Location: Eastern Europe

Adapting to Capitalism

Posted on January 21, 2013 | Policy Brief

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Author: Jenny Simon, SITE

When transitioning to a free-market economy, do people adapt to the new circumstances immediately? Undoubtedly, major shifts in the political system do not escape people’s notice. They often follow extended demonstrations, spectacular coups d’état or even violent uprising. However, the changes in economic institutions that go along with such transitions, and their implications for optimal economic behavior, although fundamental, may not be apparent immediately. The German reunification provides the opportunity to study this learning process.

Recent Dynamics of Returns to Education in Transition Countries

Posted on November 12, 2012 | Policy Brief

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While, in an international comparison, transition countries spend a relatively large share of their GDP on education, and the population in transition countries is fairly highly educated, the returns to education in transition countries have been found to be relatively low, especially in comparison to other developing countries. In our paper, ‘Recent Dynamics of Returns to Education in Transition Countries’, we investigate whether the economic boom that transition countries experienced up to the 2008 financial crisis, increased the returns to education in these countries. Theories of skilled-biased technical change typically predict that periods of fast economic growth go together with an increase in the relative demand for skilled labor and hence an increase in the returns to education. 

Using data from the 2007 wave of the International Social Survey Program (ISSP), the estimated return to an additional year of schooling in transition countries varied between a low 5.2 percent in Ukraine to a high of about 10 % in Poland (see Figure 1). Returns in transition countries were relatively low compared to developing countries in the ISSP sample, and on average not unlike OECD countries.

Figure 1. Returns to Education by Countries, 2007 Wave – Basic Specification
 
Note: Coefficients of the years of schooling variable in earning regressions. Dependent variables are monthly earnings. Specification includes: potential experience (linear and squared), dummy for gender. Source: Ukraine – ISSP 2008, all other countries – ISSP 2007.

The estimated dynamics in returns to education in the period 2002-2007 further suggest that the economic boom that took place in that period did not affect people with different amounts of education in different ways. Returns to education increased slightly in some transition countries and decreased slightly in others, but overall returns to education remained relatively moderate.  More specifically, from table 2 we can see a decrease in returns in Bulgaria, Latvia and Poland, and an increase in the Czech Republic, Russia, Slovakia and Slovenia. Both increases and decreases are small in size however.

Table 1.  Dynamics of Returns, Basic Specification
Note: Coefficients of the years of schooling variable in earning regressions with few controls as specified in the text.
Source: Estimates for 1991-2002 are from Flabbi et al. (2008); estimates for 2007 and for Ukraine are by the authors.

A more detailed analysis for Ukraine using data from the Ukrainian Longitudinal Monitoring Survey, confirmed that economic growth did not have a major impact on the returns to education. The analysis for Ukraine however does suggest that, while in 2003 a secondary degree resulted in a somewhat higher wage, just having secondary education was no longer a differentiating factor in 2007.Moreover, only academic education made a difference, possibly because less and less people were paid very small wages (i.e. less than the official minimum wage).

The relatively limited importance of education for success on the labor market does not only show itself in the low estimated returns to education, it is also clear from the opinions people express about the factors that are important to get ahead. Table 3 gives the percentage of people who say a given factor is essential, important or fairly important to get ahead in a given country (based on the 2009 ISSP).

Table 2. To get ahead, it is essential, important or fairly important to
 

In most transition countries in the sample, most people think that hard work and ambition is the key to get ahead.  Ukraine is no exception with hard work being thought to be essential, important or fairly important by about 94 percent of the respondents. Having a good education is thought to be at least fairly important by only about 73 percent of the respondents, with four other factors, besides hard work, scoring better on this criterion: having political connections, having ambition, having a wealthy family and knowing the right people. Also for the other transition countries in our sample, good education ranks only 5th, 6th or 7th.

Optimists could interpret these results as implying that at least education does not create the same social inequalities in the transition countries as it does in some other countries. Pessimists, on the other hand, who see education as an important driver of economic growth, will argue that low returns to education mean there is a low incentive for people to invest in education and that it is better to have education as a source of inequality rather than political or social connections, or having a wealth family.

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Corruption in Eastern Europe as Depicted by Popular Cross-Country Corruption Indicators

Posted on October 15, 2012 | Policy Brief

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In recent years, variously defined indicators of corruption from different sources have aimed at raising awareness about corruption and to provide researchers with better data for analyzing the causes and consequences of corruption. Most of them have achieved spectacular popularity, and are regularly cited in news reports on corruption around the world. However, in a 2006 study for the World Bank, Stephen Knack warns that the particular properties and limitations of these indicators are often neglected by data users, often leading to wrong interpretations and sometimes puzzling disagreements about the actual situation in a country or a region and its changes over time. The first part of this brief summarizes the main conclusions of this study; the second part presents updated data from different sources on recent corruption trends in the new EU members and the neighbors to the east, as a clear exemplification of the issues discussed.

Existing corruption indicators differ in many ways: where the original information or evaluation comes from, how they are built, who are their constituencies or audiences, as well as which of the many aspects of corruption they intend to capture. For these reasons, no single indicator or data source is best for all purposes.

The corruption indicators can be subdivided into three main groups: those based on surveys, either of firms or households, those reporting expert assessments, and finally, the recently popular composite indexes.

Two examples of firms’ surveys that will be presented below are the Business Environment and Enterprise Performance Survey (BEEPS) and the World Economic Forum (WEF) “Executive Opinion Survey”. Similar enterprise surveys have been conducted by the World Bank and in the IMD World Competitiveness Yearbook. However, BEEPS and WEF are more systematic and better comparable across countries and years, have broader coverage and disclose more information about their definitions and methodology, which makes them, in a sense, more research-friendly.

