ha joon 6 7

CHAPTER 5
Man exploits man
Private enterprise good, public enterprise bad?
John Kenneth Galbraith, one of the most profound economic thinkers of the 20th century, once famously said:‘Under capitalism, man exploits man; under communism, it is just the opposite.’He was not suggesting that there is no difference between capitalism and communism, he would have been the last person to do so; Galbraith was one of the leading non-leftist critics of modern capitalism.What he was expressing was the profound disappointment that many people felt about the failure of communism to build the egalitarian society it had promised.
Since its rise in the 19th century, the key goal of the communist movement had been the abolition of private ownership of the ‘means of production’ (factories and machines). It is easy to understand why the communists saw private ownership as the ultimate source of the distributive injustice of capitalism. But they also saw private ownership as a cause of economic inefficiency. They believed that it was the reason for the ‘wasteful’ anarchy of the market. Too many capitalists routinely invest in producing the same things, they argued, because they do not know the investment plans of their competitors. Eventually, there is over-production and some of the enterprises involved go bankrupt, condemning some machines to the scrap heap and laying perfectly employable workers idle. The waste caused by this process, it was argued, would disappear if the decisions of different capitalists could be co-ordinated in advance through rational, centralized planning – after all, capitalist firms are islands of planning in the surrounding anarchic sea of the market, as Karl Marx, the leading communist theorist, once put it. Therefore, if private property were abolished, communists believed, the economy could be run as if it were a single firm and thus managed more efficiently.
Unfortunately, the centrally planned economy based on state ownership of enterprises performed very poorly. Communists may have been right in saying that unfettered competition can lead to social waste, but suppressing all competition through total central planning and universal state ownership exacted enormous costs of its own by killing off economic dynamism. Lack of competition and excessive top-down regulation under communism also bred conformism, bureaucratic red tape and corruption.
Few would now dispute that communism failed as an economic system. But it is a huge leap of logic to go from that conclusion to the proposition that state-owned enterprises (SOEs), or public enterprises, do not work. This judgement became popular in the wake of Margaret Thatcher’s pioneering privatization programme in Britain in the early 1980s, and acquired the status of a pseudo-religious credo during the ‘transformation’ of the former communist economies in the 1990s. For a while, it was as if the whole ex-communist world was hypnotised by the mantra, ‘private good, public bad’, reminiscent of the anti-human slogan, ‘four legs good, two legs bad’, in George Orwell’s Animal Farm – that great satire of communism. Privatization of SOEs has also been a centrepiece of the neo-liberal agenda that the Bad Samaritans have imposed on most developing countries in the past quarter of a century.
State ownership in the dock
Why do the Bad Samaritans think state-owned enterprises need to be privatized? At the heart of the argument against SOEs lies a simple but powerful idea. The idea is that people do not fully take care of things that are not theirs.We see the corroboration of this notion on a daily basis. When your plumber takes his third coffee break of the morning at 11am, you begin to wonder whether he would do the same if he was fixing his own boiler. You know that most of those people who throw away litter in public parks would never do so in their own gardens. It seems to be human nature for people to do their best to take care of the things they own while maltreating those things that they do not. Therefore, it is argued by the opponents of state ownership, you have to give people ownership, or property rights, over things (including enterprises) if you want them to use them most efficiently.1
Ownership gives the owner two important rights in relation to his property. The first is the right to dispose of it. The second is the right to claim the profits from its use. Since profits are, by definition, what are left to the owner of the property after he has paid for all the inputs he has bought in order to use his property productively (e.g., raw materials, labour and other inputs used in his factory), the right to claim the profits is known as the ‘residual claim’. The problem is that, if the owner has the residual claim, the amount of the profits does not concern those suppliers of inputs who get fixed payments.
By definition, state-owned enterprises are properties collectively owned by all the citizens, who hire professional managers on fixed salaries to run them. Given that it is the citizenry that has the residual claim as the owner of the enterprise, the hired managers do not care about the profitability of their enterprises. Of course, the citizenry, as the ‘principal’, can make its ‘agents’, or the hired managers, interested in the profitability of the SOEs by linking their pay to it. But such incentive systems are notoriously difficult to design. This is because there is a fundamental gap in information between the principals and their agents. For example, when the hired manager says that she has done her best and that the poor performance is due to factors beyond her control, the principal will find it very difficult to prove that she is lying. The difficulty of the principal controlling the agent’s behaviour is known as the ‘principal-agent problem’ and the resulting costs (that is, the reduction in profits due to poor management) the ‘agency cost’. The principal-agent problem is at the centre of the neo-liberal argument against SOEs.
