Neoliberalism, Accountability, and Reform Failures in Emerging Markets

The agenda of neoliberal market reform known as the Washington Consensus, which was meant to turn around the economies of developing and postcommunist countries and provide the bedrock of economic success on which stable democracies could be built, has largely proved to be a failure, with Russia and many Latin American countries like Argentina left in severe economic crisis by the end of the 1990s.

Some proponents of neoliberal reform, such as Anne Krueger, have attributed this failure to the piecemeal and incomplete implementation of reform measures, while others, including Nobel Prize economist and former World Bank vice president Joseph Stiglitz, have pointed to technical flaws in the policies. While both of these assessments focus narrowly on economic factors, Luigi Manzetti highlights the crucial importance of political institutions and processes to a fully adequate explanation. His argument is that the ideology of neoliberal reform, rooted in the theories of Friedrich von Hayek and Milton Friedman, assumed political checks and balances that did not exist in many of these countries undergoing market reform, and that only by taking political accountability as an influential variable in the equation for success can we really understand what happened. Where accountability was weak, patterns of corruption, collusion, and patronage worked to undermine the intended aims of market reform. Manzetti uses both large N statistical analyses and small N case studies (of Argentina, Chile, and Russia) to provide empirical evidence for his argument.

“This book, exceptionally well written and well documented, maps the causes and consequences of the Washington Consensus, calculating the costs imposed where it was implemented.”—S. J. Linz, Choice

“This volume explores important questions about the relationship between democracy and economic crises. Specifically, Manzetti asks how institutions of accountability may produce less corruption, more open markets, and better governance, and, therefore, ultimately lead to greater economic stability. The book offers convincing empirical evidence in favor of this thesis and against alternative arguments that either disregard politics or view democracy as an obstacle to good economics.”—Sybil Rhodes, Western Michigan University

“At a time when the connections among politics, governments, and markets are more urgent concerns than ever before, Manzetti guides us through hotly contested terrain with confidence, displaying both a comprehensive view of the big picture and a keen eye for detail. He reaches beyond the usual generalizations about neoliberalism and democracy to examine the opportunities and constraints shaping behavior at many levels. We are reminded, even as government’s role in the economy changes, that those in charge will search for ways to govern—to build political support and use it—employing the incentives and institutional forces at hand. Manzetti’s emphasis on the value of democratic political processes is a welcome corrective to the notion that unfettered markets are wholly self-regulating or amount to a kind of private substitute for governance. Carefully chosen, detailed case studies both illustrate those broader arguments and show the necessity of understanding how politics and liberalized markets function in real, rather than just ideal, settings. Manzetti’s book will be both useful and provocative for analysts and policymakers alike.”—Michael Johnston, Colgate University

Luigi Manzetti is Associate Professor of Political Science at Southern Methodist University.

Contents

Preface

1. Accountability and Market Reforms

2. Financial Crises in Comparative Perspective

3. Russia

4. Argentina

5. Chile

6. Conclusion

References

Index

Figures and tables are grouped at the ends of chapters 2, 3, 4, and 6.

1

Accountability and Market Reforms

Introduction

Since the early 1980s, market reforms have been considered indispensable for reviving the ailing economies of developing and postcommunist countries. Inspired by neoliberal economic theory, these reforms were adopted, in varying degrees, throughout many countries of the world during the 1990s. One of the pivotal contentions that their proponents made from a broad political standpoint was that free markets are the best agents for bringing about individual freedom and, therefore, democracy. Rolling back the state, according to free-market advocates, would lead to sustained growth and strengthen individual rights in the economic and political realm. Thus, the message that the most industrialized nations sent struggling countries worldwide was straightforward. Free markets and democracy go hand in hand, and if a country wanted to become part of the democratic capitalist system, market reforms were in order. By the early 1990s, lacking an alternative credible strategy, and often with a dire need to obtain international financial aid, many less developed countries around the globe (now dubbed “emerging markets”) joined the bandwagon.

Indeed, the 1990s marked the heyday of market reforms, but their results were at best disappointing (World Bank 2005). After some progress in the first part of the 1990s, many Latin American countries suffered serious economic downturns. In the former Soviet republics the transition from the command economy to markets was traumatic and associated with sharp declines in output and living standards, whereas some Eastern European countries, including the Czech Republic, Hungary, Slovenia, and Poland, showed good progress after going through painful adjustments. Success stories were also the exception in the sub-Saharan region. Substantial growth and poverty reduction were primarily confined to East and Southeast Asia, but its star performers, China and India, applied the market reform agenda very selectively. On the one hand, they created incentives to export, but on the other, they ignored core policies such as privatization, labor reform, and fiscal reform and retained strong industrial policies and high trade barriers (World Bank 2005; Rodrik 2006).

Equally troubling was the fact that, as time went on, some of the largest emerging markets to have adopted market reforms were crushed under waves of unprecedented financial crises. Chile, which pioneered such reforms beginning in the mid-1970s, had already provided an early warning that when policies were implemented in a nontransparent way they were self-destructive, as its financial meltdown of 1982 proved. The trend continued with greater ramifications starting with Mexico (1995), to be followed by Thailand (1997), South Korea (1997), Indonesia (1997), Russia (1998), Turkey (2001), and Argentina (2001/2002).

While economic policies played an important role in the collapse of these economies, observers increasingly began to notice that they often shared disturbing similarities in the political realm; namely, that the lack of transparency exposed repeated instances of moral hazard. On many occasions, policy makers’ behavior raised suspicion that they exploited their positions of power to reward political clienteles, thereby enriching themselves at the expense of their own people, the national coffers, investors, multilateral aid agencies, and foreign governments. For instance, privatization, which symbolized market reforms in the former Soviet bloc and Latin America, was marred by charges of corruption and crony capitalism that undermined its many successes (IDB 2007, 1). By 2008 these factors heavily contributed to the popular rejection of state divestiture in that region of the world and gave a pretext for populist leaders such as presidents Hugo Chávez in Venezuela, Nestor Kirchner in Argentina, and Evo Morales in Bolivia to return several key industries and public utility companies that had been privatized in the 1990s to government ownership (“Populism for a Price,” Washington Post, August 3, 2007).

The danger that market reforms pursued in a political system lacking accountability opened up opportunities for old-style politics, threatening their sustainability and the legitimacy of the democratic process associated with them. Discussing the Argentine crisis of 2001/2002, the then U.S. secretary of state, Colin Powell, warned that serious political and institutional changes were needed to bring transparency and accountability to Argentine government action (“Going South: Old Demons Return to Haunt Latin America Progress,” Wall Street Journal, July 25, 2002). Months later, the then U.S. treasury department secretary, Paul O’Neill, was even more explicit as he added that his government was reluctant to bail out Latin American countries if aid would end up in Swiss bank accounts (“The U.S. Pumps $1.5 Billion into Uruguay to Avert Latin American Crisis,” The Independent, August 5, 2002).

As noted, some of the most important countries that took the path of market reforms ended up in severe financial crises with negative socioeconomic consequences that, in some cases, linger on to this day. Other countries avoided financial meltdowns but struggled, while a few instead met with success. Why have some countries succeeded and others failed? What went wrong in countries that experienced major financial crises?

An extensive literature in economics has tried to address these questions. In justifying so many “disappointments,” the International Monetary Fund (IMF) and many economists supporting market reforms have contended that political leaders lacked the necessary commitment and tried too little, and, even when the commitment was there, the breadth and scope of reforms was uneven and policies were implemented in a piecemeal fashion (Shleifer and Treisman 2000, Åslund 2002; Kuczynski and Williamson 2003; Krueger 2004; Singh et al. 2005). According to this line of thinking, the soundness of the theory behind market reforms is not the issue since the problem arose from a mix of lack of political will and poor execution.

Critics of this point of view, however, argue instead that such policies were theoretically flawed and created more problems than those that they were attempting to solve, which often ended in the worst of both worlds as they impoverished many countries while keeping corrupt politicians in power (Stiglitz 2002).

Institutions and Growth

Both sides of the argument just described contain elements of truth and have made important contributions to the scholarly debate, but they both downplay the question of how politics, and particularly political institutions, shaped the reform processes that ushered market reforms in emerging markets. This book will try to fill this gap in the literature from the vantage point of political science. This is not to imply that macroeconomic factors did not matter. On the contrary, my goal is to complement the insights that economists have developed so far by focusing on theoretical and institutional factors that contributed significantly to the design and implementation of reform policies, thus shaping their outcomes. Institutional explanations about economic performance stem from the early theoretical works of North and Thomas (1973), North (1990), and Olson (1965, 1982). While some studies have dismissed the importance of institutions (Sachs 2003; Goldsmith 2005), other empirical works have shown the importance of institutional factors in determining economic performance (Krusell and Ríos-Rull 1996; Parente and Prescott 1999; Hall and Jones 1999; Acemoglu and Robinson 2000, 2001; Easterly and Levine 2003). Dollar and Kraay (2003) found that when institutions are treated as exogenous, there is significant partial association between trade and growth even after the inclusion of a variety of proxies for institutional quality. However, their model leads to inconclusive results once institutions are treated as endogenous.