Surveys are relatively well-suited for evaluating the administrative corruption since they measure the prevalence of corruption as experienced by users of government services. They can also measure some aspects of state capture by asking about perceived undue influence over laws and regulations that affect business. However, surveys are definitely less effective in assessing the prevalence of corrupt transactions that occur entirely within the state, for example when politicians bribe bureaucrats or when funds are illegally diverted. Many types of conflict of interest are also not easily captured by surveys. For example, the equity stakes of public officials or employment promises to them by the firms (World Bank, 2000).

Expert assessments of corruption have been most widely used for comparisons across countries and over time because of bigger coverage in both dimensions. A large and growing number of organizations provide such assessments. Some examples are Freedom House’s Nations in Transit (NIT), the International Country Risk Guide (ICRG), the World Bank’s Country Policy and Institutional Assessment (CPIA). Corruption ratings from these sources are based on the assessment by a network of correspondents with country-specific expertise. In some cases, the final ratings are subsequently determined centrally by a smaller group of people. The organizations that are behind these indicators may be very different, with potential implications for what their ratings are measuring. Some are advocacy NGOs. Others are for-profit companies marketing their product to multi-national investors and paying subscribers. Most subscribers to the ICRG, for example, are more interested in conditions faced by foreign investors than in those faced by local residents. Corruption ratings produced by development agencies are also potentially influenced by their constituents (if for example they take into account the consequences for funds allocation decisions or relations with local partners).

An important difference as compared to the firms or households surveys is that corruption assessments place less emphasis on experience and more on perceptions. Moreover, the respondents in a firms’ survey can be asked more specific and objective questions because they comprise a more homogeneous group. For example, a typical question can be “Was an informal gift or payment expected or requested to this establishment, in reference to the application for an electrical connection?” (from the BEEPS 2009 questionnaire). Instead, a questionnaire directed to a group that includes public officials, academics, journalists, etc. must frame questions in such a way that they can be answered meaningfully by all of them, which necessitates broader questions.

More recently, composite indexes have gained popularity. Well known examples include Transparency International’s widely-cited “Corruption Perceptions Index” and the World Bank Institute (WBI) “Control of Corruption” index (Kaufmann, Kraay and Mastruzzi, 2008). Although the statistical methods used to produce them vary somewhat, both indexes standardize several corruption indicators such as ICRG, CPIA and even survey outcomes, to place them on a comparable scale, then aggregate them, so as to obtain a single value for each country. As a result, composite indexes suffer from the same problem as the corruption measures from individual sources such as ICRG, NIT or CPIA: if any component of a composite index is constructed in an opaque manner, the composite index will be opaque as well. Further limitations are introduced by the process of aggregation. Composite indexes have no explicit definition, but instead are defined implicitly by what goes into them. The sources used in constructing these composite indexes change over time, and from country to country in a given year. For any pair of countries the index values are very likely to reflect differing implicit definitions of corruption.

The standardization procedure used to place different indicators on a common scale precludes the ability to track changes meaningfully over time.  A final issue with the composite indexes is the interdependence of expert sources. If expert assessments display high correlations driven by the fact that they consult each other’s ratings – or that they all base their ratings on the same information sources – this can undermine the main premise of the aggregation methodology that more sources produce more accurate and reliable estimates. The addition of another expert-based source containing little new information – relying on the same information sources as its competitors, or even checking their ratings – can actually reduce the accuracy of the composite index.

A general caveat in the use of corruption indicators, beyond the weaknesses of individual types discussed above, concerns the importance of their intended use. For some purposes, broader measures may be preferable: for example, a researcher studying the relation between corruption and economic growth may have no particular view on exactly which aspects of corruption most impair growth, and is hence content with a general measure. For other purposes, however, narrower measures may be required. For example, a donor funding projects in a country may be interested in a measure of corruption in public procurement, while a donor providing budget support might prefer a measure of the likelihood of funds diversion to unintended purposes. The design of effective anti-corruption reforms requires narrow measures to identify specific problem areas and track progress over time, and so on.

Finally, it is important to remember that some indicators are more suitable than others for measuring changes over time. Broad, multi-dimensional indicators are potentially problematic in this respect, because there is no way to ensure that the implicit weights given to the various dimensions do not change over time. Some indicators have no fixed and explicit criteria provided for each ratings level, so there is no way of ensuring that the same numerical rating means the same corruption level from one year to the next.

With this background in mind, it is easy to understand why, while it is often possible to form a broad assessment on the general situation and trends in corruption, different sources might often disagree markedly on specific countries, and in particular on which countries have improved and which have not. The evidence from different sources on recent corruption trends reported below provides a clear example in this respect. We are going to focus on the new EU members (Estonia, Bulgaria, Romania, Slovenia, Slovakia, Czech Republic, Hungary, Poland, Lithuania, Latvia), indicated as EU-group, and the non-Baltic former Soviet Republics (Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, Uzbekistan), indicated as CIS-group [1].

Levels and Trends in Corruption for the New EU-Members and the Eastern Neighbors

The Business Environment and Enterprise Performance Survey (BEEPS) is a nationally-representative survey of business firms assessing corruption and other problems faced by businesses in the ECA region. The BEEPS is sponsored by the European Bank for Reconstruction and Development (EBRD) and the World Bank, and has covered almost every country in the region since 1999. The two most recent waves with a good coverage of our countries are 2005 and 2009. The surveys typically contain multiple questions pertaining to narrower aspects of corruption, and so do the BEEPS.