But this is not the only cause of inefficiency of state ownership of enterprises. Individual citizens, even if they theoretically own the public enterprises, do not have any incentives to take care of their properties (the enterprises in question) by adequately monitoring the hired managers. The problem is that any increase in profit resulting from the extra monitoring of the SOE managers by some citizens will be shared by every citizen, while only those citizens who do the monitoring pay the costs (e.g., time and energy spent in going through company accounts or alerting the relevant government agencies to any problems). As a result, everyone’s preferred course of action will be not to monitor the public enterprise managers at all and simply to ‘free-ride’ on the efforts of the others. But, if everyone free-rides, no one will monitor the managers and poor performance will be the outcome. The reader will immediately understand the ‘free-rider problem’ if he tries to recall how often he himself has monitored the performance of any of his country’s SOEs (of which he is one of the legal owners) – Amtrak, for example.
There is yet another argument against state-owned enterprises, known as the ‘soft budget constraint’ problem. Being a part of the government, the argument goes, SOEs are often able to secure additional finances from the government if they make losses or are threatened with bankruptcy. In this way, it is argued, enterprises can act as if the limits on their budgets are malleable, or ‘soft’, and get away with lax management. This theory of soft budget constraint was originally advanced by the famous Hungarian economist, Janos Kornai, to explain the behaviour of state-owned enterprises under communist central planning, but it can be applied to similar enterprises in capitalist economies too. Those ‘sick enterprises’ of India that never go bankrupt are the most frequently cited example of the soft budget constraint problem in relation to state-owned enterprises.2
State vs private
So the case against state-owned enterprises, or public ownership, seems very powerful. The citizens, despite being the legal owners of public enterprises, have neither the ability nor the incentive to monitor their agents, who have been hired to run the enterprises. The agents (managers) do not maximize enterprise profits, while it is impossible for the principtals (citizens) to make them do so, because of the inherent deficiency in information they possess about the agents’ behaviour and the free-rider problem amongst the principals themselves. On top of this, state ownership makes it possible for enterprises to survive through political lobbying rather than through raising productivity.
But all three arguments against state ownership of enterprises actually apply to large private-sector firms as well. The principal-agent problem and the free-rider problem affect many large private-sector firms. Some large companies are still managed by their (majority) owners (e.g., BMW, Peugeot), but most of them are managed by hired managers because they have dispersed share ownership. If a private enterprise is run by hired managers and there are numerous shareholders owning only small fractions of the company, it will suffer from the same problems as state-owned enterprises. The hired managers (like their SOE counterparts) will also have no incentive to put in more than sub-optimal levels of effort (the principal-agent problem), while individual shareholders will not have enough incentive to monitor the hired managers (the free-rider problem).
As for politically generated soft budget constraints, they are not confined to SOEs. If they are politically important (e.g., large employers or enterprises operating in politically sensitive industries, such as armaments or healthcare), private firms can also expect subsidies or even government bail-outs. Right after the Second World War, a lot of large private enterprises were nationalized in many European countries because they were not doing well. In the 1960s and the 1970s, the British industrial decline prompted both Labour and Conservative governments to nationalize key firms (Rolls Royce in 1971 under the Conservatives; British Steel in 1967, British Leyland in 1977, and British Aerospace in the same year under Labour). Or, to take another example, in Greece, 43 virtually bankrupt private-sector firms were nationalized between 1983 and 1987 when the economy was going through a difficult patch.3 Conversely, state-owned enterprises are not totally immune to market forces. Many public enterprises across the world have been shut down and their managers sacked because of bad performance – these are equivalent to corporate bankruptcies and corporate takeovers in the private sector.
Private firms know that they will be able to take advantage of soft budget constraints if they are important enough, and they are not shy about exploiting the opportunity to the full. As one foreign banker reportedly told the Wall Street Journal in the middle of the 1980s Third World debt crisis, ‘[w]e foreign bankers are for the free market when we’re out to make a buck and believe in the state when we are about to lose a buck’.4
Indeed, many state bail-outs of large private sector firms have been made by avowedly free-market governments. In the late 1970s, the bankrupt Swedish shipbuilding industry was rescued through nationalization by the country’s first right-wing government in 44 years, despite the fact that it had come to power with a pledge to reduce the size of the state. In the early 1980s, the troubled US car maker Chrysler was rescued by the Republican administration under Ronald Reagan, which was in the vanguard of neo-liberal market reforms at the time. Faced with the financial crisis in 1982, following its premature and poorly designed financial liberalization, the Chilean government rescued the entire banking sector with public money. This was General Pinochet’s government, which had seized power in a bloody coup in the name of defending the free market and private ownership.
The neo-liberal case against state-owned enterprises is further undermined by the fact that there are numerous well-functioning SOEs in real life. Many of them are actually world-class firms. Let me tell you about some of the more important ones.