Some studies have focused specifically on the role of democracy in promoting economic growth. For his part, Barro (1996) argued that low levels of democracy positively affect growth, but as democracy becomes more mature, its impact turns negative, whereas Rodrik (1997, 1999, 2007) concluded that democracy produces less randomness and economic volatility, is better suited to manage shocks, and produces more equitable distributional outcomes. In yet another study, Rivera-Batiz’s (2007) results suggested that democracy does have a direct influence in total factor productivity but only when democratic institutions are associated with greater quality of governance. Conversely, when democratic institutions do not result in enhanced governance, then democracy has a negligible effect on growth. For Keech (2009), instead, the impact of democracy in the short term is mixed at best. It is in the long run that democratic institutions, once consolidated, are instrumental in the sustainability of good economic performance.

However, only a handful of studies have focused on the relationship between institutions and economic crises, and the results have run counter to conventional wisdom. The most important of such works concluded that “distortionary macroeconomic policies are more likely to be symptoms of underlying institutional problems rather than the main causes of economic volatility, and also that the effects of institutional differences on volatility do not appear to be primarily mediated by any of the standard macroeconomic variables. Instead, it appears that weak institutions cause volatility through a number of microeconomic, as well as macroeconomic, channels” (Acemoglu et al. 2003, 49).

Moreover, and just as important, Acemoglu et al. (2003) asserted that the economic instability of institutionally weak societies is not particularly the result of external shocks (such as a world recession) but is caused by their inability to deal with their own political problems in the first place. Further works (Addison and Baliamoune-Lutz 2006, 1030) pointed out that the economic literature “has less to say about the relationship between economic reform and institutions, and how that relationship can differ at different stages in the process of improving institutional quality.” Indeed, when institutions do not conform to policy reforms (either because they are in the process of being reformed themselves or are obsolete), it is not surprising then that “donor-sponsored reforms break down and . . . have unintended results” (Addison and Baliamoune-Lutz 2006, 1030). Consistent with previous findings by Acemoglu, Johnson, and Robinson (2001), Dollar and Kraay (2003), and Rodrik, Subramanian, and Trebbi (2004), Addison and Baliamoune-Lutz (2006, 1040) found evidence that institutions play a crucial role, but their impact is not linear. In fact, countries in the middle range of institutional quality (measured by using Freedom House’s indexes on political rights and liberties), and moving only slowly toward a free society, may experience weak or even negative economic results. In other words, not only do institutions matter for successful reforms but their quality matters even more.

However, while economists have been interested in explaining growth and/or economic crises using broad measurements of institutional capacity, my focus in this book centers on the logic behind market reforms and how their success or failure has been influenced by democratic institutions of political accountability in emerging markets. Accordingly, the first goal of the book is to show how market-oriented economic theory, despite its strong belief in individual freedom when it comes to the economic realm, is rather ambivalent about the virtues of the democratic process. As I will argue later, this partly explains why market-oriented reforms once put into concrete policy action in emerging markets were often used to undermine political accountability and the due process associated with democratic governance. The logic vis-à-vis the practice of conservative economic theories is an aspect of the market-reform agenda that has been usually scarcely examined in the economic literature but is of fundamental importance if we want to understand why by the early 2000s such theories fell in disrepute in so many emerging markets as they became associated with corruption, crony capitalism, and patronage politics. Focusing on the theory and practice of conservative economic thinking will also shed light into the reasons why the United States and the international financial institutions (IFIs) often condoned, and on occasions even blessed, policies that they knew were marred by all kinds of irregularities and deliberately ignored or even dismantled the checks and balances of the democratic process.

The second goal of the book is to support its core argument. My thesis, which I will develop in greater detail later in this chapter, is that if market reforms are implemented without accountability, then they are likely to be manipulated in a way that creates opportunity for corruption, crony capitalism, and political patronage—all factors that are conducive to large fiscal deficits and costly rent-seeking behavior. Consistent with previous works on Russia and Eastern Europe (Stark and Bruszt 1998; Orenstein 2001; and Gould 2003), I will argue that governments that implement market reforms without being bound in their action by accountability institutions are likely to experience financial crises. Conversely, those countries whose executives are held in check through a variety of accountability institutions are more likely to avoid financial crises and put into place market-friendly policies that yield positive results as the proponents of market reforms envisioned.

The Rise of Neoliberal Economic Theory

Market reforms have been inspired by the theories of Friedrich von Hayek (1944) and Milton Friedman (1962). These scholars have usually been dubbed as “neoliberal” because their writings are modern adaptations of the “liberal” or “laissez faire” economic thinking pioneered by Adam Smith, who postulated that capitalism performs best when left to its own devices and unhindered by government regulation. While economists have written much about the pros and cons of Hayek’s and Friedman’s theories, analysts have paid relatively little attention to the role that these two scholars have assigned to politics and the role of government institutions in a capitalist economy.

Consistent with the teachings of Ludwig von Mises and the Austrian school of economics, of which he was a member, Hayek (1944) contended that the best way to coordinate people’s economic activity is to promote free markets and foster competition whenever possible. In Hayek’s view, competition is at the heart of economic growth as it functions as a voluntary social control mechanism by allowing individuals to pursue their self-interest. In so doing, competition is a much more efficient tool to organize an economy than government regulation, which he regarded as cumbersome, wasteful, and prone to arbitrary and coercive decision-making processes. Far from advocating the status quo benefiting vested interests, Hayek argued that where competition does not exist, it should be created. He also believed that democracy is an important safeguard against tyranny but can only exist if there is first freedom of contract. Thus, democracy is a means to strengthen economic freedom, not an end in itself. Moreover, to prevent that democracy from becoming captive to special interests and totalitarian legislative majorities, it must be bounded by the “rule of law” (Bellamy 1994). In this regard, Hayek believed that the best means to accomplish effective democracy and healthy competition was by having government establish a legal framework that protected individuals’ rights and the contract obligations of the parties involved. These measures would, on the one hand, restrict the coercive powers of government vis-à-vis its citizens and, on the other, discourage collusion and entry barriers.

Friedman (1962) later argued much of the same, but at times in a more radical fashion. For Friedman economic freedom is an end in itself and a prerequisite for the establishment of political freedom. Thus, the freer individuals are from government regulation in economic transactions, the freer they would be in the polity. Friedman believed that because government regulation allows politicians to abuse their power to pursue their own interests, it is a universal culprit impinging on individual freedoms. Therefore, if politicians are to be deprived of the authority to curtail individual freedom, government intervention must be reduced to only the most basic tasks, including national defense and the definition and enforcement of property rights. This last point was particularly important in Friedman’s theory, as it was meant to create a level playing field that would prevent noncompetitive behavior. Like Hayek, Friedman believed that competition in the marketplace is the best means to promote freedom and, at the same time, the best antidote to prevent monopolistic behavior from private agents. Within this context, Friedman assigned to government the role of establishing antitrust legislation and institutions to deter collusion. Everything else, Friedman contended, could be handled much more efficiently by the private sector.

In the mid-twentieth century Hayek and Friedman played a pivotal role in sharpening and keeping alive economic liberalism, which had dominated economic policy in the United Kingdom, the United States, and Latin America until 1929 but had fallen in disrepute as it was identified as the main cause behind the Great Depression. In fact, from the 1930s until the early 1980s, policies in industrialized nations abided to the principles enunciated by John Maynard Keynes, which created welfare states and granted government extensive regulatory powers along with the control of key industries in what Lenin called the “commanding heights” of the economy. In a similar vein, after World War II the most important developing countries, in their attempt to become more self-sufficient and less exposed to commodity fluctuations, adopted import substitution industrialization (ISI) and economic protectionism (Prebisch 1950). Yet, the most radical rejection of economic liberalism came from Marxism-Leninism. As the Soviet Union influence increased tremendously after World War II in Eastern Europe and developing countries, so did its model based on a command economy.

However, by the mid-1970s the theoretical ideas of Hayek, Friedman, and their colleagues at the University of Chicago began to achieve greater acceptance not just among economists but, most important, among conservative leaders such as General Augusto Pinochet, Margaret Thatcher, and Ronald Reagan who embraced parts of their theories and turned them into policies. This is why economic neoliberalism has usually been identified with conservative (if not authoritarian) political agendas. For instance, Chile was the first country to experiment extensively with many of Friedman’s principles, but, due to the brutal nature of the Pinochet’s dictatorship (1973–90), its accomplishments were usually dismissed. For her part, Thatcher proudly admitted that her controversial reforms, which overhauled the United Kingdom between 1979 and 1990, were deeply influenced by Hayek’s ideas. However, it was only after President Reagan (1981–89) assumed power and reshaped the U.S. economy according to Hayek’s and Friedman’s theories that the neoliberal economic view began to shape the policies of the U.S. Treasury (Stiglitz 2002).