Looking at the outcomes of the BEEPS, the most dramatic change between 2005 and 2009 is in the “bribe tax”, the share of annual sales paid in “informal payments or gifts to public officials to get things done”. The average in the new EU members increased more than four-fold from .72% to 3.11% of firm revenues. A positive value for the bribe tax was reported by 28.12% of firms in 2005, increasing to 62.1% in 2009, although this might simply reflect an increasingly open attitude in answering the survey. The corresponding increases for the CIS-group are more moderate, from 1.31% to 4.26% bribe tax and from 40.7% to 60.1% of firms declaring positive values. The only country where the bribe tax did not increase is Poland, although data for 2009 are not available for Belarus, Georgia, Tajikistan, Ukraine and Uzbekistan. The biggest increases are reported in Estonia and Slovenia, although they started from the lowest levels within the EU-group (0.29 and 0.17 respectively). These are two countries that, as we will see later, are consistently singled out as the best performers by the other indicators. This apparent contradiction might be due to a different reporting attitude in these countries. Similarly, the lowest level of bribe tax in the CIS-group for 2009 is reported in Russia (1.31), while the highest levels (8.8) in Azerbaijan, a country that according to other indicators is doing relatively well.

Besides the bribe tax, among the numerous other questions on corruption issues in the BEEPS, most show evidence of a modest improvement.  For example, in 2005 about 13.4% (24%) of firms in the EU- (CIS-) group reported that paying bribes was frequently, usually or always necessary to get things done, and this figure is down to 6.75% (18.8%) in 2009.  Most questions about specific public services also show evidence of a decline in the incidence of bribe paying, e.g. when paying taxes, dealing with customs and the courts.

The assessment on the fairness of the courts got worse in both areas, but at the same time it is considered a big obstacle by fewer businesses as compared to 2005. Also, the share of businesses that admit to paying a kickback payment to obtain a government contract, and the share of sales required for this payment, decreased over this period, markedly for the new EU members, though only slightly for the former Soviet Republics.

Slovenia and Estonia are the champions also in this respect, as well as Armenia in the CIS-group. Kickback payments are most expensive in Latvia (3.06% of sales) and Russia (4.65%). Corruption was however cited as the biggest obstacle to doing business by an increasing share of firms everywhere [2]. In the CIS-group as a whole, the share of firms that consider corruption the biggest obstacle to business increased from 6.4% in 2008 to 8.16% in 2009. The individual countries with the biggest shares are Romania (9.5%) and Azerbaijan (17.8% of firms), respectively in the first and second group. Ironically, the biggest increase between 2005 and 2009 is in Poland, the only country where the reported bribe tax actually decreased. This highlights how tricky it is to aggregate the information from these sources, given that very different aspects of the situation in a country are captured by each item.

More difficulties emerge with respect to evaluating change over time since different measures often move in opposite directions for a given country. For example, both Hungary and Azerbaijan experienced the biggest increases in bribe tax, but also a sharp decrease in kickback payments for government contracts and it is hard to balance the one against the other. This is also a reason why the picture emerging from these data does not necessarily agree with the aggregate indicators discussed below, although they are in part based on the very same outcomes of the surveys.

The World Economic Forum (WEF) “Executive Opinion Survey” is another cross-country survey of firm managers. The sample in each country is selected with a preference for executives with international experience, who tend to be from larger and exporting firms. The questions are designed to elicit “the expert opinions of business leaders” on corruption and other issues, and focus much less on direct firms’ experiences. Moreover, the aim is solely to produce country-level measures of the business climate, and not firm-level analyses. Cross-country rankings on several corruption questions from this survey are published in WEF’s annual Global Competitiveness Report. Ratings are computed as the simple average of all executives’ responses.

The 2011 WEF data include 7 variables related to corruption, all scaled from a low value of 1 to a high value of 7: Diversion of public funds, Irregular payments and bribes, Judicial independence, Favoritism in decisions of government officials, Burden of government regulation, Transparency of government policymaking and Ethical behavior of firms. The sample includes a total of 142 countries, including many developed countries, and covering most of the countries we have been addressing above. Both the average rating and the average rank are slightly higher for the EU-group, but the similar average hides quite a bit of variation between different countries and in different dimensions.

In particular, the CIS-group ranks higher with respect to both the extent to which government regulation is perceived as a burden for business, and the perceived transparency of policymaking, and the two averages are extremely close when it comes to the assessment of favoritism in officials’ decisions. The largest difference between the two groups seems to be the prevalence of irregular payments and bribes, in accordance with the evidence from the BEEPS.

Nevertheless, some countries in the second group, like Georgia and Tajikistan, have a higher average ranking than most of the new EU members and position themselves extremely well even in global terms in some dimensions. For example, Georgia is number 7 in the world with respect to the (absence of) burden of regulation, although not many more reach the upper quartile or even the upper half of the ranking. On the other hand, some of the new EU countries do very poorly in some respects, like the Slovak Republic ranking 135th (of 142) in terms of favoritism by public officials and the Czech Republic being 124th in diversion of public funds.

Compared to 2010, the EU-group saw a slight worsening in their rating, while the CIS-group improved. More in detail, half of the countries in the first group went down, including some quite substantial drops (Estonia, Poland and Slovenia, down by more than 1 point) while the others improved, though not spectacularly. All but one country (Georgia) in the second group improved their average rating from 2010, the biggest progress taking place in Azerbaijan with 1.5 points.

As opposed to the surveys discussed above, the NIT, CPIA and ICRG each provide a single measure of corruption, intended to reflect a mix of various aspects of corruption.

The NIT index is mostly concerned with the impact of corruption on business. It measures the corruption with on a 1-7 scale, 1 being the best possible rating and 7 being the worst, with quarter-point increments allowed.

The ranges of variation in the ratings during the last five years for the two regions do not overlap at all: all of the new EU countries positioned themselves always below a score of 4, while all the countries in the CIS-group stayed well above this threshold. This implies that the best performers within this group (Georgia and Armenia) have a consistently lower rating than the worst performing EU countries (Bulgaria and Romania). However, the trend over time in this period is very similar across the two regions. Both the averages are very flat, with a slight upward trend (i.e. to the worse). In the EU-group, this reflects the fact that five countries saw worsening in their rating, three saw no change at all and only two (Estonia and Lithuania) a slight progress. The lowest (and hence best) score is Estonia and Slovenia’s 2.25. Also in the other group only two countries – Armenia and Georgia – improved their rating. They also have the lowest scores in the region, 5.25 and 4 respectively. Six countries kept a stable rating while four got worse. The highest (and hence worst) score, 6.75, goes to Turkmenistan and Uzbekistan.

