledge Revolution 17 competition. By contrast, if the regulations were such that Russian Infrastructure Needs Overhaul airlines had to have a proven five-year track record of profitable flying before they were allowed to fly passengers, Railroad Restructuring 20 new entry would again be killed off, for how could new Telecommunications Reform 23 entrants have a proven record? Competition flourishes in the EVENTS delicate middle ground. A country can only achieve this balance when there is CEPR/WDI Conference on Transition Economics 25 broad consensus in favor of markets, and such consensus Roma in an Expanding Europe 25 arises only with the right distribution of ownership. Too much Life in Slovakia’s Roma Settlements 27 ownership concentration is inimical to market development, because large owners can protect their interests without a fair DISCUSSION and objective judicial system, and so they have no interest in Comprehensive Development Framework Probed 29 developing one. Indeed, they often have an interest in VOICE preventing its development so they can continue their privileged violations unimpeded. But too dispersed an Crossing Lithuania and Kaliningrad by Bike 31 ownership structure is not conducive to capitalism either, WORLD BANK AGENDA 32 because it makes coordinating a strong pro-market movement NEW BOOKS AND WORKING PAPERS 35 more difficult. England achieved this delicate balance in the 16th century CONFERENCE DIARY 41 following the expropriation of large landowners and the BIBLIOGRAPHY OF SELECTED ARTICLES 43 widespread sale of land that took place under Henry VII and Henry VIII. This created a powerful gentry, who were neither too powerful individually to dispense with the law nor too markets as being against them, not realizing that what they weak collectively to demand its enforcement and to withstand are experiencing is a corrupted version of what capitalism the monarch’s depredations. Not only did the United States should and could be. import this economic structure from England, it actively Not only does this corrupt version of capitalism generate promoted it. Americans like William Penn and Thomas economic inefficiencies and social injustice, it also Jefferson were deeply influenced by the British philosopher undermines the political consensus for a truly free market James Harrington, who in his 1656 book, Oceana, argued in system. In the early 1990s, Robert Shiller documented that favor of a more equal distribution of land ownership, which Russians had attitudes toward private property and markets he saw as the key to England’s success. that were very similar to those of Americans, but a recent Paradoxically, a country can achieve this balance of power survey finds that 72 percent of Russians would like to see more easily when it lacks natural resources. Natural privatized property returned to the state. Ten years of corrupt resources such as oil and diamonds create an automatic capitalism have undermined the consensus in favor of free concentration of economic, and hence of political, power that markets even more than seven decades of communist is difficult to undo, especially during the early phases of propaganda did. development when no offsetting sources of power exist. In the The World Bank • 3 absence of natural resources the government has no choice. If therefore have an enormous stake in promoting the good of it wants to be able to raise some revenues, it has to promote the country. This idea is not new. In the 1950s Charles commerce and trade, and to do so it has to restrain itself and Wilson, president of General Motors (GM) and later establish a reliable system of law. But when it controls a lot of secretary of defense under President Eisenhower, stated: easily extracted natural resources, the government can fund “What’s good for GM is good for the country.” This was not itself without the people’s consent and can therefore afford to true for the United States back then, and it is not going to be be despotic. It is no coincidence that in modern times more true for Russia today.