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Finance & Development
A quarterly magazine of the IMF
June 2006, Volume 43, Number 2

Book Reviews

Deciding how to divide the economic pie

Daron Acemoglu and James A. Robinson

Economic Origins of Dictatorship and Democracy

Cambridge University Press, 2005, 540 pp., $28.00 (hardcover).

Francis Fukuyama famously pronounced that democracy, along with market capitalism, heralded the "end of history." H.L. Mencken, on the other hand, was cynical about it: "a pathetic belief in the collective wisdom of individual ignorance." But democracy has neither been inevitable à la Fukuyama nor seen as a consummation that should be steadfastly avoided as Mencken might imply. This leaves the ground open for such fascinating questions as why and how does democracy arise? And why does it take root in some places at some times, while making only cameo appearances in others? Daron Acemoglu and James Robinson take on—and are equal to—the challenge of providing sharp and simple answers.

Political outcomes such as democracy and dictatorship reflect fundamental conflict between the elites and the masses about their stake in the economic pie. Each group wants more, but it is the elites who decide how to share it. While it is relatively easy to share the pie in the present, a promise to share in the future can be reneged on. The nub of the authors' thesis is that extending the franchise (democracy) is a more credible way of agreeing to share the pie in the future than is a simple promise: a promise to give more food can be more easily reneged on than a promise to allow the right to vote. One is a policy, the other is an institution.

Acemoglu and Robinson then analyze the circumstances under which it is in the interest of the elites to extend the franchise rather than maintain a dictatorship. Inequality is a key determinant. The more unequal a society, the more the establishment of a subsequent democracy is likely to equalize wealth through redistribution, increasing the cost of democratization. A related determinant is the type of assets the elites possess. If the masses in a democracy can easily expropriate assets—such as, for instance, land—a transition to democracy may be more costly for the elites. The failure of democracy to take root in Latin America is, in large measure, a reflection of high inequality and asset vulnerability.

Elites may not want to cede power, but their ability to resist doing so will be influenced by how easily and effectively the masses can challenge the status quo. If the masses can easily get together—overcoming collective action problems—or easily expropriate assets without destroying the basis for future wealth creation, they are more likely to mount a challenge. Agrarian societies with dispersed masses are less easily organized and, hence, less likely to mount a challenge. But with the rise of manufacturing and urbanization, collective action problems are more easily overcome.

Weighing the evidence

How well do these parsimonious explanations stack up against experience? Acemoglu and Robinson apply their theory to four cases—England, Argentina, Singapore, and South Africa—and find a good fit between theory and historical experience. This is reassuring because the list of countries is plausibly representative of the broader historical experience. Still, the discussion of these country experiences could have been wider in scope.

The most glaring exception to almost every theory of democracy—one that has confounded political scientists—has been India, which has sustained democracy in the face of overwhelming odds. The authors have nothing to say about the Indian experience. India has been predominantly agrarian, with low levels of literacy, high levels of inequality, and, until recently, a very small middle class. Yet it has remained democratic. Why? And why did Pakistan, with its near-identical starting point, evolve so differently?

The authors are silent on the Middle East and the oil economies, where the lack of democratization cries out for analysis and explanation. The region's omission is particularly surprising, given the obvious relevance and applicability of the theory: oil economies are perhaps the archetypal example of large rents accruing to the elites—who strenuously resist forgoing these rents through democratization.

In the Acemoglu-Robinson view, there is also little room for noneconomic objectives or sources of conflict. Amartya Sen has argued that freedom, including political freedom, is and should be an independent objective of development. Does man live by bread alone? Economic well-being might be an opiate for Singaporeans (a disputed view), but poor and unequal India rebelled when Indira Gandhi attempted to curtail freedom.

A gripe about the book's structure. If the more mathematical parts had been kept separate, the book could have been more accessible to the curious generalist in addition to being a reference for the specialist. But such quibbles pale in significance considering the sheer ambition of the effort: nothing less than to provide a simple, unified, and, perhaps most refreshingly, falsifiable explanation of democracy. Acemoglu and Robinson have dared to set themselves up as targets. It is unlikely that the naysayers and nitpickers will be able to desist. Nor should they. And if the authors' effort survives the pounding—as well it might—it will be a triumph not just for Acemoglu and Robinson but for economics and its methods.

Arvind Subramanian
Division Chief
IMF Research Department

Brain drain or brain gain?

Devesh Kapur and John McHale

Give Us Your Best and Brightest

Center for Global Development, Washington, D.C., 2005, 246 pp., $22.95 (paperback).

As the world market becomes increasingly competitive, multinational companies in rich countries have become global shoppers for talent. This development raises a host of questions. Does skilled migration from developing countries delay economic growth, aggravate poverty, and inhibit democratic progress? Or does it encourage skill formation, the flow of remittances, and the return of skilled and entrepreneurial people? Devesh Kapur and John McHale shed light on these and other issues in their well-written book and provide us with timely and valuable input to the increasingly intense debate on skilled migration.