By the mid-1980s the policy cycle had come full circle. Keynesianism and ISI had produced on many occasions stagflation, whereas the Soviet economic system was rapidly crumbling. In sharp contrast to these events, the Chilean, British and U.S. economies, with their emphasis on free markets, were on the rebound and, by either default or true change of heart, world leaders began to look to neoliberalism as the only way out to jump-start their troubled economies (Yergin and Stanislaw 1998).

As a direct consequence of the return to prominence of economic liberalism, the late 1980s witnessed the emergence of the so-called Washington Consensus (henceforth WC), which borrowed extensively from Hayek’s and Friedman’s seminal works. According to John Williamson (1990), who coined the term, the consensus represented the prevailing economic thinking at the U.S. Treasury, the IMF, the World Bank, and many policy think tanks in Washington on how to tackle the Latin America economic crisis. Indeed, the relevance of the WC’s agenda was that its thinking shaped much of the IFIs’ policy advice, chief among them the IMF and the World Bank, as well as their conditionality clauses in disbursing financial aid (World Bank 2005; Woods 2006). Eventually, as more countries began to ask for the IFIs’ financial assistance, the WC’s recommendations began to be applied, almost indiscriminately, to the former Soviet bloc, Asia, and Africa. As such, in line with Hayek’s and Friedman’s teachings, the WC advocated neoliberal policies along the following lines (Williamson 1994). First, the WC endorsed the establishment of macroeconomic stability through the efficient use of economic resources. This meant balancing government budgets while liberalizing the economy and opening up domestic markets to foreign competition. Reducing tariffs and quotas, ending price and exchange controls, eliminating agricultural/industrial subsidies, and lifting restrictions on financial inflows and services were all policies that the WC required for the disbursement of financial assistance. Second, private initiative had to replace government intervention in allocating resources. This implied reducing the size of government and its role in the economy only to fundamental tasks. Privatizing state-owned enterprises (SOEs), dismantling a web of business licenses and regulations, and breaking up monopolies were the most visible policy measures in this regard.

In justifying the inevitable hardship associated with the market reform agenda, the WC painted a rosy picture by promising to accomplish two interrelated goals in a relatively short period of time. Economically, its policies, after the initial social costs, would bring sustained growth. Politically, following Hayek and Friedman, it assumed that by freeing the market from government interference the individual’s freedom would be enhanced and, consequently, democracy in emerging markets would be strengthened as well.

By the early 1990s, Przeworski (1991, viii) described the impact of the WC’s policy advice to emerging markets in the following terms: “We are living in a highly ideological epoch. . . . They implement an intellectual blueprint, a blueprint developed within the walls of the North American academia and shaped by international financial institutions. They are radical: they are intended to turn upside down all the existing social relations. And they offer a single panacea, a magic wand, which, once waved, will cure all the ills. For the first time in history, capitalism is being adopted as an application of a doctrine, rather than evolving as a historical process of trial and error.”

Neoliberalism and Accountability

To understand the WC’s broad ramifications from a political economy perspective, it is worth remembering that, following Hayek and Friedman, its main proponents assumed two main conditions. First, economics drives politics, and once the right policies were designed, politicians would implement them. Second, and more important in our case, markets must operate within a polity where:

1. Executives are bound by constitutional checks and balances in the exercise of their authority.

2. The legislative branch is responsive to an appreciable degree to the electorate.

3. The judiciary is expected to render decisions that are predictable and fairly independent from political interference, which guarantees the upholding of property rights.

These three conditions are essentials for a thriving capitalist economy because they restrain politicians, legislators, and judges alike from making discretionary decisions that could otherwise spook the market and distort asset allocation (Kydland and Prescott 1997). By the same token, they are the essence of the principle, developed early on by James Madison, that government institutions must be accountable to their citizens and to one another. Following this rationale, if accountability is a sine qua non for a modern capitalist economy, the same applies to market reforms because their goal is to create the same kind of economic regime in developing countries.

While theoretically sound in principle, the WC for the most part purposely neglected the importance of strengthening institutions of accountability. As Rodrik (2006) noted, the neoliberal proponents of the WC reform policies did not require major institutional changes. Indeed, even if the three assumptions mentioned above did not materialize, the WC hoped that the soundness of its policies would, in their own right, make up for possible institutional weaknesses (World Bank 2005). The rationale behind this line of thought rested on the belief that had market reform succeeded in promoting sustained economic growth, they would create the incentives for establishing effective institutions at a later stage. The strong bias against government institutions, which up until the 1980s had been instrumental in enacting interventionist policies, led the WC’s advocates to emphasize instead the establishment of a few rule-based reforms with a narrow focus; namely, limiting policy discretion. This meant insulating central banks from political interference, joining international and regional trade agreements (General Agreement on Tariffs and Trade and its successor, the World Trade Organization), submitting government-foreign business disputes to international arbitration, and adopting currency boards or even dollarizing the economy to impose monetary discipline (World Bank 2005, 49).

Only in the mid-1990s as problems began to mount did the WC’s policy recommendation list expand by adding the so called “second generation” reforms, some of which began to address institutional issues. The policy approach just described explains why the neoliberals of the WC gave top priority only to one side of the equation (the economic one) despite abundant theoretical evidence (North 1994) suggesting that when a country adopts the formal rules (in our case, promarket reforms) of another, the results may turn out quite differently because the recipient country may have very different formal and informal institutions (in our case, political).

To make things worse, once the theory was put into practice, it was clear that the neoliberals leading the U.S. Treasury Department, IFIs, and prominent think tanks were quite ambivalent about the democratic process and the feasibility of combining sweeping market reforms within the context of democratic principles and procedures (Orenstein 2001; Stiglitz 2002; Rodan 2004). Their fear was that democratic institutions and their processes could be manipulated by those parties and vested interests opposing market reforms.

It soon became evident that despite the official statements supporting democracy and the due process, the U.S. Treasury and the IFIs’ top priority was the quick implementation of trade liberalization, privatization, and anti-inflationary policies before the honeymoon period would evaporate. Likewise, the short-term costs of market reforms could prove too severe, thus resulting in a political backlash and reform-minded governments being voted out of office. Thus, the WC stressed a quick implementation of the reform package to take advantage of the window of opportunity opened by the demise of the previous economic regime before powerful interests could block it. The “shock therapy” approach (i.e., the adoption of the core neoliberal policies in very short order) was the main policy style to usher market-friendly reforms. This was an open rejection of the “gradualist approach,” which had been tried unsuccessfully in Latin America and the Soviet bloc in the second half of the 1980s. Indeed at the time “a belief in gradualism had almost become tantamount to a confession of a lack of reforming virility” (World Bank 2005, 7).

Sachs (1993), one of the most influential supporters of shock therapy, having advised several key reformers including Bolivia, Argentina, Poland, and Russia in this direction, made the point quite clear on how such an economic approach should be managed politically. He stated that the executive should be (a) insulated from checks and balances and (b) entrusted upon with special decree powers bypassing the legislature to ensure a quick execution of the reform agenda. After all, this apparent contradiction between promoting free markets through not-so-democratic means could still be reconciled with Hayek’s and Friedman’s contention that market freedom drives democracy, not the other way around. Once you establish the first, the other will follow. Consequently, for the neoliberals the technocratic reforms imposing limits on democratic procedures were a short-term cost worth paying because if their policies were to be well executed they would strengthen democracy in the medium term (Orenstein 2001, 15). Thus, the neoliberals regarded the market reforms enshrined in the WC as the optimal technocratic solution to decades of economic mismanagement created either by ISI (Latin America, Asia, Africa) or Communism (Soviet Union, Eastern Europe). Such a belief was synthesized by Lawrence Summers: “Spread the truth—the laws of economics are like laws of engineering. One set of laws works everywhere.”

Unfortunately, from a political standpoint the problem was that all too often neoliberals were so eager to see market reforms take advantage of the window of opportunity presented by the demise of ISI and Communism that they trusted their execution on national leaders who had a troublesome track record. Their underlying hope was that former Communist and populist politicians would have a change of heart and become true believers in the power of the market. Regrettably, such leaders often manipulated foreign governments and IFIs rather than the other way around because, on many occasions, they pledged to enact some of the WC’s policies but made sure that such policies would be crafted in a way that increased their power and favored economic groups close to them. Indeed, self-proclaimed economic reformers in Mexico, Argentina, Indonesia, Thailand, and Russia, to name a few, expressed willingness to embark on the reform process in exchange for substantial foreign aid but nonetheless continued to operate according to the shady formal and informal norms of the past through the emasculation of accountability institutions. The means may have changed (market capitalism replacing Communism or ISI), but the end game’s ultimate goal, from a politician’s perspective, remained the same: retaining political power. Not surprising, when reforms were characterized by highly concentrated executive powers they often failed and ended, in some cases, in serious financial crises.