State-owned success stories
Singapore Airlines is one of the most highly regarded airlines in the world. Often voted the world’s favourite airline, it is efficient and friendly. Unlike most other carriers, it has never made a financial loss in its 35-year history.
The airline is a state-owned enterprise, 57% controlled by Temasek, the holding company whose sole shareholder is Singapore’s Ministry of Finance. Temasek Holdings owns controlling stakes* (usually the majority share) in a host of other highly efficient and profitable enterprises, called GLCs (government-linked companies). The GLCs do not just operate in the usual public ‘utility’ industries, such as telecommunications, power and transport. They also operate in areas that are owned by the private sector in most other countries, such as semiconductors, shipbuilding, engineering, shipping and banking.5 The Singapore government also runs the so-called Statutory Boards that provide certain vital goods and services. Virtually all land in the country is publicly owned and around 85% of housing is provided by the Housing and Development Board. The Economic Development Board develops industrial estates, incubates new firms and provides business consulting services.
Singapore’s SOE sector is twice as big as that of Korea, when measured in terms of its contribution to national output.When measured in terms of its contribution to total national investment, it is nearly three times bigger.6 Korea’s SOE sector is, in turn, about twice as large as that of Argentina and five times bigger than that of the Philippines, in terms of its share in national income.7 Yet both Argentina and the Philippines are popularly believed to have failed because of an overextended state, while Korea and Singapore are often hailed as success stories of private-sector-driven economic development.
Korea also provides another dramatic example of a successful public enterprise in the form of the (now privatized) steel maker, POSCO (Pohang Iron and Steel Company).8 The Korean government made an application to the World Bank in the late 1960s for a loan to build its first modern steel mill. The bank rejected it on the grounds that the project was not viable. Not an unreasonable decision. The country’s biggest export items at the time were fish, cheap apparel, wigs and plywood. Korea didn’t possess deposits of either of the two key raw materials – iron ore and coking coal. Furthermore, the Cold War meant it could not even import them from nearby communist China. They had to be brought all the way from Australia. And to cap it all, the Korean government proposed to run the venture as an SOE.What more perfect recipe for disaster? Yet within ten years of starting production in 1973 (the project was financed by Japanese banks), the company became one of the most efficient steel-producers on the planet and is now the world’s third largest.
Taiwan’s experience with state-owned enterprises has been eve more remarkable.9 Taiwan’s official economic ideology is the so-called ‘Three People’s Principles’ of Dr Sun Yat-Sen, the founder of the Nationalist Party (Kuomintang) that engineered the Taiwanese economic miracle.10 These principles dictate that the key industries should be owned by the state. Accordingly, Taiwan has had a very large SOE sector. Throughout the 1960s and the 1970s, it accounted for over 16% of national output. Little of it was privatized until 1996. Even after the ‘privatization’ of 18 (of many) state-owned enterprises in 1996, the Taiwanese government still retains a controlling stake in them (averaging 35.5%) and appoints 60% of the directors to their boardrooms. Taiwan’s strategy has been to let the private sector grow by creating a good economic environment (including, importantly, the supply of cheap, high-quality inputs by public enterprises) and not bothering about privatization very much.
In the past three decades of its economic ascendancy, China has used a strategy similar to that of Taiwan. All Chinese industrial enterprises had been owned by the state under Maoist communism. Now China’s SOE sector only accounts for around 40% of industrial output.11 Over the past 30 years of economic reform, some smaller state-owned enterprises have been privatized under the slogan of zhuada fangxiao (grabbing the big, letting go of the small). But the fall in the share of state ownership has been mainly due to the growth of the private sector. The Chinese have also come up with a unique type of enterprise based on a hybrid form of ownership, called TVEs (township and village enterprises). These enterprises are formally owned by local authorities, but usually operate as if they were privately owned by powerful local political figures.