The CPIA question “Transparency, Accountability and Corruption in the Public Sector”, is assessed on a 1-6 scale, where a lower level corresponds to a worse situation in terms of corruption. This index focuses on less developed countries, so the EU-group is not covered. The most recent available data are for the period 2008-2011, during which four out of the six developing regions in the world improved.

In contrast to the stagnation with slight worsening described by the NIT, the ECA region is the one that sees the steepest improvement in the CPIA rating, increasing to 2.87 in 2011. This contrasting assessment can be explained by the fact that only six of our CIS-group countries are included in the CPIA sample: Armenia, Azerbaijan, Georgia, Kyrgyzstan, Moldova and Uzbekistan. If we look at the average only in those six, also the NIT rating improved by about the same relative amount (1.5% of the value range). The two indexes do not agree, though, on the individual countries that they reward with a higher or punish with a lower score. In particular, only Georgia improved in both ratings, while Uzbekistan, for example, got a better CPIA score but a worse NIT score; Armenia and Azerbaijan, that respectively improved and worsened in the NIT assessment, are completely stable in the CPIA, and the opposite is true for Moldova.

Unlike the CPIA, the ICRG sample includes most developed countries. The focus of the ICRG is to establish the relative incidence of corrupt transactions. Its corruption ratings range from a minimum value of 0 to a maximum of 6, where higher rating corresponds to a better situation.

The latest available data are however not as recent as for the other indicators discussed here. In the three years up to 2007, the mean rating remained stable in both groups, around 2.5 in the new EU members and 1.8 in the former soviet countries, although only three of eleven countries from this group are included. Also in this case, the two ranges of values for the two regions do not overlap.

In the EU, Lithuania’s rating went down while Poland’s went slightly up. Estonia and Slovenia are again the best performers together with Hungary. The lowest rating in the region goes to Bulgaria, just as in the NIT evaluation, together with Latvia. All the three countries in the CIS-group made improvements, although from dismally low levels. This is not in contrast to the other assessments, since the data refer to an earlier period. The highest score of the three is Moldova’s (low) 1.5.

Both of the widely-known composite indexes of corruption (TI and WBI index) show large differences between the EU members and their eastern neighbors. The average score, varying from 1 to 10 and from -2.5 to 2.5, respectively, are much higher for the first than for the second group. Similarly the ranks – from 1 (best) to 182 (worst) for TI, reversed scale from 0 (worst) to 100 (best) for WBI – reflect a much worse situation in the CIS-group. However, the former Soviet countries improved their WBI rank between 2009 and 2010, as opposed to the new EU members which saw a slight drop. Although changes over time for these indexes should be taken with caution, this is coherent with the 2010-2011 comparison in the WEF.

The two indexes also agree on best and worst performer, respectively; Estonia and Bulgaria in the first group (Slovenia was best performer in 2009 according to WBI) and Georgia and Turkmenistan (on par with Uzbekistan according to TI) for the second. Both the largest improvement (Lithuania) and the largest backslide (Slovenia) from 2009 happened in the EU-group, but a larger share of the CIS-group countries experienced improvements, which is reflected by a smaller drop in the average score. The main difference between the two indexes is that WBI uses more sources and reports a value even for cases when only one source is available (TI requires a minimum of three sources), obtaining as a consequence a broader coverage. Otherwise, the two indexes are quite correlated, and subject to the same problems.

Summing up, all the indicators agree, not surprisingly, that the situation looks much brighter in the EU-group than in the CIS-group. Although, it is not clear that they are keeping up the good work in the most recent years. There is relatively more evidence of improvement over time in the CIS-group, despite the dismal starting point. Only few countries emerge unequivocally as good or bad performers. One example being the coherently positive performance of Georgia; for most of the other countries, the picture is mixed.

Given the variety and breadth of indicators, this conclusion was very much expected. Corruption is such a broad and multidimensional phenomenon that different indicators and different assessments are bound to result in different, often contrasting pictures. Unless one is very clear on which specific aspect is in focus, and sticks consequently with one particular measure, any conclusion based on general comparisons of corruption indicators both between countries and over time should be taken with serious cautiousness.

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References

[1] Turkmenistan and Uzbekistan are only unofficial members of the official Commonwealth of Indipendent States (CIS), and Georgia is not a member any longer since 2009.

[2] Bigger obstacles in the EU-group are the level of tax rates (19% of firms), access to finance and an inadequately educated workforce (11% each), along with political instability (10%). The biggest concern for most firms in the CIS-group is instead market practices from competitors in the informal sector.

Political Instability in Fragile Democracies: Political Cycles Kyrgyz Style

Posted on September 24, 2012 | Policy Brief

Political Cycles Kyrgyz Style Image

Democratization is rarely a straight and predictable process. Freedom House data from the Central and Eastern European Countries (CEEC) and the countries of the Commonwealth of Independent States (CIS) since 1991 reveals two distinct patterns. In one set of countries, democratization took root quite quickly and the transformation of political institutions seems quite deep and sustainable. In the other countries, the road to democratization, if ever started, has been much more partial and full of reversals. Among the CIS countries, none is regarded as free by Freedom House in 2012, four are regarded as partly free (Armenia, Kyrgyz Republic, Moldova and Ukraine), while the remaining seven countries (Azerbaijan, Belarus, Kazakhstan, Russia, Tajikistan, Turkmenistan, and Uzbekistan) are regarded as non-free. There has also been volatility over time within countries. Russia and Belarus have seen their score steadily deteriorating, while countries on the Balkan and south-east Europe have seen gradual improvements. With the lack of consolidated democratic institutions has also typically followed much political instability. Frequent changes in power, civil unrest, popular revolutions and military conflicts have pervaded countries like Ukraine, Georgia, and the Kyrgyz Republic. In other nations, repressive leaders have put a lid on visible instability, but at the cost of political rights and a fair judiciary system. In both cases, the economy has suffered as instability has deterred investors looking for a predictable environment guided by transparent rules of the game implemented equally for all. Corruption has flourished and political connections and nepotism has determined the opportunities for economic success.  