For instance, in order to “democratize” the market many countries in Latin America (Argentina, Brazil, Bolivia, Ecuador, and Venezuela) indiscriminately used executive orders/emergency decrees and in the case of Peru the closing of the Congress, which made a mockery of the democratic process. Government officials in these countries defended their unorthodox methods by arguing that time was pressing and that resorting to normal legislative procedures would give vested interests the opportunity to derail the reform effort. By 1992, however, there were already clear signs that some administrations, with the excuse of swiftly implementing government plans, were using loopholes, created by the emergency powers acquired by the executive, to pursue old-style corrupt and clientelistic ways. The impeachment of presidents Fernando Collor de Mello (Brazil) and Carlos Andrés Pérez (Venezuela) began to raise questions not only about the soundness of market reforms per se but also about the consequences for democratic governance of their controversial implementation. Brazil and Venezuela were able to get rid of corrupt leaders relatively quickly, but other countries were incapable of doing the same, which penalized them even further as time went on. In the end, it was not just individual countries that lost out but also the neoliberal argument to reshape the world economy.

The Meaning of Accountability

Since the late 1960s there has been a growing demand for the accountability of public officials in many countries around the world. In both developed and developing countries the gulf between citizens vis-à-vis the government institutions that are supposed to pursue the public interest has widened as a barrage of scandals has tarnished the reputation of politicians and civil servants. In fact, the past few decades have witnessed a marked decline in public trust and government effectiveness even in the strongest democracies (Pharr and Putnam 2000). People have become increasingly frustrated with the amount of government secrecy and lack of accountability in the industrialized world, much of which was tolerated during the cold war years but could not be justified after the demise of the Soviet bloc. As research has shown, the less information is available to citizens, the more politicians are prone to pursue their own agendas and appropriate economic rents for their supporters (Barro 1973; Ferejohn 1986). However, the emergence of an aggressive investigative media, grassroots movements, and nongovernmental organizations (NGOs), among other factors, has placed greater and greater pressure on public institutions to become more accountable. The trend has not been confined to advanced industrial societies and in the last two decades has taken a global dimension (Kahler 2004; Held and Koenig-Archibugi 2005). Since the early 1980s in the developing world the demise of various types of autocratic and Communist governments has prompted citizens to question their politicians and the authoritarian manner in which they often use public institutions. In describing the phenomenon taking place in developing countries, Mulgan (2003, 3–4) noted: “[People] are looking to strong institutions of accountability, such effective political opposition, and independent judiciary and free media, as means of making their societies both [freer] and more prosperous. They see the lack of transparency and the potential for corruption as an affront to increasingly universal democratic values. Lack of accountability also detracts from the ‘good governance’ which is considered to be necessary for social and economic development.” Indeed, political accountability is today regarded as being an indispensable component of good governance and economic growth because as political accountability increases, so do the costs that public officials incur when acting to their own personal benefit or that of their cronies. Thus, political accountability works as a powerful deterrent against illegal practices.

What is accountability? In a democratic system, citizens delegate broad powers to their representatives (elected officials) and their agents (civil servants) to rule them. Restraining officeholders from abusing such powers is a defining feature of modern democracies that sets them apart from various types of authoritarian regimes where the exercise of authority is instead highly arbitrary and subjective (Schacter 2001). Ensuring that political power is exercised according to well-defined rules is therefore a pillar of democratic governance. In other words, in a democracy, both elected and nonelected officeholders must be accountable for their actions while exercising the power granted to them by the citizenry. Thus, accountability works to promote fair, honest, and effective government. It implies the notion that elected and nonelected officials should answer and take responsibility for their actions (Keohane and Nye 2001). Equally important, “political accountability must be institutionalized if it is to work effectively” (Schmitter 2004, 48).

We can distinguish two broad types of accountability. The first is what scholars define as direct or “vertical” accountability, which is exercised by the citizenry on government officials. The most common forms of this type are “bottom up” in kind, such as elections through which voters have a chance to hold elected officials accountable for their past behavior. The assumption here is that citizens are capable through the ballot box to force the government to choose between addressing its wrongdoings and suffering declining support or potentially losing office.

However, this type of accountability suffers important limitations. As noted by Manin, Przeworski, and Stokes (1999), elections represent weak means in order to keep politicians accountable since they take place over relatively long periods of time, voters’ preferences may be influenced by multiple issues that may not be linked to the intention of punishing incumbents for their past behavior, and voters often lack the necessary information to assess government performance. Other forms of direct accountability, however, can be even more effective. For instance, civil organizations and the media can play an important role as societal agents of control (Peruzzotti and Smulovitz 2006). As opposed to elections, they can do so continuously and their actions can be quite focused and clearly linked to specific issues of wrongdoing. As Wampler (2004) noted, “citizens now have access to a range of legal and political resources to pressure public officials, including lawsuits, public demonstrations, public hearings, and participatory institutions.” Stark and Bruszt’s (1998) “extended accountability” tries to incorporate both institutional and societal means to limit executive authority through networks of autonomous societal and political institutions.

The weakness of elections and other forms of vertical accountability is what first drove the United States, and many countries later, to devise an elaborate system of checks and balances. As democracies developed they embraced the idea of limited government, whose aim is to prevent the concentration of coercive power and its use in an arbitrary fashion. Limited government espouses the idea of respecting individual rights in the political and economic realm through a number of self-enforcing institutions and the upholding of the rule of law. Economically, limited government is fundamental because if elected and nonelected officials do not restrain themselves, investors will fear confiscation and sudden changes in the rules of the game that, as discussed earlier, is at the center of Hayek’s and Friedman’s theories. Politically, limited government in a democracy aims at safeguarding individual rights and is the fabric holding together the social contract between the citizens and their rulers (Shepsle 1991; Weingast 1997). Limited government institutions vary across democracies, but they tend to be multiple in nature, creating overlapping veto points in the decision-making structure. In this way, rulers can assure their citizens of their commitment to restrain their authority by creating institutional checks and balances. In fact, empirical evidence demonstrates that appropriate checks and balances create enough conflicts of interest between the executive and the legislature on public policy to force both institutions to compromise and thus discipline themselves to the voters’ advantage (Persson, Roland, and Tabellini 1997).

This consideration brings us to the second type of accountability, which is exercised within the state through a variety of institutions to check and restrain itself (Schmitter 2004). It entails both monitoring and oversight functions. More recent works emphasize a broader, more encompassing definition, such as enforcement in addition to answerability (Schedler, Diamond, and Plattner 1999). The first element fits the standard definition. However, accountability does not necessarily imply punishment. One may account for his/her behavior but not be punished if the oversight institution in charge of controlling does not have the mandate to impose punishment. This is not an unusual situation, and oversight institutions without the power to sanction are often perceived as weak and ineffective (Ostrom 1990). The second element, enforcement, explicitly adds the notion that power is subject to punishment if oversight institutions detect unlawful behavior on the part of officeholders. The effectiveness of oversight institutions is therefore not based solely on establishing the parameters of who answers to whom and on what matters; rather, it also depends on their having tools to prosecute those who violate the public trust (O’Donnell 1999). As Schedler, Diamond, and Plattner (1999, 17) pointed out, “unless there is some punishment for demonstrated abuses of authority, there is no rule of law and no accountability.”

Accountability also goes beyond the limits imposed by principal-agent relationships. Legislative scholars (McCubbins and Schwartz 1984; Laver and Shepsle 1999; Shugart, Moreno, and Crisp 2002) have usually stylized accountability as a way for the principal (voters/legislatures) to keep in check its agent (the legislator/prime minister/president). While this clear-cut application of the concept makes it suitable for statistical and game-theoretic analyses, it is restrictive (Ferejohn 1999). In fact, it limits the means of accountability to a few cases (voters and elected officials, parliaments and cabinets) while excluding a large number of other institutions that do not fall into the principal-agent relationship (Mainwaring and Welna 2003). These institutions are not elected (some administrative units of the bureaucracy) and in some cases are given autonomy in performing their tasks (special oversight agencies, the judiciary). Thus, principal-agent relationships can be better understood as a subset of a broader definition of accountability (Mainwaring and Welna 2003).