It is not only in East Asia that we can find good public enterprises. The economic successes of many European economies, such as Austria, Finland, France, Norway and Italy after the Second World War, were achieved with very large SOE sectors at least until the 1980s. In Finland and France especially, the SOE sector was at the forefront of technological modernization. In Finland, public enterprises led technological modernization in forestry, mining, steel, transport equipment, paper machinery and chemical industries.12 The Finnish government gave up its controlling stake in only a few of these enterprises even after recent privatizations. In the case of France, the reader may be surprised to learn that many French household names, like Renault (automobiles), Alcatel (telecommunications equipment), St Gobain (glass and other building materials), Usinor (steel; merged into Arcelor, which is now part of Arcelor-Mittal, the biggest steel-maker in the world), Thomson (electronics), Thales (defence electronics), Elf Aquitaine (oil and gas), Rhone-Poulenc (pharmaceuticals; merged with the German company Hoechst to form Aventis, which is now part of Sanofi-Aventis), all used to be SOEs.13 These firms led the country’s technological modernization and industrial development under state ownership until their privatization at various points between 1986 and 2000.14
Well-performing state-owned enterprises are also found in Latin America. The Brazilian state-owned oil company Petrobras is a world-class firm with leading-edge technologies. EMBRAER (Empresa Brasileira de Aeronáutica), the Brazilian manufacturer of ‘regional jets’ (short-range jet planes), also became a world-class firm under state ownership. EMBRAER is now the world’s biggest producer of regional jets and the world’s third largest aircraft manufacturer of any kind, after Airbus and Boeing. It was privatized in 1994, but the Brazilian government still owns the ‘golden share’ (1% of the capital), which allows it to veto certain deals regarding military aircraft sales and technology transfers to foreign countries.15
If there are so many successful public enterprises, why do we rarely hear about them? It is partly because of the nature of reporting, whether journalistic or academic. Newspapers tend to report bad things – wars, natural disasters, epidemics, famines, crime, bankruptcy, etc. While it is natural and necessary for newspapers to focus on these events, the journalistic habit tends to present the public with the bleakest possible view of the world. In the case of SOEs, journalists and academics usually investigate them only when things go wrong – inefficiency, corruption or negligence.Well-performing SOEs attract relatively little attention in the same way that a peaceful and productive day in the life of a ‘model citizen’ is unlikely to make front-page news.
There is another, perhaps more important, reason for the paucity of positive information on state-owned enterprises. The rise of neo-liberalism during the past couple of decades has made state ownership so unpopular in the public mind that successful SOEs themselves want to underplay their connection with the state. Singapore Airlines does not advertise the fact that it is owned by the state. Renault, POSCO and EMBRAER – now all privatized – try to underplay, if not exactly hide, the fact that they became world-class firms under state ownership. Partial state ownership is practically hushed up. For example, few people know that the state (Land) government of Lower Saxony (Niedersachsen), with an 18.6% stake, is the largest shareholder in the German carmaker Volkswagen.
The unpopularity of state ownership, however, is not entirely, or even mainly, due to the power of neo-liberal ideology. There are many SOEs all over the world that are not performing well. My examples of high-performing SOEs are not meant to distract the reader’s attention away from the poorly performing ones. They are given to show that there is nothing ‘inevitable’ about poor performance by public enterprises and that improving their performance does not necessarily require privatization.
The case for state ownership
I have shown that all the reasons cited as causes of poor SOE performance apply also to large private-sector firms with dispersed ownership, if not always to the same degree. My examples also show that there are many public enterprises that do very well. But even that is not the whole story. Economic theory shows that there are circumstances under which public enterprises are superior to private-sector firms.
One such circumstance is where private-sector investors refuse to finance a venture despite its long-term viability because they think it is too risky. Precisely because money can move around quickly, capital markets have an inherent bias towards short-term gains and do not like risky, large-scale projects with long gestation periods. If the capital market is too cautious to finance a viable project (this is known as ‘capital market failure’ among economists), the state may do it by setting up an SOE.
Capital market failures are more pronounced in the earlier stages of development, when capital markets are underdeveloped and their conservatism greater. So, historically, countries have resorted to this option more frequently in the earlier stages of their development, as I mentioned in chapter 2. In the 18th century, under Frederick the Great (1740–86), Prussia set up a number of ‘model factories’ in industries like textiles (linen above all), metals, armaments, porcelain, silk and sugar refining.16 Emulating Prussia, its role model, the Meiji Japanese state established state-owned model factories in a number of industries in the late 19th century. These included shipbuilding, steel, mining, textiles (cotton, wool and silk) and armaments.17 The Japanese government privatized these enterprises soon after they were established, but some of them remained heavily subsidized even after privatization – especially the shipbuilding firms. The Korean steel maker POSCO is a more modern and more dramatic case of an SOE set up due to capital market failure. The general lesson is clear: public enterprises have often been set up in order to kick-start capitalism, not to supersede it, as it is commonly believed.
State-owned enterprises can also be ideal where there exists ‘natural monopoly’. This refers to the situation where technological conditions dictate that having only one supplier is the most efficient way to serve the market. Electricity, water, gas, railways and (landline) telephones are examples of natural monopoly. In these industries, the main cost of production is the building of the distribution network and, therefore, the unit cost of provision will go down if the number of customers that use the network serves is increased. In contrast, having multiple suppliers each with its own networks of, say, water pipes, increases the unit cost of supplying each household. Historically, such industries in the developed countries often started out with many small competing producers but were then consolidated into large regional or national monopolies (and then often nationalized).
When there is a natural monopoly, the producer can charge whatever it wants to, as consumers have no one else to turn to. But it is not just a matter of the producer ‘exploiting’ the consumer. This situation also generates a social loss that even the monopoly supplier cannot appropriate – known as ‘allocative deadweight loss’ in technical jargon.* In this case, it may be economically more efficient for the government to take over the activity in question and operate it itself, producing the socially optimal quantity.