Rich countries' increased demand for skilled services is the result of both aging and affluence and their desire to retain a competitive edge in high-value, knowledge-intensive industries. But these are not the only reasons. Skills are also needed for innovation and job creation. And while these (and many other) factors serve to forge a powerful convergence of state and employer interest in skilled immigration, domestic trade union resistance to it is often weak. These pressures will not go away. But, as the authors suggest, they can be eased if rich countries invest more in domestic human capital and if developing countries find ways to better use the undervalued skills of their potential emigrants.

If skilled migration implies the erosion of human capital, we must know how to measure that erosion. Kapur and McHale rightly point out that the usual yardsticks—years of schooling or level of education—say little about quality. The question of quality is not just a matter of academic excellence but also of relevance. In many developing countries, a mismatch between the specific skill needs of the economy and the content of their educational programs creates a problem of "brain overflows." More attention to this aspect would have befitted this richly researched book.

The authors tend to overemphasize the potential of transnational diasporas and migrant remittances—reflecting the current widespread euphoria about their merits. Experience shows that when a developing country reaches the point of an economic takeoff, and a general feeling of resurgence and optimism prevails among its people, the diasporas become more interested in reestablishing links with their countries of origin. The return of skilled and successful migrants also tends to follow. China, India, and Korea all benefited from the return of skilled migrants and from support from their transnational diasporas once their economies took off, but until that point, their efforts to attract such support had failed for the most part. These countries' experience shows that if a stable political and macroeconomic environment is lacking, the home bias of diasporas, however real, does not work. As the authors themselves admit, diasporas "cannot by themselves improve development prospects of a country."

The same applies to remittances. In 2004, developing countries probably received $160 billion in remittances—a large amount, which certainly helped promote the welfare of households left behind. But unless the economy is flexible, macroeconomic conditions are right, and the business environment is sufficiently friendly, remittance-induced growth will be confined to local areas and a few urban centers. Meanwhile, remittance-dependent countries remain vulnerable to external shocks.

Kapur and McHale recognize that "it is impossible to arrive at a simple judgment about the skilled migration issues." In the end, however, they conclude that the displacement of scarce talent does an undeniable disservice to a country that needs talent for long-term development. But they also explain why the effects could vary depending on the country-specific situation. The book closes with a list of sensible policy options to improve the balance of skill migration effects on poor countries.

But what remains unsaid is that successful implementation of these options requires simultaneous and concerted action on different fronts by the various actors concerned. Action to control migration, for example, fails when it is taken in isolation. Rich countries' ban on recruitment of African doctors is no substitute for creating conditions that ensure retention and better use of their services at home. But effective concerted action needs a common framework freely agreed between rich and poor nations. Such a regime does not exist today. A main justification for a new world migration organization (to which the authors refer) lies precisely in developing such a framework. This thoughtful and forward-looking book, though limited to skill migration, will spur further thinking and action toward this goal.

Bimal Ghosh
International Consultant on Migration, Trade, and Development
Former Senior Director,
United Nations Development System

Weighing the risks

Kern Alexander, John Eatwell, and Rahul Dhumale

Global Governance of Financial Systems
The International Regulation of Systemic Risk

Oxford University Press, 2006, 328 pp., $45.00 (hardcover).

According to the blurb of Global Governance of Financial Systems, "the current structure of international financial regulation . . . is inefficient, fragmented, and lacks political legitimacy . . . and fails to manage systemic risk." Although this blurb puts the main point in an arresting way, it does not do justice to the book's subtle analysis of the dilemmas associated with improving financial sector supervision worldwide. Kern Alexander, John Eatwell, and Rahul Dhumale have combined their economic, financial, and legal expertise to write an enlightening book that addresses two distinct issues. First, how can the international financial community improve regulation and prudential oversight? And, second, who oversees systemic risk in the global financial system, and how well are they carrying out this task?

The demand for better financial sector oversight originated at home. It was almost always the shock of painful crises—not delegations from international financial institutions (IFIs)—that forced governments to think more critically about the quality of financial regulation. Those countries hit by crises and with limited expertise in financial stability issues were keen to tap the experience of other countries. They also called upon the various IFIs to help, each according to its own comparative advantage. To use the common (if inaccurate) buzzwords, there were several different "standard setters" (such as the Basel Committee, which developed the Core Principles of Banking Supervision) and "compliance officers" (mainly the IMF, with support from the World Bank). Meanwhile, the Financial Stability Forum was established by the Group of Seven industrial countries in 1998 to bring the key players together and give the process essential political impetus.