Who is accountable? Both elected and nonelected officials (civil servants) are. The latter fall primarily within the purview of the executive, but the legislative and judicial branches can also exercise considerable oversight over them. Which institutions are in charge of accountability? O’Donnell (1999, 38–39) labels the relationship interlocking different state institutions as “horizontal accountability,” which in his view is “the exercise of state agencies that are legally enabled and empowered, and functionally willing and able to take actions that span from routine oversight to criminal sanctions, or impeachment in relation to actions, or omissions by other agents or agencies of the state that may be qualified as unlawful.” Vertical institutions of accountability include the executive, the judiciary, and the legislature, as well as an array of specialized institutions such as the auditors general, anticorruption agencies, ombudsmen, special prosecutors, electoral and human rights commissions, and public-complaints and privacy commissions. For O’Donnell, horizontal accountability can be violated in two ways—by “encroachment” of one institution on another (that is, the executive encroaches on the legislature and the judiciary) and by “corruption” (the use of public office for private gain).

O’Donnell’s definition confines horizontal accountability to situations involving illegal behavior by individuals or institutions. Others, however, have espoused a broader understanding of accountability, which includes holding elected and nonelected officials responsible for their political behavior (Schmitter 1999; Schedler, Diamond, and Plattner 1999; Mainwaring and Welna 2003). According to this view, violations occur when political actors behave in a way that undermines the institutional checks and balances even if that does not represent a violation of the law.

So far we have examined accountability from the perspective of political science, but interest has been growing in similar topics in economics as well. Economists usually refer to some of the same issues under the mantle of good governance. What is the meaning of good governance? Governance, per se, describes the process of decision-making and the process by which decisions are implemented. For economists good governance implies a high degree of government effectiveness and efficiency in promoting economic policies that contribute to growth, stability, and the welfare of the citizenry. Further characteristics are a high level of responsiveness (to societal demands), accountability, transparency, public participation, openness, and a strong respect for the rule of law (Healey and Robinson 1992). According to the World Bank (1994, 2), good governance is “epitomized by predictable, open and enlightened policy making, a bureaucracy imbued with a professional ethos acting in furtherance of the public good, the rule of law, transparent processes, and a strong civil society participating in public affairs. Poor governance (on the other hand) is characterized by arbitrary policy making, unaccountable bureaucracies, un-enforced or unjust legal systems, the abuse of executive power, a civil society un-engaged in public life, and widespread corruption.”

Why did IFIs become so interested in good governance in the second half of the 1990s? This is in part due to a change in perception of their major shareholders, including the United States and to a lesser extent the European Union and Japan. The collapse of the command economies in the former Soviet bloc, combined with the abandonment of ISI in most developing countries, created a historic opportunity for the promotion of trade liberalization and privatization around the globe. However, this required that capital and portfolio investments, coming primarily from the industrialized nations, be safeguarded from old-style-government corrupt and collusive practices. In other words, the changed geopolitical and economic conditions made it imperative that governance standards be substantially improved. Under the Clinton administration (1993–2001) the United States began to sponsor several efforts that resulted in the establishment of international anticorruption conventions through the Organization of the American States (1996), the Organization for Economic Cooperation and Development (1997), and the United Nations (2003). Concomitantly, as a result of the United States’ diplomatic effort, by the late 1990s the World Bank and the IMF began to include governance clauses in many of their loan agreements, placing strong emphasis on the fight against corruption and noncompetitive behavior.

Moreover, although not publicly stated in the beginning, World Bank and IMF officials became increasingly worried that their aid funds aimed at combating inflation and promoting much-needed structural reforms were actually being wasted, and reforms were severely undermined by the lack of transparency in government accounts and in the regulatory environment for private sector activity (Broadman and Recanatini 2000). In the mid-1990s, World Bank and IMF cross-national studies invariably concluded that good governance in emerging markets was of fundamental importance for the success of structural reform programs, whereas poor governance was strongly associated with slow economic progress. More specific, some studies (Mauro 1995, 1997; Knack and Keefer 1995) showed that the quality of governance was important for growth and investment rates, foreign aid, and in preventing inefficient government spending. Subsequent studies found that reducing transparency had negative effects on finance and governance in both industrialized countries and emerging markets (Mehrez and Kaufmann 1999). Better governance was positively associated with substantial improvements in poverty reduction and standards of living. For instance, an improvement of one standard deviation in the rule-of-law indicators for Russia or the Czech Republic or a reduction in corruption in Indonesia or South Korea was correlated with a twofold improvement in income per capita, a similar decline in infant mortality, and an increase of fifteen to twenty-five points in literacy levels (Kaufmann, Kraay, and Zoido-Lobatón 1999). Researchers also found a strong causal relationship between civil liberties and the performance of World Bank projects (Ritzen, Easterly, and Woolcock 2000). Improved property rights protection and civil liberties could significantly reduce regulatory capture, while banking crises were more likely in those economies with poor transparency requirements (Hellman, Jones, and Kaufmann 2000; Hellman and Kaufmann 2001; Mehrez and Kaufmann 1999). Finally, state capture (to be discussed more in depth later) had very negative consequences for privatization and market deregulation in many Eastern European and former Soviet republics (Hellman and Kaufmann 2001).

Neoliberal Assumptions and Transaction Costs

Despite being closely related, political and economic research have often developed separately. While economists acknowledge the role of politics but do not incorporate it in their models, political scientists often neglect how macroeconomic policy can be manipulated to pursue collusion, political patronage, and corruption. In the late 1990s, however, some economists began to acknowledge the deficiencies of the neoliberal approach to reforms in emerging markets and the fundamental role politics and government institutions play in shaping the final outcome. Based on their experience as advisers to the Russian government in the 1990s, Shleifer and Vishny (1998) contended that theories that may be excellent in providing policy solutions in some markets may deliver the wrong answers with disastrous consequences in markets that do not share the same characteristics. In analyzing the contribution of the neoliberal school, for instance, Shleifer and Vishny found it inadequate when addressing the problems of emerging markets. Hayek’s and Friedman’s theories work on the assumption that government institutions defining and enforcing property rights as well as promoting antitrust policies are in place. What if they are not? What if the political and legal institutional foundations promoting competition, individual freedom, and property rights are not there in the first place? What if the private sector itself does not operate according to well-defined corporate governance rules?

The neoliberal recommendation is to create such institutions and rules, but it is usually much less helpful in indicating how to craft them. Yet, more important, the greatest shortcoming of the neoliberal approach is that it ignores politics entirely. As Shleifer and Vishny (1998, 10) put it, neoliberal economists ignore “the fundamental fact that institutions supporting property rights are created not by fiat of a public-spirited government but, rather, in response to political pressure on the government exerted by the owners of private property.” Indeed, as we shall see in this book, when market reforms are implemented in an institutional vacuum, it creates enormous opportunities for politicians to pursue their corrupt ends and for privileged sectors of the business community to protect their rents. The crucial question then is how to prevent government from politically manipulating market reforms, which, on paper, are supposed to promote competition, individual freedom, and better living standards. For Shleifer and Vishny, if one is to comprehend in which direction reform is going, one must first understand the interests of the political actors involved and how such interests translate into the type of institutions and policies that cater into their personal interests. Unfortunately, as Shleifer and Vishny acknowledge, neoliberal economists do not focus either on corruption or on other politically related factors. In turn, this leads them to prescribe policies that ignore politicians’ priorities and institutional deficiencies, thus resulting in disastrous consequences.

Economics and political science research can actually be reconciled if we look at the problem of accountability vis-à-vis economic performance from the vantage point of transaction costs. As theorized by Williamson (1986), Olson (1982), and North (1990), when political institutions reward efforts to alter government decisions, rather than technical innovation, people will devote much of their effort in capturing the state in order to acquire rents. Politically, when accountability and transparency in government policy making are lax, corruption, collusion, and patronage abound. Economically, these three factors can be regarded as transaction costs of the worst kind, as they add tremendously to the costs associated with understanding the environment, protecting property rights, and enforcing contracts.

Thesis

The contribution of this book to the scholarly debate derives from focusing on the transaction costs arising from the lack of political accountability; this allows us to explain how economic mismanagement and politics function as two sides of the same coin in democratic polities. Moreover, it brings evidence to some of the political science works mentioned earlier that are rich in theoretical insights but short on empirical applications. The thesis of the book is that if market reforms are carried out within a democratic polity where accountability institutions are weak (or even deliberately emasculated to accelerate policy implementation), then corruption, collusion, and patronage will be strongly associated with severe economic crises in the medium term. Conversely, where vertical and horizontal accountability institutions are in place, we should expect less economic upheaval and greater success in achieving the market reforms’ stated goals. If the thesis were to be found correct, it would bring evidence about how accountability institutions, far from being an impediment to market reforms, help produce more effective policies. This is because they are more likely to prevent executive abuses and allow for changes based on a more consensual approach between government and opposition that enhances policy coherence and sustainability over time.