New Tools to Fight Corruption and the Need for Complementary Reform

Posted on June 20, 2012 | Policy Brief

High office buildings facing sky representing Institutions and Services Trade

Corruption remains a serious problem for most developing countries, undermining state capacity and incentives to invest besides social cohesion and democratic institutions. It is also an increasingly important problem for many highly developed ones. In Italy, for example, corruption has increased in the last decades and the parliament is now finally struggling to pass a (rather mild)”anti-corruption law”. Even in Sweden, a country constantly considered among the least corrupt ones in the world, the problem seems to be increasing according to a recent report by the Agency for Public Management (Statskontoret), which also suggests that the current legislation needs to be improved, for example by offering some form of protection to whistleblowers.

In most Central and Eastern European countries, however, the problem appears particularly serious. Corruption seems to have been rapidly increasing in the region this last decade (The Economist, April 11, 2011 ; Nations in Transit, editions 2001-2012), although there are some virtuous exceptions (for example Georgia and Estonia).

Corruption is often caused by, and at the same time, an instrument for political developments towards autocracy, such as those recently observed in some of these countries (limiting judicial autonomy, democratic participation and the free press). This suggests that in countries where these political developments are taking place we may expect a further worsening of the corruption problem in coming years.

A country that is apparently taking the fight against corruption seriously is India, where a strong grassroots anticorruption movement has developed. The issue has become central in recent political debates and several proposals have been put forward and debated in the parliament. Among these proposals is one by Kaushik Basu, the finance minister’s Chief Economic Advisor. He suggests – for a specific class of bribes paid to obtain a service to which one is entitled for – to treat bribe paying as legal while doubling the sanctions against bribe taking (Basu 2011). The logic behind this proposal is to create stronger incentives for bribe-paying individuals to report it to law enforcers and expose corrupt civil servants: reporting should lead to the restitution of the bribe, besides the conviction of the bribe taker.

Since this proposal was made last year, there has been a lively debate both at the Indian as well as the international level. The debate has however been rather informal, and involved some (voluntary and involuntary) misunderstanding of the proposal (see Dufwenberg and Spagnolo 2011 for a short account of this debate). The proposal has been deemed as “radical” by the proponent, and has sometime been treated and dismissed as a theoretical curiosity. In fact, the proposal is similar to existing legal provisions against corruption that have been in place for quite some time in several countries. The proposal is also related to other legal provisions widely used around the world to fight related forms of illegal transactions, in primis leniency policies now used by most antitrust authorities to fight price-fixing cartels, but also accomplice-witness amnesty and protection program against mafia-like criminal organization (see Spagnolo 2008 for an overview).

We know from academic research on these related revelation schemes that they can be very powerful if appropriately designed and administered, but they may fail or even be counterproductive if they are poorly designed or run (see e.g. Spagnolo 2004, Buccirossi and Spagnolo 2006, Apesteguia et al. 2007, Miller 2009, Bigoni et al. 2009). The exact details how these subtle mechanisms are designed and then actually implemented are crucial to their success.

Asymmetric Sanctions, Leniency and Whistleblowers

As earlier mentioned, the main idea behind Basu’s proposal for India, treating partners in corruption asymmetrically is not a theoretical curiosity. It is already present in milder form in the Russian, Japanese and German (violation-of-duty) legislation, where bribe payers face lower sanctions than bribe takers and in the way prosecutorial discretion is used in Anglo-Saxon countries. An analogous provision seems to have also been introduced in China in 1997, and its effectiveness has recently been questioned by some observers, although in a very superficial way. Unfortunately we have no serious evidence of how these legislations have affected corruption.

More generally, the idea of deterring a collaborative crime by shaping the incentives of criminal partners so that one of them has the incentive to betray the others and report information to law enforcers is well established. The Prisoner’s Dilemma story, where each among the partners in crime are promised a light sentence in exchange for cooperation to convict the other criminal partners is familiar to most countries’ standard law enforcement practice.

These schemes have been the main and most successful tool in the fight against mafia and political terrorism in Italy and other countries, and they are currently regarded as the most important and effective instrument in the hands of competition authorities in their fight against cartels (US Department of Justice, Spagnolo 2008, Acconcia et al. 2009).

Apart from law enforcement, analogous “divide and conquer” schemes have been widely used ever since the Roman Empire in war-related situations to break down enemies’ coalitions. They are tools that many do not like on moral grounds, because they induce distrust and betrayal of partners, which some people see as bad even when the betrayed partnership is a criminal one and distrust prevents the criminal activity.

Still related but somewhat different are the whistleblower protection (from retaliation) and reward schemes aimed at inducing innocent witnesses to report a crime. Reward schemes for whistleblowers have been used in the US since the civil war to limit corruption in federal procurement and to fight government fraud (through the False Claim Act, sometimes called the Lincoln Law from the president that introduced it). They have more recently been introduced by the IRS against tax evasion and by the Dodd-Frank Act against financial fraud.

When witnesses are working in the same organization as the wrongdoers, or when the latter are powerful individuals (besides being prone to commit illegal acts, like violent retaliation), blowing the whistle typically generates very harsh consequences for the witness; ranging from various forms of harassment in the organization, to the loss of job, isolation and directly or indirectly induced death.[1] Legal action is typically slow and uncertain but immediate, certain, and very costly, while whistleblower protection provisions are typically imperfect (if present). This is why, even with a relatively efficient legal enforcement system like the American, large rewards are seen as necessary and justified to induce more whistleblowing and compensation for its consequences.

