This paper was written for a class on Development Management.
Institutional Reform and State Capacity
The current intellectual climate in some key international institutions presupposes that the state is not the most effective provider of services. Instead, markets are assumed to be the most efficient organisers of economic activity. Decades of state enterprise failure in developing countries, especially in Latin America and Sub-Saharan Africa, contributed to this attitude. However, the dogmatic approach that markets are the only efficient way to provide services overlooks key aspects of the actual functioning of economic systems. The state still has a key role in promulgating effective regulation, the absence of which has detrimental effects on markets and ultimately public services. For success in reforms of any kind, strengthening state capacity is the most important task.
The state is vital in providing services to people and the market itself. As Putterman and Rueschemeyer point out, “Ironically, the very institutional infrastructure necessary for functioning markets – securing property rights, guaranteeing contracts, establishing the legal foundations for the incorporation of collective enterprises, providing a more or less stable currency, etc. – represents exactly a series of such collective or public goods that are beyond the reach of economic actors in competition with each other.” (pg. 244) Even neo-liberal theorists agree that the state is indispensable to well-functioning markets. “The commitment and integrity of government and the strength of the country’s underlying institutions determine the enabling environment,” for the success of reforms in infrastructure provision. (World Bank, 112-113)
Effective state regulation is especially important in the era of pragmatic pluralism, the use of various organisational types to manage service provision. Esman enumerates a long list of all governments’ required minimal activities, while noting that rich countries tend to expand the government’s role to include welfare services. However, where there is choice, the state “should promote and facilitate the development of market institutions,” (Esman, 92-93) because markets sometimes better maximise efficiency. Still, the government has an essential role in the promotion and facilitation of those institutions. “For the proper working of markets, strong, and in many cases expanded, state intervention … is necessary.” (Streeten, 15) A minimalist state is not the answer.
Aside from the pragmatic regulator, the state has a responsibility to solve market failures related to monopoly power, distributional equity and non-existence of markets. The private sector’s weakness in servicing dispersed rural populations and problems of monopoly need to be addressed, especially in developing countries. (Bayliss and Cramer, 59) The government also must work towards the country’s goals, which may include rapid industrialisation or equitable income distribution, potentially requiring purposeful intervention in the market. The state had a part in creating the conditions for late industrialisation in every case of backward countries catching up to industrialised countries, including the now-rich countries in Europe and North America. (Gerschenkron, 7; Chang, 126-8) Only an effective state sector has the ability to solve these market failures.
Different services lend themselves to certain forms of delivery based on characteristics such as subtractability, excludability, exit/voice options, and the role of hierarchy. (Picciotto, 351) The World Bank’s “matrix of marketability,” used to determine which services are best suited to private sector delivery (pg. 115), is one methodology to determine the ideal organisation type for service delivery. However, the position that sectoral characteristics are more important than national characteristics (pg. 114) seems flawed because it ignores the varying capacity of the state. A more nuanced approach would involve case-by-case analyses of governance ability and market functioning to determine what will work most effectively in each scenario.
If the state is unable to fulfil its key role, such as regulation or competition policy, then any reforms are likely to fail to achieve their desired results. The government still must play a role regardless of who ultimately provides services: the public sector, contracted private sector enterprises, state-owned enterprises, community or civil society organisations, local governments, or the private sector. Thus, state capacity to implement successful policies in a heterogeneous administrative environment of service provision is the most important factor determining reform success.
The need for good governance, whether regulatory oversight or interventionist industrial policy, is demonstrated by examining cases of weak public sector participation. The first examples relate to government absenting itself from regulation of the market. The “trusts” that were built in the late 19th and early 20th century in the United States of America held consumers hostage to poor services and higher than expected prices. Modern day cases are being made against giants such as Microsoft, accused of overpricing and deliberate creation of the need to upgrade low-quality products, and Wal-Mart, charged with predatory, loss-making pricing when it opens stores in new markets. In these cases, the state originally left the market to its own devices, but where there are increasing returns to scale, state action is necessary (Putterman, 248), otherwise the result is a tendency towards monopoly and harm to the public.
That said, if a state-owned enterprise is poorly regulated and managed then it also tends to produce low-quality, over-priced services. The interference of political elites in SOE operation, either through management or financial meddling, turned many of them into permanent loss makers dependent on state bailouts for survival. (Esman, 100) But, clientelism and predatory behaviour extend into the contracting out sphere because “collusion, corruption, inefficiency, and insensitivity to the public find their way into contracting arrangements also.” (Esman, 98)
Failure is not unique to Third World public enterprises, as developed countries also have difficulties balancing public and private action in their institutional reform efforts. A prominent example is the widely criticised British railway privatisation, which The Economist called, “a catalogue of political cynicism, managerial incompetence and financial opportunism.” (Economist, 1999) It blamed the fiasco on the creation of perverse incentives and inappropriate structuring of privatisation, leading to no increase in rail-infrastructure investment and no service improvement. Beyond railways, an empirical study assessing the UK’s privatisation programme of the 1980s concluded that in the 11 organisations privatised before 1989, there was no clear net improvement in productivity and that efficiency may have on-balance declined. (Martin and Parker, 214) So, even in a country where the state is considered strong and highly competent, public sector reform was fraught with difficulty.