Although other scholars have made similar arguments (Stark and Bruszt 1998; Orenstein 2001; Gould 2003), their analyses have been limited to a few country studies based on the experiences of Eastern Europe and Russia. This book instead brings greater empirical evidence based on a broader, cross-national sample using a multistage level of analysis. This book also complements Stiglitz’s thesis (2002) that the recent financial crises in emerging markets can be traced back to the misguided policy advice of the IMF and the World Bank. However, it challenges Stiglitz’s contention that governments’ lack of transparency and accountability does not cause crises and is a convenient way for the U.S. Treasury, the IMF, and neoliberal economists in general to shift the blame to borrowing countries.

Summing up, this work aims to show that accountability plays a major role in understanding whether market reforms succeed or fail and how corruption, crony capitalism, and patronage result when accountability is weak. These three elements turn into transaction costs, which end up undermining the reform process along the following channels:

• Corruption. The manipulation of reforms allows elected and nonelected officials to use the proceeds from privatization and deregulation for private gain instead of the intended public use.

• Crony capitalism. Instead of fostering market competition, elected and nonelected officials craft economic policies to reallocate rents from the state to the private sector, thus depriving reforms of their potential for sustaining long-term growth.

• Political patronage. Elected and nonelected officials circumvent fiscal austerity agreements contracted with international lending agencies by borrowing massively in the international bond market to secure support from political clienteles.

The research design in this book adopts the definition of accountability that includes the two dimensions of answerability and enforcement. It also uses the broader definition of accountability that incorporates both legal and nonlegal transgressions, as discussed earlier. At the same time, it focuses not only on the three branches of government but also on the oversight agencies within the public administration. Let us briefly examine the significance of these three factors based on a selected sample of the existing literature.

Corruption

Today there is substantial agreement in both the political and economic literature on the fact that corruption turns formal property rights into very expensive, personalized exchanges of a tenuous nature since a change in the political personnel guaranteeing them can undermine the exchange itself at any time (Jain 2001; Johnston 2005).

This, however, was not always the case. From the 1960s until the late 1980s, the so-called functionalist theory dominated much of the academic debate on political corruption. It viewed corruption as a necessary evil to cut bureaucratic red tape, redistribute resources (Heidenheimer 1970; Waterbury 1976), and sustain socioeconomic development in countries whose governments opposed Communism (Leff 1964; Nye 1967; Huntington 1968). However, the end of the cold war, which had provided much of its rationale, made the functionalist perspective obsolete, and it quickly fell out of favor.

Since the early 1990s there has been a resurgence of studies on corruption that have highlighted its pernicious consequences. Such studies invariably show that corruption has profound negative effects on growth and a host of socioeconomic issues. High levels of corruption in countries facing poor economic performance are not coincidental; rather, these conditions are causally related. To this end, World Bank and IMF economists have developed much-needed cross-national data sets to test a series of hypotheses that have often confirmed what previously had been described by country analyses or journalistic accounts. The underlying assumption of the World Bank and the IMF studies is that much corruption stems from poor government administration, particularly when it comes to the realm of economics. What follows is that a good deal of corruption could be curbed by promoting well-meaning administrative reforms.

In addition to having negative effects on both gross domestic product (GDP) and the ratio of investments to GDP (Mauro 1995, 1997; Mo 2001), some studies have found evidence that the more open an economy is, the lower the level of corruption (Ades and Di Tella 1999). Wei (2001a) also found that corruption increases the likelihood of currency crises and reduces the benefits of globalization. Corruption also thwarts foreign aid (IMF 1997a). Likewise, countries with high levels of corruption tend to have low levels of tax collection relative to GDP (Tanzi and Davoodi 1997). Furthermore, Mauro (1998) concluded that corruption has more negative effects than taxation. It significantly hampers development by reducing domestic investments, discouraging foreign investments, ballooning government spending, and diverting government resources from health, education, and infrastructure maintenance to benefit often useless public projects (Wei 1999). In similar vein, corruption severely affects the investment strategies of foreign companies (Smarzynska and Wei 2000) with negative consequences on joint ventures with domestic partners when the risk involved is perceived as being very high. Another study challenged the old functionalist argument that “grease money” facilitates commerce. Kaufmann and Wei (1999) point out that firms willing to pay more bribes are likely to have higher operating costs. Other works have focused on financial liberalization, demonstrating that financial crises are more likely and more severe in countries with poor government transparency (Mehrez and Kaufmann 1999). Hellman, Jones, and Kaufmann (2000) also found evidence that the improvement of property rights and civil liberties can significantly reduce state capture by powerful lobbies. Likewise, corrupt governments seem responsible for low tax collection, as entrepreneurs prefer to go underground to avoid corrupt officials and red tape (Johnson, Kaufmann, and Zoido-Lobatón 1999). By contrast, reducing corruption improves economic growth and technological change (Rivera-Batiz 2007).

For their part, political scientists and sociologists usually focus on the causes and effects of corruption, typically regarded as dysfunctional in a democratic system. High levels of corruption undermine interpersonal and government trust (Morris 1991; Mishler and Rose 2001), preventing collective action and the development of civic behavior. This, in turn, may have deleterious consequences for the survival of a political system—an issue particularly troublesome for new democracies (Rose-Ackermann 1999; Doig and Theobald 2000; Tulchin and Espach 2000; Montinola and Jackman 2002). Some have also focused on the pernicious effects of neoliberal policies. Weyland (1998), for example, noted that corruption in many Latin American countries increased since the 1990s due to the reemergence of populism and misguided market reforms. Others have focused on the relationship between corruption and electoral rules. Persson, Tabellini, and Trebbi (2003), Kunicova and Rose-Ackerman (2005), and Chang and Golden (2007) found that closed-list proportional representation electoral rules in presidential systems are particularly associated with corruption.

Other studies have looked closely at the relationship between corruption and system support. In their study of central and Eastern Europe, Rose, Mishler, and Haerpfer (1998) found that high levels of corruption negatively affected support for the democratic system and conversely increased the acceptance for authoritarian alternatives. In his analysis of Bolivia, El Salvador, Nicaragua, and Paraguay, Seligson (2002) also produced even stronger statistical evidence that corruption undermines the political legitimacy of democracy and negatively affects interpersonal trust in particular and civil society relations more generally. In a subsequent study using a broader country sample, Anderson and Tverdova (2003) confirmed earlier hypotheses contending that in countries experiencing high levels of corruption people display more negative attitudes toward civil servants than in industrial nations. Yet more interesting, they found that in such countries, negative evaluations are unlikely to be shared by government supporters, which may explain the ability of tainted administrations to retain power in the face of scandals and poor performance.

Within the context of market reforms, corruption can alter the policy process in a number of ways, which I will try to stylize with a few examples. One case that has received much attention is linked to privatization, which in many countries was the most visible and controversial reform advocated by the WC. As Rose-Ackerman explains (1996, 2), “a firm may pay to be included in the list of qualified bidders or to restrict their number. It may pay to obtain a low assessment of the public property to be leased or sold off, or to be favored in the selection process.” How does this happen in practice? Privatization occurs primarily through direct sales or international bids. Direct sales are particularly susceptible to corrupt behavior since they occur behind close doors without any third party monitoring the process; as a result, illicit agreements can be hammered quickly (World Bank 2005, 264).

Government officials can even extract bribes through competitive bids by selling confidential information to firms willing to pay for “bidding specifications, the actual condition of soon-to-be-privatized firms, and the location of future capital projects” (Rose-Ackerman 1996, 2). Once the government selects incoming bids, it may rig the process to award the ownership (or concession contracts) of former SOEs based on the willingness of private investors to pay hefty bribes. In return, as a way of compensation, governments may award to a private bidder an SOE under monopolistic or oligopolistic conditions. In so doing, the new private owner can charge high prices because it does not face competition and, in the process, can recoup the bribe paid. Of course, this arrangement is detrimental to consumers who pay prices higher than under competitive conditions, as well as firms using the same goods and services. In the latter case, corrupt competition penalizes the economy as a whole because it increases the cost of doing business. Moreover, by not facing competition, the new private owners have few incentives to improve their companies in terms of technology and customer service. Another drawback is that at times the private companies that are more willing to bribe are the ones that have the weakest qualifications to bid. In that case, bribing works as a way to beat better rivals. Thus, inefficient firms facing stiff competition may actually initiate a corrupt deal rather than be on the receiving end of it.