The third reason for the government to set up state-owned enterprises is equity among citizens. For example, if left to private-sector firms, people living in remote areas may be denied access to vital services such as post, water or transport – the cost of delivering a letter to an address in the remote mountain areas of Switzerland is much higher than to an address in Geneva. If the firm delivering the letter was solely interested in profit, it would raise the price of letter delivery to the mountain areas, forcing the residents to reduce their use of the postal service, or might even discontinue the service altogether. If the service in question is a vital one that every citizen should be entitled to, the government may decide to run the activity itself through a public enterprise, even if it means losing money in the process.
All of the above reasons for having SOEs can be, and have been, addressed by schemes whereby private enterprises operate under some combination of government regulation and/or tax-and-subsidy scheme. For example, the government may finance (through a government-owned bank, for example) or subsidize (out of its tax revenue) the private enterprise undertaking a risky, long-term venture which may be beneficial for the country’s economic development, but which the capital market is unwilling to finance. Or the government may license private-sector firms to operate in natural monopoly industries but regulate the prices they can charge and also the quantity they produce. It can license private-sector firms to provide essential services (e.g., post, rail, water) on condition that they provide ‘universal access’. Therefore, it may appear that SOEs are no longer necessary.
But the regulation and/or subsidy solutions are often more difficult to manage than SOEs, particularly for developing country governments. Subsidies require tax revenues in the first place. Collecting tax may seem straightforward, but it is not easy. It requires capabilities to collect and process information, calculate the taxes owed, and detect and punish evaders. Even in today’s rich countries, it took a long time to develop such capabilities, as history shows.18 Developing countries have only limited abilities to collect taxes and, consequently, to use subsidies to address the limitations of the markets.As I pointed out in chapter 3, this difficulty has been recently compounded by the reduction in tariff revenues following trade liberalization – especially for the poorest countries that have a particularly high dependence on tariff revenues in their government budgets. Good regulation has proved difficult even in the richest countries, which have sophisticated regulators commanding ample resources. The messy outcome of British rail privatization in 1993, which resulted in the de facto re-nationalization of the rail tracks in 2002, or the failure of electricity deregulation in California, which resulted in the infamous blackout in 2001, are merely the most prominent examples.
Developing countries are even more deficient in their capacity to write good regulatory rules and to deal with the legal manouevring and political lobbying by the regulated firms that are often subsidiaries of, or joint ventures with, gigantic well-resourced enterprises from rich countries. The case of Maynilad Water Services, a French-Filipino consortium that took over water supply for about half of Manila in 1997, and that was once hailed by the World Bank as a privatization success story, is very instructive in this regard. Despite having secured, through skillful lobbying, a series of tariff hikes that were not formally permitted under the terms of the original contract, Maynilad walked away from the contract when the regulator refused to grant yet another tariff hike in 2002.19
State-owned enterprises are often more practical solutions than a system of subsidies and regulations for private-sector providers, especially in developing countries that lack tax and regulatory capabilities. Not only can they do (and, in many cases, have done) well, under certain circumstances they may be superior to private-sector firms.
The pitfalls of privatization
As I have pointed out, all the alleged key causes of SOE inefficiency – the principal-agent problem, the free-rider problem and the soft budget constraint – are, while real, not unique to state-owned enterprises. Large private-sector firms with dispersed ownership also suffer from the principal-agent problem and the free-rider problem. So, in these two areas, forms of ownership do matter, but the critical divide is not between state and private ownership – it is between concentrated and dispersed ownerships. In the case of the soft budget constraint, arguably the distinction between state and private ownership is sharper, but even here it is not absolute. For, as we have seen, politically important private-sector firms are also able to get financial help from government, while SOEs can be, and, on occasion, have been, subject to hard budget constraints, including management change and the ultimate sanction of liquidation.
If state ownership itself is not entirely, or even predominantly, the root cause of problems with SOEs, changing their ownership status – that is, privatization – is not likely to solve the problems. What is more, privatization has a lot of pitfalls.
The first challenge is selling the right enterprises. It would be a bad idea to sell public enterprises with natural monopolies or those providing essential services, especially if the regulatory capability of the state is weak. But even when it comes to selling off enterprises for which public ownership is not necessary, there is a dilemma. The government usually wants to sell the worst performing enterprises – precisely those that least interest potential buyers. Therefore, in order to generate private sector interest in a poorly performing SOE, the government often has to invest heavily in it and/or restructure it. But if its performance can be improved under state ownership, why then privatize it at all?20 Therefore, unless it is politically impossible to restructure a public enterprise without a strong government commitment to privatization, a lot of problems in public enterprises may be solved without privatization.