Trust, Distrust and Corruption

In some sense, one can see Basu’s proposal of legalizing bribe paying for services one is entitled to (while doubling sanctions for bribe taking) as transforming potential accomplice-witnesses into potential innocent whistleblowers. The question is then whether this scheme will induce more people to blow the whistle and consequently fewer bureaucrats to demand/accept bribes. Some observers have suggested that this provision might instead induce more people to pay bribes because it makes it legal and thereby may erode moral norms against bribe paying.

In Dufwenberg and Spagnolo (2011), we argued that amending Basu’s proposal in a way resembling leniency programs used in antitrust, where immunity is awarded only if the wrongdoing is reported to the law enforcement agency, is one way to avoid sending the signal that bribe paying is now legal. The real problem for these schemes is therefore whether at the end they will really induce bribe payers to report.

The way these revelation mechanisms deter corruption is by generating “distrust” among potential partners in crime (Bigoni et al. 2012). By making it very attractive to report to law enforcers for one party and very costly to be reported for the others, these schemes may deter illegal cooperation by ensuring that the parties cannot trust each other.

However, for these schemes to generate distrust and produce their potentially strong deterrence effects, the risk that accomplice-witnesses and other potential whistleblowers report must be a real one. For this to be the case, whistleblowers must trust the law enforcement agency to which they report. The example of leniency policies in antitrust is illuminating. In the US, as long as competition authorities retained discretion, colluding firms rarely applied for reporting under the leniency program. It was only when the Department of Justice gave up discretion by making immunity “automatic” – subject to an explicit set of conditions being satisfied – and committed to this policy through published rules that firms started to again to report information on cartels.

Besides a high risk of being reported, for these schemes to elicit reports and produce deterrence it is also necessary that sanctions for convicted parties are sufficient. To continue the parallel with antitrust enforcement, even after the authorities gave up discretion on the programs, they are not inducing cartel members to report in other countries than the US.

Indeed, the most serious problem for the success of the Basu proposal, as well as for that of the leniency-based modification put forward in Dufwenberg and Spagnolo (2011), remains whether witnesses/bribe payers will trust the law enforcement agency to which they should report the crime. If the law enforcement agency is inefficient or also corrupt, reporting may lead to further harassment or worse, rather than protection and justice.

When protection programs are poorly administered and law enforcement agencies inefficient or corrupt, so that potential witnesses don’t trust law enforcement agencies, it becomes very difficult to induce whistleblowers to report, as well as dangerous for the whistleblower.

A second important reason why these schemes may fail to generate reports and to produce the intended deterrence effects is, as we mentioned, the low sanctions against bribe takers. Recent experimental results (in Bigoni et al. 2012) suggest that reporting incentives provided by leniency programs are only effective in deterring collusion if the sanctions for the convicted partners are sufficiently strong. If not, these schemes may have no effects or even perverse ones (they reduce the sum of expected sanctions, and because of their complexity, they could be manipulated; see e.g. Buccirossi and Spagnolo 2006). Basu did suggest doubling the sanctions for the bribe payers. This, however, may or may not be enough for the case at hand, and would require a more thorough evaluation.

Note than in the case of corruption, there is an additional reason for sanctions to be reinforced, in particular by the requirement to always remove from office the convicted bribe taker. The reason is that if the bribe taker is not removed from office after the report, bribe payers may fear that after whistleblowing the bribe taker may retaliate in future interactions.

Conclusions

Asymmetric sanctions as proposed by Basu (2011) and leniency conditional on reporting as proposed by Dufwenberg and Spagnolo (2011) have the potential to deter corruption in a systematic way.  Necessary conditions for this to happen, however, are that:

  1. Sanctions are sufficiently robust to ensure that the increased risk of being convicted because of a report by a whistleblower dominate on the lenient treatment offered to induce reports;
  2. Potential whistleblowers trust that the law enforcement institutions will act on the report and protect them from retaliation by the corrupt and their friends, rather than harass them.

Countries with sufficiently independent and efficient law enforcement institutions should definitely consider introducing or reinforcing their revelation schemes, asymmetric treatment or leniency conditional on reporting, to counter the current widespread increase in corruption.

Simply introducing these schemes in countries with weaker institutions, in particular with a low level of independence of law enforcement agencies, may do more harm than good: after all they imply reduced sanctions and their complexity makes them easily manipulated.

These schemes can be very useful for these countries, but only if they are introduced as part of a broader set of complementary reforms that include increased judicial independence and the creation of a specialized law enforcement unit with particularly high levels of accountability and independence, able to credibly offer to whistleblowers at least confidentiality and protection from retaliation, if not monetary rewards.

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References

[1] The sad recent stories of Sergei Magnitsky in Russia and of S.P. Mahantesh in India clarify that this risks are real.

Shock “Therapy” the Market Way

Posted on September 5, 2011 | Policy Brief

Policy Brief Image with Tall Buildings Representing Transition, Market Economy and Shock Therapy

Twenty years after transition began and the merits of “shock therapy” were argued the most hotly, (former) transition countries are hard hit by global shocks originating in Western market economies. Although discussions now focus on troubles in Western developed countries, countries in Eastern Europe and the CIS were particularly hard hit in 2008/09. This should not come as a surprise given their pre-crisis vulnerabilities. As transition countries opened up to trade and capital flows—like other countries that want to reap the benefits of the global economy—they also became subject to the shocks that hit open economies. The very high current account deficits and/or reliance on commodity exports prior to the crisis exposed many countries in this region to two of the shocks that have been most costly to emerging markets and developing countries in the past, namely sudden stops in capital flows and terms of trade shocks. However, the lesson from the crisis should not be that opening up is bad in general, but that shock absorbers should be put in place to minimize the damage market-based “shock therapy” can do.