Another, more subtle way to pursue corruption through privatization is through concession contracts and their regulation after state divestiture. Such contracts usually affect the largest privatization transactions, which tend to be in public utilities, such as telecommunications, electricity, gas generation and distribution, water and sanitation services, and transportation. Many SOEs in these sectors often are not sold but transferred through concession contracts for a fixed term, which may be susceptible to renewal. Early literature on privatization underscored the need to create regulatory institutions prior to privatization since SOEs were left regulating themselves under state ownership. Regulatory agencies are important in ensuring that contracts are enforced, the rights of private operators and consumers are protected accordingly, and tariffs strike a sensible balance between affordability (for the consumer) and profitability (for the utility provider). Moreover, regulatory agencies should foster competition when technology and market size allow it. However, corrupt governments are likely to act in the opposite direction. In return for bribes, they may prevent regulatory agencies from doing their job by negotiating sensitive issues directly with private utility companies to their mutual satisfaction. In a scenario of this kind, government officials may renegotiate tariff rates to the benefit of the utility companies, fail to enforce penalties when private operators do not meet investment and service requirements, extend concession contracts, and provide subsidies and tax brakes in return for kickbacks. Even in those cases where infrastructure privatization leads to increased investments, studies show that they are still prone to open the door to corrupt deals (Martimort and Straub 2006). For some scholars this helps explain the widespread public dissatisfaction with state divestiture, particularly among middle-class consumers who believe that they end up paying the costs of corruption through high utility rates (Bonnet et al. 2006).

Crony Capitalism

Crony capitalism thrives on government-created rent conditions. An economic “rent” is the result of a financial income that is not matched by corresponding labor or investment. According to the seminal works of Tullock (1967) and Krueger (1974), rents occur through distortions to the competitive environment (i.e., monopolies, oligopolies, import and trading restrictions, subsidies), often by lobbying political authorities to create rules and regulations that prevent market competition. Economic rents are generally considered to be very harmful for economic activity because they create price distortions, prevent competition, and fuel corruption. For instance, Ades and Di Tella (1999) showed that corruption is much higher in countries where domestic firms enjoy monopoly conditions and protective trade barriers.

Rent seeking is a phenomenon that affects even the most advanced economies worldwide, where it artificially allows protected markets to co-exist with competitive ones. However, recent scholarship has suggested that in developing (particularly East Asia) and postcommunist countries, rent seeking becomes the system on which economies are organized. Some analysts define such a system as “crony capitalism” (Pye 1997; Soros 1998; Bernstam and Rabushka 1998; Haggard 2000; MacIntyre 2001; Kang 2002; Putzel 2002). In other words, the difference between economic rents that exist in an advanced industrial country vis-à-vis the crony capitalism of a developing nation is one of degree. In advanced industrial societies noncompetitive behavior exists but affects only a relatively small amount of the most crucial markets, whereas in many developing nations the noncompetitive behavior established by crony capitalism is an arrangement affecting the most important economic activities (Hutchcroft 1998). By definition, crony capitalism takes place in an economy where, according to Haber (2002, xii), “those close to the political authorities who make and enforce policies, receive favors that have large economic value. These favors allow politically connected economic agents to earn returns above those that would prevail in an economy in which the factors of production were priced by the market.” In a system of crony capitalism, business people approximate what can be described as “political entrepreneurs,” that is, entrepreneurs who can be in business and profit from it only thanks to the government’s special protection. These people are quite a different breed from “market entrepreneurs,” who, in a context of market competition, must produce quality goods at a low cost if they want to succeed.

Economically, crony capitalism is a dysfunctional type of capitalism for a number of reasons (Khan and Sundaram 2000; Haber 2002). First, it misallocates resources, as it channels funds into unproductive or obsolete activities and allows artificially high prices to sustain rents, which in turn fuels inflation and depresses growth (Krueger 2002). Second, it discourages long-term investing since crony arrangements are by nature subject to sudden changes in political leadership. This situation puts business people in a short time-horizon situation because it forces them to lobby for high rates of return in a relatively short period of time. Third, crony capitalism has negative consequences on income distribution because the general public is subject to paying artificially high prices that benefit only a small minority. Because of its pervasiveness, crony capitalism is more likely to generate corruption, unlike a country in which markets are competitive. Moreover, according to some scholars (Wei 2001b), crony capitalism is strongly associated with a higher external loan-to-foreign-direct-investments (FDIs) ratio and can increase the likelihood of a financial crisis.

Politically, because of its collusive and secretive nature, crony capitalism thrives in authoritarian systems and weak democracies. In fact, Haber (2002) concluded that the more authoritarian the government is, the more efficiently crony capitalism works. Such an economic system also thrives where economic inequality between rich and poor is severe and where voting rights for most of the population have been restricted during a long period of time. Moreover, and equally important, crony capitalism flourishes in democracies where accountability institutions are weak, resulting in a lack of transparency, which can lead to serious economic crises. Michel Camdessus (1999), the IMF managing director during the 1990s, described the nexus between crony capitalism and transparency as follows: “A lack of transparency has been found at the origins of the recurring crises in the emerging markets, and it has been a pernicious feature of the ‘crony capitalism’ that has plagued most of the crisis countries and more besides. More positively, the very first principles of the market economy tell us that open, competitive markets function only where transparency exists.”

Crony capitalism has been associated with market reforms in a number of ways. The most typical one has been tailoring reforms to pursue the interest of individuals or firms close to the government in return for party financing and/or bribes. Again, privatization is a typical case in point. In a country where there is a sizable domestic business class, the government may favor politically close domestic firms by preventing (or restricting) foreigners or domestic groups out of favor to bid on the most lucrative SOEs. This, for instance, was the case in Mexican, Russian, and many Eastern European privatizations. In these countries the government handed over to domestic businessmen very lucrative companies, often under monopoly conditions, in return for generous campaign financing. In Mexico alone this type of privatization turned several entrepreneurs into billionaires in a few years. A variation on this method is when a government requires foreign investors to form joint ventures with domestic firms, even if such firms have little capital and expertise to offer in return, under the pretext of averting a nationalist backlash, as it was the case in Argentina in the early 1990s.

An alternative strategy is when government officials in charge of designing the privatization of SOEs end up, shortly after the state divestiture is completed, on the board of directors of the new private company or, even worse, turn out to be major shareholders as happened in Chile in the late 1980s. Moreover, the government can restrict the awarding of new to import/export licenses related to trade deregulation only to politically connected businesses.

Political Patronage

Patronage imposes an additional and unnecessary cost on society by channeling resources to unproductive activities and unnecessary employment. It also often hampers the development of human capital by rewarding the wrong people with the right jobs (Desai and Pradhan 2005). For the most part, social scientists tend to agree that patronage politics perpetuates elite rule and its control on economic resources, which ultimately results in economic rents benefiting the elites and in economic stagnation due to the lack of competition (Bates 1981; Easterly 2001).

Although patronage is often associated with corruption, it can actually take place legally as officeholders and lawmakers can issue decrees and legislation channeling resources to their own clienteles. In our own case this is particularly relevant, as governments in developing countries not only spend their scarce resources to appease the narrow interests of their political clienteles but also divert the use of foreign loans and other types of foreign economic aid for the same purpose with very negative consequences on the quality of governance (Knack 2001) and economic growth (World Bank 1998; Easterly, Levine, and Rodman 2003)

Patronage, according to much of the literature, takes place in polities where resources are scarce and controlled by entrenched political cliques, and people willingly exchange their votes for whatever favors they can muster (Brusco, Nazareno, and Stokes 2004). For instance, Acemoglu and Robinson (2001) argued that patronage spending is a function used to maintain the strength of a particular political group. They added that weak political institutions, which do not constrain political elites from pursuing poor macroeconomic policies, are responsible for, among other things, widespread corruption, ineffective property rights, and a high degree of economic and political instability (Acemoglu et al. 2003).

What is at the root of the problem? According to Geddes (1994), political patronage and voting for corrupt leaders is the result of a lack of collective action, while Samuels and Snyder (2001) emphasize the importance of electoral rules. Medina and Stokes (2007) stylize the relationship between voters and candidates as one where the latter retain a monopolistic control of economic resources and restrict preferences to their advantage.

Economists have been mainly concerned with the question of why patronage politics induce elected and nonelected officials to opt for inefficient policy choice. In her pioneering work on rent seeking, Krueger (1993) first demonstrated that seemingly incompetent policies were not the result of poor knowledge but rather the rational decision by political elites to appropriate rents for themselves and their clienteles. More recently, scholars have examined the economic consequences of patronage politics. Robinson and Verdier (2003) provided evidence showing that political patronage can be quite attractive in countries where income inequalities are high, money in politics matters more than ideology, and productivity is low. Using a rational choice model, Robinson and Verdier (2003) contended that inefficiencies in income distribution are the result of clientelistic exchanges during which politicians dispense jobs and favors in return for votes. As a result patronage prevents the provision of public goods that would enhance economic conditions for all. In another study, Mauro (2004) asked why so many countries experiencing poor growth patterns and entrenched patronage systems that fuel corruption do not try to reform their political systems. His explanation is that when patronage and corruption are widespread, people do not have incentives to organize against it.