Moreover, the privatized firm should be sold at the right price. Selling at the right price is the duty of the government, as the trustee of the citizens’ assets. If it sells them too cheaply, it is transferring public wealth to the buyer. This raises an important distributional question. In addition, if the wealth transferred is taken outside the country, there will be a loss in national wealth. This is more likely to occur when the buyer is based abroad, but national citizens can also stash the money away, if there is an open capital market, as seen in the case of Russian ‘oligarchs’ following post-communist privatization.
In order to get the right price, the privatization programme must be done at the right scale and with the right timing. For example, if a government tries to sell too many enterprises within a relatively short period, this would adversely affect their prices. Such a ‘fire sale’weakens the government’s bargaining power, thus lowering the proceeds it receives: this is what took place in a number of Asian countries after the 1997 financial crisis.What is more, given fluctuations in the stock market, it is important to privatize only when the stock market conditions are good. In this sense, it is a bad idea to set a rigid deadline for privatization, which the IMF often insists on and which some governments have also voluntarily adopted. Such a deadline will force the government to privatize regardless of market conditions.
Even more important is selling the public enterprises to the right buyers. If privatization is going to help a country’s economic future, the public enterprises need to be sold to people who have the ability to improve their long-term productivity. Obvious as this may sound, it is often not done. Unless the government demands that the buyer has a proven track record in the industry (as some countries have done), the enterprise may be sold to those who are good at financial engineering rather than at managing the enterprise in question.
More importantly, SOEs are often sold off corruptly to people who have no competence to run them well – massive state-owned assets were transferred in a corrupt way to the new ‘oligarchy’ in Russia after the fall of communism. In many developing countries, the very processes of privatization have also been riddled with corruption, with a large part of the potential proceeds ending up in the pockets of a few insiders, rather than in the state coffers. Corrupt transfers can sometimes be effected illegally, through bribery. But they can also be done legally, for example, where government insiders act as consultants and get high fees in the process.
This is ironic, given that one frequent argument against SOEs is that they are rife with corruption. However, the sad fact is that a government that is unable to control or eliminate corruption in its SOEs is not suddenly going to develop the capacity to prevent corruption when it is privatizing them. Indeed, corrupt officials have an incentive to push through privatization at all costs, because it means they do not have to share the bribes with their successors and can ‘cash in’ all future bribery streams (e.g., bribes that SOE managers can extract from input suppliers). It should also be added that privatization will not necessarily reduce corruption, for private-sector firms can be corrupt too (see chapter 8).
Privatization of natural monopolies or essential services will also fail if they are not subject to the right regulatory regime afterwards. When the SOEs concerned are natural monopolies, privatization without the appropriate regulatory capability on the part of the government may replace inefficient but (politically) restrained public monopolies with inefficient and unrestrained private monopolies. For example, the sale of the Cochabamba water system in Bolivia to the American company Bechtel in 1999 resulted in an immediate tripling of water rates, which sparked off riots that resulted in the re-nationalization of the company.21 When the Argentinian government partially privatized roads in 1990 by awarding contractors the right to collect tolls in return for road maintenance, ‘[c]ontractors in control of a road leading to a popular beach resort sparked protests by building earthen barriers across alternative routes in order to force motorists to pass through their pay booths. And after travellers complained about the rip-off along another highway, contractors parked a fleet of phony squad cars at tollbooths to give the appearance of police backing’.22 Commenting on the privatization of the Mexican state-owned telephone company, Telmex, in 1989, even a World Bank study concluded that ‘the privatization of Telmex, along with its attendant price-tax regulatory regime, has the result of “taxing” consumers – a rather diffuse, unorganized group – and then distributing the gains among more well-defined groups; [foreign] shareholders, employees and the government’.23
The problem of regulatory deficit is particularly severe at the local government level. In the name of political decentralization and ‘bringing service providers closer to the people’, the World Bank and donor governments have recently pushed for breaking up SOEs into smaller units on a geographical basis, thereby leaving the regulatory function to local authorities. This looks very good on paper, but it has, in effect, often resulted in regulatory vacuums.24
Black cat, white cat
The picture regarding the management of state-owned enterprises is complex. There are good state-owned enterprises, and there are bad state-owned enterprises. Even for a similar problem, public ownership may be the right solution in one context and not in another. Many problems that dog SOEs also affect large private-sector firms with dispersed ownership. Privatization sometimes works well, but can be a recipe for disaster, especially in developing countries that lack the necessary regulatory capabilities. Even when privatization is the right solution, it may be difficult to get it right in practice.
Of course, saying that the picture is complex does not mean that ‘anything goes’. There are some general lessons that we can draw from economic theories and real life examples.