Shock Therapy and Transition

It is now twenty years since the failed 1991 coup that led to the breakup of the Soviet Union and started the transition from plan to market in (then) communist countries. A few years earlier, in 1989, the Stockholm Institute of East European Economies was set up at the Stockholm School of Economics. Its first director was Anders Åslund who was a strong proponent of shock therapy (see Åslund 1992). The basic idea was that a rapid transition from plan to market through changing institutions, privatizations and other liberal reforms would minimize the cost of transition. There are still different views on the merits of shock therapy as a reform strategy, but this brief will not address this debate.

In the wake of the academic debate of shock therapy, the broader research agenda was put under the heading “transition economics”, which became a new field in economics. This also lead Erik Berglöf, the new director of the Stockholm Institute of East European Economies, to change the institute’s name to the Stockholm Institute of Transition Economics, or SITE for short, the name we still use today. The economics of transition was also the title of the fifth Nobel symposium in Economics (Berglöf and Roland, 2007).

The use of the label “transition economics” may see a revival in the aftermath of the Arab spring. However, the economic issues that now face the (former) transition countries are much the same issues that emerging markets, developing countries and also advanced countries around the world grapple with. This is not least true when we look at what has happened in the current crisis.

Below this brief will argue that the shock therapy ex-communist countries were subject to in the early 90’s has been changed to the shock “therapy” open market economies around the world have been facing for a very long time. And just as there were heated debates on what the right therapy was then, the world is now debating what the “therapy” for the current shocks should be.

Output Drops Around the World

Significant drops in output have not only been observed in countries transitioning from plan to market but have occurred with regularity throughout modern history in countries around the world. The figure from Becker and Mauro (2006) shows the frequency of countries that entered into a major output loss event—defined as a cumulative loss of at least 5 percent of initial GDP in an event that last at least two years—during the 20th century. In the after-war period, a relative modest 5 to 10 percent of countries have entered into a period of significant output loss. However, in the great depression, almost half of the countries for which data is available entered into a period of significant loss of output.

Since the methodology used in Becker and Mauro follows countries until they return to pre-crisis levels of GDP, it is too early to provide a full account of what the number would be in the current crisis that started in 2008. Nevertheless, it is straightforward to compute how many countries have experienced output losses in 2008/09 (which is the first criteria to satisfy in the Becker and Mauro measure) and this number is close to fifty percent, on par with the great depression. This is not to say that the total output loss will be as high as in the great depression, but it clearly tells the story that this is the worst global crisis we have seen since then in terms of how many countries have been affected. The share of countries affected at the onset of this crisis varied greatly in different parts of the world and at different levels of development. The most surprising statistic from this crisis is that 90 percent of advanced economies experienced an output drop whereas “only” 40 percent of emerging market countries did. The regional differences between emerging markets are also striking; 85 percent of countries in Central and Eastern Europe (CEE) and more than half of CIS countries saw output decline, far above other regions.

Shocks 2.0

The Becker and Mauro paper also looks at the correlates of major output drops and focuses on a number of domestic and external macro, financial and political shocks as triggers of output collapses. A large dataset of shocks and output drops is used to compute the frequency of the different shocks; the likelihood that a particular shock leads to an output collapse (as defined above); and the output loss associated with such event. These numbers are then used to calculate how much different types of shocks have cost in terms of lost output for emerging markets and developing countries. The scale in the chart shows how much it would be worth in terms of GDP per annum to avoid a certain shock.


For emerging market countries, the worst shock has been sudden stops in capital flows that cost almost a percent of GDP per year. Unless countries have high levels of foreign exchange reserves, sudden stops in capital flows mean that (often large) current account deficits have to contract and even become surpluses quickly because there is no external financing available for a deficit. This, in turn, affects domestic production and demand and can have a serious effect on output. Add to this the financial uncertainty that is often associated with sudden stops and it makes it the number one shock to worry about for emerging market countries integrated in the global economy and financial markets.

Less developed countries are in several cases dependent on concentrated commodity exports to generate foreign exchange. This makes this group of countries more vulnerable to terms-of-trade shocks. The estimates of how costly these shocks are range from around half a percent of GDP per year, as is shown in the chart, to around 2.5 percent of GDP if a more extensive sample including very long-lasting output events is used.

Other shocks like currency, political and debt crisis have also been associated with significant losses in output, but tend to occur less frequently, which makes the cost per year smaller.

The 2008/09 Crisis

As was mentioned previously, not enough time has passed since the start of the crisis in 2008 to use the methodology in Becker and Mauro to compute cumulative output losses since many countries are still below their pre-crisis GDP levels. However, projected losses can be computed by using the IMF’s World Economic Outlook forecasts of GDP growth rates. If we then rank the countries according to worst output performance, CEE and CIS countries dominate the “top-ten” list with seven entries. Latvia at the top of the list is projected to lose a cumulative 40 plus percent of pre-crisis GDP during the 11 years it is projected to take the country to return to the GDP level it enjoyed in 2007. The other Baltic countries, Ukraine and Armenia have also been hit particularly hard in this crisis. Russia and Romania are close behind three advanced countries that had to seek IMF and EU assistance to deal with the crisis; Ireland, Iceland and Greece.

The forecasts used for these calculations are constantly being revised and the ranking of countries based on actual outcomes will certainly look different years from now. We can only hope that the current forecasts are too pessimistic although right now many revisions go in the wrong direction.

Could we have predicted what countries were hit in this crisis based on history? Based on the Becker and Mauro (2006) paper: Yes and no. “No” regarding the fact that overall, many advanced countries were hit this time. The paper found that in the past, the frequency of output collapses have decreased with the income level of countries, contrary to what has been the case this time. “Yes” for the fact that CEE and CIS countries were hit significantly more that other emerging markets since they were particularly vulnerable to the sudden stops and terms-of-trade shocks that the paper showed often are associated with severe output losses.