In another cross-national analysis, Keefer (2003) argued that the association between corruption and weak democratic institutions is related to patronage politics. He claimed that the reason young democracies have poor economic performance rests on the number of continuous years when countries had competitive elections. Keefer’s point is that in young democracies, corruption and political patronage are clear symptoms of weak government institutions. Consequently, weak government institutions are unable to provide public goods based on fair and rational criteria because they tend to be captured by power groups that use them to dispense pork and create rent seeking favoring their clienteles. Thus, in such a context political parties do not make credible pre-electoral promises based on a clear program and voters are all too aware that such promises will not be honored. Consequently, the only credible promises are those on which politicians build a reputation for dispensing tangible goods in exchange for votes.

How can political patronage be related to market reforms? In most cases democratically elected leaders embraced the WC agenda based on pragmatic motives as they desperately needed the IFIs’ financial assistance to keep their countries afloat. However, they also needed the economic resources to stay in power and retain political support while funds were being drastically reduced by the very reforms they were enacting. In fact, the combination of privatization, government downsizing, and fiscal austerity measures deprived them of traditional war chests to funnel money to appease their followers. Compounding the problem was the fact that several reforming leaders ran for a second term and, in some cases, had to amend their constitutions to do so. This meant disbursing a substantial amount of funds to veto players in Congress whose vote was crucial to this end.

Part of the problem could be solved by diverting privatization funds to political schemes. Ironically, another means came from the IFIs’ financial assistance, which at times provided additional resources making up for the end of traditional ones. Indeed, once leaders had satisfied the IFIs’ initial demands for policy implementation, they could receive a larger amount of loans to improve and expand on their reform effort. Moreover, as their countries’ credit ratings improved, reforming leaders could receive the IFIs’ seal of approval to obtain commercial loans from international investment banks, an option that was not available prior to the launching of market reforms. The key point here is that once loans were disbursed, IFIs and commercial banks had a limited ability to oversee how their funds were actually spent. Thus, governments found it relatively easy to use international borrowing for clientelistic purposes.

Indeed, empirical studies have shown that political elites are quite capable of continuing clientele-driven spending even if, at the same time, they are in the process of implementing market reforms whose philosophy runs counter to patronage politics. For instance, Schady (2000) found evidence that President Fujimori spent the Peruvian Social Fund disproportionately to favor his clienteles using proceeds from privatization with the blessing of the IMF and the World Bank. Likewise, Mexican president Carlos Salinas de Gortari used the poverty alleviation program PRONOSOL (Programa Nacional de Solidaridad) in much the same way (Oppenheimer 1996; Diaz-Cayeros, Estevez, and Magaloni 2001). Patronage spending was also very high at the height of market reforms in Argentina and Brazil during the 1990s (Rodden and Arretche 2003; Calvo and Murillo 2004).

Methodology and Case Selection

The research adopts a two-tiered approach to test the thesis, combining statistical measurements with an intensive examination of a few case studies, similar in conception to Lieberman’s (2005) nested analysis method. Chapter 2 starts with a comparative analysis of countries under democratic or partially democratic forms of government that attempted market reforms at both the cross-national and the regional levels in the 1990s. This will allow us to scrutinize whether the general thesis that I proposed earlier can be supported by the examination of a large number of cases. Accordingly, in the cross-national analysis I include countries that suffered major financial crises as well as others that either did not experience such crises or had less severe recessions while implementing similar reforms (World Bank 1995, 2003, 2005).

The second part of the analysis (chapters 3 and 5) shifts from the comparative to the case-study approach. This is because cross-national analyses, though most useful for theory building, often miss specific variables and information that can complement and strengthen a general thesis by showing the importance of a given socioeconomic phenomenon and its multifaceted manifestations over time. In the case study chapters I will assess the impact of a common set of accountability institutions to make the comparison more rigorous.

To accomplish this goal I use what is usually referred to as a theory-guided process-tracing method (George and McKeown 1985). The reason is that through this method it is possible to identify the “intervening causal processes—the causal chain and causal mechanism—between the independent variable (or variables) and the outcome of the dependent variable” (George and Bennett 2005, 206). Thus, while the statistical method in cross-national analysis aims at identifying the causal effects of one or more independent variable on the dependent one, process-tracing analysis allows us to discover the causal mechanisms linking causes and effects. The theoretically explicit narratives in the country chapters “trace and compare the sequences of events of the constituting process” that we want to examine (Aminzade 1993, 108). Through the process-tracing method we can better understand (than we can in cross-national statistical analyses) the decision makers’ goals, “preferences, their perceptions, their evaluation of alternatives, the information they posses, the expectations they form, the strategies they adopt, and the constraints that limit their actions” (Bates et al. 1988, 11). By using two different methodological approaches I hope to establish in a more precise fashion whether accountability standards help explain differences in economic performance depending on how reforms were pursued. Should both levels of analysis uncover the same policy pattern, we could be more confident about our findings.

The case study is based on the experiences in Chile, Russia, and Argentina for the following reasons. Hayek and Friedman always hailed Chile as a textbook case of how market-oriented policies can dramatically turn around a languished economy. Moreover, because of its success in promoting steady growth from 1985 on, Chile became a primary example that the IMF and the World Bank used to persuade countries considering the adoption of market reforms worldwide. Chile also provides a unique example where policy variance, under different political regimes, can be observed within one case. This is because it pioneered market reforms between 1973 and 1990 under a dictatorship that allowed no accountability. However, such reforms were continued and expanded on under a democratic regime after 1990 with a much greater emphasis on transparency and competition. While in the 1980s, under Pinochet’s authoritarian government, Chile’s GDP grew an average of 3.2 percent; a decade later under a democracy it averaged 6 percent annually (Beyer and Vergara 2002). By 2008 poverty had been more than halved as opposed to in 1989. Although the economy grew at a slower pace between 1998 and 2008, it weathered well the international crises affecting emerging markets in East Asia and in neighboring Argentina.

The other two cases presented here, Russia and Argentina, are those in which market reforms were associated with major economic collapses. Russia (under the Yeltsin administration, 1991–99) and Argentina (under President Menem, 1989–99) promoted radical market reforms in the 1990s in a context of weak political accountability, and both eventually succumbed to major financial crises in 1998 and 2001/2002, respectively. These two countries are particularly important because during the early 1990s, in their respective regions of the world, they represented crucial test cases for the success of the neoliberal economic policies sponsored by the U.S. Treasury, the IMF, and the World Bank.

The international financial community’s support of market reforms in Russia under Yeltsin’s tenure, despite early signs that their design and execution were seriously flawed, was justified as being critical to destroy the command economy of the Soviet era and prevent the Communists from returning to power. Moreover, had Russia succeeded it would have induced many former Soviet republics to follow its lead and abandon what still was a political culture entrenched in government intervention and hostile to free enterprise and democracy. In August 1998, despite privatizing most SOEs and liberalizing capital markets, Russia suffered a devastating financial crisis, forcing it to default on its domestic debt and putting a moratorium on its foreign debt. It was partially restructured a few years later through the London Club, which represented some of Russia’s largest creditor nations. According to most indicators, the consequences of Russia’s debacle were far worse than those resulting from the Wall Street crash of 1929.

Likewise, Argentina led the way in Latin America by enacting sweeping market reforms. Indeed, during the 1990s the IMF, the World Bank, the U.S. Treasury, and a score of financial analysts hailed Argentina as a model for the rest of Latin America. According to the World Bank (2005, 34), the significance of Argentina’s case rests on the fact that its crisis put into question the neoliberal model since that country “had provided the clearest and, for the better part of the 1990s, most successful example of a trend to reinforce macroeconomic stability.” In fact, at the end of December 2001, Argentina defaulted on its $132 billion debt, the largest such event in history, which triggered a socioeconomic meltdown of unprecedented proportions. By August 2002 fears of financial contagion in the region forced a grudging IMF to increase lending to Brazil and Uruguay to avert those countries with very close economic ties to Argentina lest they fall under the same spell. Indeed, “economically, the decade known as the 1990s, could be said to end with the Argentine crisis of 2001” (World Bank 2005, 31). Just as important, Argentina’s collapse virtually sanctioned the demise of the WC and its policies.

Thus, since Chile, Russia, and Argentina were commonly regarded as test cases for the success of market reforms, their analysis is quite significant and can bring insights with broad theoretical ramifications for similar cases. The way these countries confronted similar policy problems can shed light on the importance of accountability in explaining the success and failures of market reforms since such cases should display enough variance. In fact, many of the challenges that these countries confronted were often observed in other emerging markets that embarked on the same policies. Within this context, we want to ascertain to which degree the strengths (or weaknesses) of their accountability institution environments made the difference.

Chapter 6 sums up the conclusions of the book by first assessing the degree to which the accountability thesis held up under cross-national and country-specific tests and then discussing what its implications are for both academics and policy makers in view of the latest development in the global economy.

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