Enterprises in industries that are natural monopolies, industries that involve large investment and high risk and enterprises that provide essential services should be kept as SOEs, unless the government has very high tax-raising and/or regulatory capabilities. Other things being equal, there is a greater need for SOEs in the developing countries than in the developed countries, as they have underdeveloped capital markets and weak regulatory and taxation capabilities. Privatizing politically important enterprises on the basis of dispersed share sales is unlikely to resolve the underlying problems of poor SOE performance, because the newly privatized firm will have more or less the same problems as when it was under state ownership. When privatizing, care must be taken to sell the right enterprise at the right price to the right buyer, and to subject the enterprise to the right regulatory regime thereafter – if this is not done, privatization is not likely to work, even in industries that do not naturally favour state ownership.
SOE performance can often be improved without privatization. One important thing to do is to review critically the goals of the enterprises and establish clear priorities among them. Very often, public enterprises are charged with serving too many goals – for example, social goals (e.g., affirmative action for women and minorities), employment generation and industrialization. There is nothing wrong with state-owned enterprises serving multiple goals, but what the goals are and the relative priority among them need to be made clear.
The monitoring system can also be improved. In many countries, SOEs are monitored by multiple agencies, which means either that they are not meaningfully supervised by any particular agency or that there is a supervisory over-kill that disrupts daily management – for example, the state-owned Korean Electricity Company was reported to have undergone eight government inspections, lasting 108 days, in 1981 alone. In such cases, it may be helpful if the monitoring responsibilities are consolidated into a single agency (as they were in Korea in 1984).
Increase in competition can also be important in improving SOE performance. More competition is not always better, but competition is often the best way to improve enterprise performance.25 Public enterprises that are not natural monopolies can easily be made to compete with private-sector firms, both domestically or in the export market. This has been the case with many SOEs. For example, in France, Renault (fully state-owned until 1996 and still 30% controlled by the state) faced direct competition from the private firm Peugeot-Citroën, as well as from foreign producers. Even when they were virtual monopolies in their domestic markets, SOEs like EMBRAER and POSCO were required to export and, therefore, had to compete internationally. Moreover, where feasible, competition can be increased by setting up another SOE.26 For example, in 1991, South Korea set up a new SOE, Dacom, specializing in international calls, whose competition with the existing state-owned monopoly, Korea Telecom, greatly contributed to increasing efficiency and service quality throughout the 1990s. Of course, SOEs are often in industries where there is a natural monopoly, where increasing competition within the industry is either impossible or would be socially unproductive. But, even in these sectors, some degree of competition may be injected by boosting some ‘neighbouring’ industries (airlines vs railways).27
In conclusion, there is no hard and fast rule as to what makes a successful state-owned enterprise. Therefore, when it comes to SOE management, we need a pragmatic attitude in the spirit of the famous remark by China’s former leader Deng Xiao-ping: ‘it does not matter whether the cat is white or black as long as it catches mice.’
* There is no agreed definition of what is a controlling stake in an enterprise’s shares. A holding of as little as 15% could give the shareholder effective control over an enterprise, depending on the holding structure. But, typically, a holding of around 30% is considered a controlling stake.
* The full argument is somewhat technical, but the gist of it is as follows. In a competitive market, producers do not have the freedom to set the price, as a rival can always undercut them until the point where lowering the price further will result in a loss. But the monopolist firm can decide the price it charges by varying the quantity it produces, so it will produce only up to the quantity where its profit is maximized. This level of output is, under normal circumstances, lower than the socially optimal one, which is where the maximum price a consumer is willing to pay is the same as the minimum price that the producer requires in order not to lose money. When the amount produced is less than the socially optimal quantity, it means not serving some consumers who are perfectly willing to pay more than the minimum price that the producer requires but who are unwilling to bear the price at which the monopoly firm can maximize its profit. The unfulfilled desire of those neglected consumers is essentially the social cost of monopoly.

CHAPTER 6
Windows 98 in 1997
Is it wrong to ‘borrow’ ideas?
In the summer of 1997, I was attending a conference in Hong Kong. The boundless energy and commercial bustle of the city were thrilling even to a Korean, who is no stranger to such things. Walking down the busy street, I noticed dozens of street hawkers selling pirated computer software and music CDs.What caught my eye was the display of the Windows 98 operating system for PCs.
I knew that people in Hong Kong were, like my fellow Koreans, good at pirate-copying, but how could the copy come out before the real thing? Had someone invented a time machine? Unlikely, even in Hong Kong. Someone must have smuggled out the prototype Windows 98 that was being given the final touch in the research labs ofMicrosoft and knocked off a bootleg version.
Computer software is notoriously easy to duplicate. A new product which is the result of hundreds of man-years of software development effort can be duplicated onto a disk in a few seconds. So, Mr Bill Gates may be exceptionally generous in his charity work, but he is a pretty hard man when it comes to someone copying his software. The entertainment industry and the pharmaceutical industry have the same problem. This is why they are exceptionally aggressive in promoting the strong protection of intellectual property rights (IPRs), such as patents, copyrights and trademarks.