An example from the United States further highlights the challenge. The restructuring of the system for electricity generation, distribution and sale in California created rolling blackouts, widespread inconvenience, and higher prices for end users. California’s deregulation split the system into three parts, with generation units sold to private operators. The investor-owned utilities continued to manage transmission and distribution under a state-sponsored monopoly, while the retail sale of electricity was deregulated so that the utilities competed with other companies, including non-profit organisations marketing green energy. (Borenstein, 193) This design kept unified control over the transmission system, perceived as the only true natural monopoly, while bringing competition into areas that could supposedly sustain it, namely generation and retailing.
However, this pluralistic structure ignored many factors at play in the electricity market, including the lack of competition in neighbouring markets that supplied California, the ban on long-term contracts by the biggest distributors (Bushnell, 1049-1050), the retailers’ inability to raise their prices beyond a government-set cap, and the inelastic nature of electricity supply and demand. (Borenstein, 193-196)
Similar reforms in other markets ‑ Alberta, the UK, and Norway ‑ have also generally failed when assessed by the criteria of having well-functioning, competitive markets with marginal-cost pricing. While these systems have not had catastrophic collapses like California, probably due pre-existing conditions of oversupply and the absence of a ban on long-term contracts, they also needed price capping, saw exercises of market power by generators, and experienced limited demand change with supply-price differentials. (Woo et al., 1109) Clearly inappropriate regulation and the lack of a suitable institutional framework doomed California to an electricity market disaster and could potentially do the same for other markets where reforms took place.
The lesson is not that electricity markets should not be reformed, but that reform of any service is an extraordinarily complicated and difficult task. This begs the question: if the UK and the US can not manage reform successfully, can developing countries ever hope to have the institutional capacity to successfully privatise or restructure?
Clearly, reform of any infrastructure provision systems must focus not only on getting the right balance between the state and market, but also on governance ability so that the state can act effectively. Thus, capacity building for state organisations and their employees is the main task that confronts planners of reform projects.
Reforming state-owned enterprises is one option that the World Bank overlooks in its zeal for privatisation. If incentives are set properly and there is managerial capacity – both doubtlessly difficult to achieve – SOEs can operate efficiently, as they do in Germany and Korea. (Putterman and Rueschemeyer, 251) The World Bank has frequently cited its study by Galal pointing to the net benefit to the public of privatising public enterprises, but using this study to justify turning over public assets to the private sector ignores the authors’ own warnings about the limits of the report’s applicability. (Ramamurti, 148) Additionally it, and other statistical studies ignore the possibilities for systemic change to improve the functioning of the public sector. (Stiglitz, 76) Creating better competition policy and enhancing the managerial capacity of the public sector to learn from global best practices would facilitate service improvement without forcing underdeveloped countries to endure the immediate painful economic side-effects, such as unemployment and industrial collapse, associated with privatisation and liberalisation.
Aside from reform of public services, states have other goals. If states want to implement industrial policy in a context of relative backwardness, then they must have the capacity to do so successfully. That means purposefully distorting the market so as to achieve a desired outcome, but this is only possible where there is a strong state with high capacity. This kind of developmental state, such as the one that developed in Korea and Taiwan, must “get prices wrong” instead of letting the market efficiently determine prices, and it must do it in a disciplined way, so that subsidies enhance the economy’s competitiveness instead of merely creating corruption. (Amsden, 146-148) That is no easy task and requires a disciplined set of highly capable government institutions.
However, successful reform is a two-sided coin, as effective states will need to learn when to regulate, to intervene and to not be involved. State actions that disrupt traditional or indigenous systems of resource control often create failure in terms of sustainable management. (Picciotto, 348) Additionally, government involvement with voluntary-sector organisations can sometimes be perceived as co-option. In that case, organisation members will no longer invest time and resources in the NGO, seriously hampering its ability to serve its participatory function or even provide services. (Esman, 105) States must know when it is appropriate to allow autonomy and when it should be more closely involved, otherwise the benefits of reform will not be realised. (Ostrom, 201)
No doubt, using market forces or other institutional arrangements, such as devolution of power, can improve efficiency and responsiveness in service provision, but the main indicator of reform success seems to be governance. The state’s role is so important that ignoring it in favour of looking at reforms using only a sectoral analysis would be deeply flawed. Equally, designing a reform programme that limits the state’s role based on its current capacity is likely to lead to just the kind of market and state failures that the reformers are trying to solve. Thus, interventions and reform programmes targeted at improving service provision in developing countries should first focus on capacity strengthening rather than pushing premature privatisation. While certainly more difficult than simply removing the state from the sphere of service provision, it is likely to lead to better outcomes in the long run. Once the government has the ability to create effective policies, then it will also have the ability to choose which path, interventionist or liberal governance, is best for its own economy.
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