The authors, however, see this division of labor as fragmented and "lacking in political legitimacy." There is some truth in this. It is also true that the Bank for International Settlements (BIS) and several committees that help devise standards are not subject to the oversight of a board with universal membership. The IMF, however, does have a near-universal membership. Together with the World Bank, it developed the Financial Sector Assessment Program (FSAP) in 1999. Drawing on supervisory expertise from developed financial centers, the FSAP provides detailed voluntary examinations of countries' financial sectors. As for the BIS, it is well aware that its own outreach to emerging market countries—which began only a decade ago—has further to go. But ways to make the process more representative must not compromise its efficient pragmatism.

The central point is that informal understandings can be much more effective than comprehensive rule-making mechanisms. The authors explain how international soft law (which is nonbinding and flexible) can encourage legal authorities in different jurisdictions to shape their own national regulations in the light of international best practice. In this way, excessive risk taking by powerful financial firms operating in different countries can be disciplined.

Most of those involved would say that these arrangements have been effective—and much more has been achieved over the past 10 years than many would have expected. There is now a more widely shared understanding about what is needed to create a stable and efficient financial system. The FSAP may have played a role in this regard. While a recent report by the IMF's Independent Evaluation Office evaluating the FSAP found that the program could be improved, it also documented how it has helped foster an internal policy dialogue in many countries, strengthening the hand of reformers on the ground.

The other big question the authors raise about the quality of systemic oversight is much harder to answer. They are surely right to suggest that systemic risk remains a very present danger to the global economy and should therefore remain high on the policy agenda of the IFIs and other policy forums. Their analysis of how microeconomic risks interact with macroeconomic developments and the detailed descriptions of potentially systemic episodes are particularly enlightening. Crises almost always contain a good dose of the unexpected. The threats to financial stability over the past decade came from near-simultaneous crises in several medium-sized emerging market countries. The next crisis will probably be different. This is why flexibility and pragmatism in the global governance of the financial system is so important.

Philip Turner
Bank for International Settlements

Paying for old age

Franco Modigliani and Arun Muralidhar

Rethinking Pension Reform

Cambridge University Press, 2005, 272 pp., $24.99 (paperback).

This is a turbulent time in the debate about pension reform. Following the earlier lead of many U.K. companies, major U.S. corporations are not only shutting out new employees from their defined-benefit pension programs (which promise the participant a specific monthly benefit at retirement until he or she dies), but they are also ceasing further contributions toward defined-benefit plans for existing employees. Instead, they are contributing to defined-contribution-type accounts (in which benefits are based on the amount contributed, thus shifting risk from the state or company to the individual).

The Bush administration has explored ways of introducing private accounts within the context of the U.S. defined-benefit social security system, and many European countries are combining parametric reforms that reduce benefits and postpone the age for defined-benefit eligibility with the addition of a second pillar encouraging personal accounts. Moreover, in Chile—the original bastion of mandatory defined-contribution accounts—there is now a consensus that reforms have not only proved costly and inadequate for contributors but have also failed to reduce costs for the government 20 years after their introduction.

Into this breach comes a new study by the late Nobel Prize winner Franco Modigliani and Arun Muralidhar (an economist and investment portfolio manager). It seeks to clarify the key issues involved in reforming existing public pension programs (with case studies of the United States and Spain) and designing new ones, including the relative roles that different pension pillars should play. Early chapters take the reader through the basic terms and concepts, provide examples of alternative pension system approaches, and explore the multiple objectives of a pension system, the types of risks to which these systems and their participants are exposed, and the inter- and intragenerational distributional issues that arise. And the authors weigh in as to what would constitute an "ideal system."

There is no doubt that changes will need to take place. Many industrial and transition countries are wrestling with government pension schemes that will cause government fiscal deficits to balloon as aging baby boomers retire following decades of low birth rates. Many emerging market countries, including some of the largest (China and India) are also grappling with how to design new public pension systems to cope with the eventual aging of their populations.

A bold new proposal

This book is bold in its advocacy of a way to sensibly reform and structure defined-benefit approaches at a time when the "advocacy" pendulum would appear to be swinging in the opposite direction. The authors advocate a two-pillar system, part public, part private. It would be rooted in a mandatory defined-benefit pillar, which would be publicly managed, contributory, and funded, and would allow for a guaranteed real rate of return on fixed contributions—with the option of voluntary additional contributions. And, to maintain the guaranteed benefit associated with a defined-benefit scheme, variable contribution rates would be permitted if needed. This public pillar would be supplemented with a private pillar based on voluntary individual accounts.

The proposed scheme recognizes the role that the public pension system should play in ensuring a basic (albeit modest) replacement rate. It also underscores the importance of limiting the administrative cost of managing individual accounts—a key weakness of the Chilean system—and the need for ongoing innovations in financial markets that can provide financial products to mitigate certain key risks. But can the proposal work? Will governments be able to implement higher contribution rates when they are needed? Will people be discouraged from saving privately by the guaranteed returns of a public scheme? These and other questions will need to be answered before we know whether this book's proposed solution to the pension dilemma is superior to the many other options currently being debated.

Peter Heller
Deputy Director
IMF Fiscal Affairs Department