The signs of vulnerability in CEE and CIS countries were easy to see, but warnings ignored; the Baltic countries and Romania had double-digit current account deficits that where to a large part financed by external debt. For example, current account deficits in Latvia passed 20 percent of GDP in some years, far beyond the 4-5 percent deficits some Asian countries had prior to the Asian crisis in 1997. Ukraine also had large current account deficits and concentrated (metal) exports on top of that, exposing the country to both sudden stops and terms-of-trade shocks.

Russia’s dependency on energy and mineral exports was also well known, with 80 percent of export revenues coming from this source. However, the pre-crisis boom in oil and mineral prices had made Russian policy makers think this was a strength and not a vulnerability. On top of that, the strong external position of the government and central bank obscured the external financial vulnerabilities that had built up in the private sector. With the sharp decline in oil prices in the crisis, Russia was hit both by a terms-of-trade shock and a sudden stop in capital flows to the private sector.

There were of course individual countries in other regions that were showing vulnerabilities and were hit in the crisis, but the countries in the CEE and CIS region stood out as particularly vulnerable to the shocks that hit emerging market and developing countries in the past. The IMF’s Global Financial Stability Report from October 2008 summarizes these vulnerabilities in its Table 1.5 on macro and financial indicators for emerging markets very well. The shaded boxes that indicate potential problems in the table completely dominated the picture for CEE and CIS countries whereas other regions looked significantly less vulnerable. In short, history told us what shocks matter and the vulnerability indicators clearly showed where the shocks would do most damage.

Therapy 2.0

What are the policy lessons from this? Countries will always be subject to different types of shocks, and the question is how these shocks can best be absorbed to minimize the economic costs. In other words, what is the “therapy” needed to deal with these shocks? A key challenge is to find the policies and tools that strike the right balance between crisis prevention and high sustainable growth. Isolation to protect against external shocks is certainly not the answer.

Early warning systems (EWS) that identify vulnerabilities ahead of time and give policy makers time to reduce these vulnerabilities and thus avoid crisis is of course what everyone dreams of. The IMF and others have worked on various EWS models since the Mexican and Asian crises with mixed success (see Berg, Borensztein and Pattillo, 2005). With this crisis, the G20 and other groups of policy makers have made new calls for developing EWS, at times seemingly unaware of past efforts and the limited success in this area.

However, at the IMF the more formalized or mechanical EWS models are complemented with both bi-lateral and multilateral surveillance with the bulk of the findings made publicly available and communicated to relevant policy makers. These surveillance efforts contain much more information than more limited EWS models and also come with policy recommendation on how to deal with potential vulnerabilities.

There are of course limitations also with the surveillance by the IMF and other international and domestic organizations. First of all, they have to get it right and at the right time. This is far from trivial, not least because of our limited understanding of the links between the financial sector and the real economy. And even when the analysis gets it “right” in the sense of identifying vulnerabilities, it may take a long time before vulnerabilities translate into real problems and during this time, the analysis and recommended policies may seem misguided.

This is linked to the second major issue; to make relevant policy makers (politicians) listen to and take action on the advice. There is a reason Reinhart and Rogoff called their book “This time is different” since this is often the response to warnings from the IMF and others that suggest a party has been going on for too long and the punch bowl needs to be taken away.

Given the limitations of early warnings and surveillance more generally, there remains a strong need to reduce vulnerabilities in a systematic manner and develop tools to deal with the crises that were not prevented. This will require both domestic measures and a strong commitment to international cooperation. The latter part is of course extremely important right now in order to find appropriate solutions (read debt resolutions) to the problems cross-border banking and capital flows have created. It will also be key in setting up the rules for the future: what capital requirements should banks have; (how) should financial transactions or institutions be taxed; how can cross-border supervision be made more efficient; what type of crisis resolution mechanisms should be put in place both at the international and regional levels; etc, etc. Unless there is broad international agreement on these issues they will do little to address the weaknesses that were at the heart of this crisis.

On the domestic side, the usual IMF recommendation of creating a stable macroeconomic environment—with fiscal room to maneuver and a monetary policy that leads to stable prices—is always going to be part of a countries ability to absorb shocks. For countries that are integrated in international financial markets, exchange rate flexibility and a reasonable level of international reserves seem to be advisable. Jeanne and Rancière (2008) analyze optimal foreign exchange reserves for countries that are subject to sudden stops. Becker (1999) instead looked at accumulation of government assets as part of an optimal public debt and asset management strategy in a world with bailouts of the private sector which seems particularly relevant today.

The macro side should of course be combined with strong domestic supervision of the financial sector; structural policies that lead to sustainable growth in a competitive global environment; and strategies in commodity exporters to reduce the vulnerabilities associated with a narrow export base.

Although advanced countries get most of the attention in the international financial press today, emerging market and developing countries should not think that this is a new world were the shocks of the past do not matter to them. They do, so better get ready for “shock therapy” the market way while there still is time.

Bibliography

  • Becker, T., (1999), “Public debt management and bailouts”, IMF WP 99/103.
  • Becker, T. and P. Mauro, (2006), “Output drops and the shocks that matter”, IMF WP 06/172.
  • Berg, A., E. Borensztein, and C. Pattillo, (2005), “Assessing Early Warning Systems: How Have They Worked in Practice?”, IMF Staff Papers, 52:3, 462-502.
  • Berglöf, E. and G. Roland (2007), The economics of transition—The fifth Nobel symposium in economics, Stockholm Institute of Transition Economics (SITE) and Palgrave Macmillan.
  • IMF (2008), Global Financial Stability Report, “Financial stress and deleveraging”, October, Table 1.5 p.46.
  • Jeanne, O. and R. Rancière, (2008), “The optimal level of international reserves for emerging market countries: A new formula and some applications”, CEPR Discussion Papers 6723.
  • Reinhart, C. and K. Rogoff, (2009), “This time is different: eight centuries of financial folly”, Princeton University Press.
  • Åslund, A., (1992) “Post-Communist Economic Revolutions: How Big a Bang?”, Center for Strategic & International Studies, Washington D.C..

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.