Unfortunately, this handful of industries has been driving the whole international agenda on IPRs over the past two decades. They led the campaign to introduce the so-called TRIPS (Trade-Related Intellectual Property Rights) agreement in the World Trade Organisation. This agreement has widened the scope, extended the duration and heightened the degree of protection for IPRs to an unprecedented extent, making it much more difficult for developing countries to acquire the new knowledge they need for economic development.
‘The fuel of interest to the fire of genius’
Many African countries are suffering from an HIV/AIDS epidemic.1 Unfortunately, HIV/AIDS drugs are very expensive, costing $10–12, 000 per patient per year. This is three to four times the annual income per person of even the richest African countries, such as South Africa or Botswana, both of which happen to have the most serious HIV/AIDS epidemic in the world. It is 30–40 times that of the poorest countries, like Tanzania and Uganda, which also have a high incidence of the disease.2 Given this, it is understandable that some African countries have been importing ‘copy’ drugs from countries like India and Thailand, which cost only $3–500, or 2–5% of the ‘real’ thing.
The African governments have not been doing anything revolutionary. All patent laws, including the most pro-patentee US law, have a provision for restricting the rights of IPR-holders when they clash with the public interest. In such circumstances, governments can cancel patents, impose compulsory licensing (forcing the patent holder to license it to third parties – at a reasonable fee) or allow parallel imports (imports of copy products from countries where the product is not patented). Indeed, in the aftermath of the anthrax terror scare in 2001, the US government utilized the public interest provision to maximum effect – it used the threat of compulsory licensing to extract a whopping 80% discount for Cipro, the patent-protected anti-anthrax drug from Bayer, the German pharmaceutical company.3
Despite the legitimacy of the actions of African countries concerning the HIV/AIDS drugs, 41 pharmaceutical companies banded together and decided to make an example of the South African government and took it to court in 2001. They argued that the country’s drug laws allowing parallel imports and compulsory licensing were contrary to the TRIPS agreement. The ensuing social campaigns and public uproar showed the drug companies in a bad light, and they eventually withdrew the lawsuit. Some of them even offered substantial discounts on their own HIV/AIDS drugs to African countries to make up for the negative publicity generated by the episode.
During the debate surrounding the HIV/AIDS drugs, the pharmaceutical companies argued that, without patents, there will be no more new drugs – if anyone can ‘steal’ their inventions, they would have no reason to invest in inventing new drugs. Citing Abraham Lincoln – the only US president to be issued a patent* – who said that ‘patent adds the fuel of interest to the fire of genius’, Harvey Bale, director general of the International Federation of Pharmaceutical Manufacturers Associations, asserted that ‘without [intellectual property rights] the private sector will not invest the hundreds of millions of dollars needed to develop new vaccines for AIDS and other infectious and non-infectious diseases.’4 Therefore, the drug companies went on to say, those who are criticizing the patent system (and other IPRs) are threatening the future supply of new ideas (not just drugs), undermining the very productivity of the capitalist system.
The argument sounds reasonable enough, but it is only a half-truth. It is not as if we always have to ‘bribe’ clever people into inventing new things. Material incentives, while important, are not the only things that motivate people to invest in producing new ideas. At the height of the HIV/AIDS debate, 13 fellows of the Royal Society, the highest scientific society of the UK, put this point powerfully in an open letter to the Financial Times: ‘Patents are only one means for promoting discovery and invention. Scientific curiosity, coupled with the desire to benefit humanity, has been of far greater importance throughout history.’5 Countless researchers all over the world come up with new ideas all the time, even when they do not directly profit from them. Government research institutes or universities often explicitly refuse to take out patents on their inventions. All these show that a lot of research is not motivated by the profit from patent monopoly.
This is not a fringe phenomenon. A lot of research is conducted by non-profit-seeking organizations – even in the US. For example, in the year 2000, only 43% of US drugs research funding came from the pharmaceutical industry itself. 29% came from the US government and the remaining 28% from private charities and universities.6 So, even if the US were to abolish pharmaceutical patents tomorrow and, in response, all the country’s pharmaceutical companies shut down their research labs (which will not happen), there would still be more than half as much drugs research as there is today in that country. A slight weakening of patentee rights – for example, being forced to charge lower prices to poor people/countries or being made to accept a shorter patent life in developing countries – is even less likely to result in the disappearance of new ideas, despite the patent lobby mantra.
We should also not forget that patents are critical only for some industries, such as pharmaceutical and other chemicals, software, and entertainment, where copying is easy.7 In other industries, copying new technology is not easy, and innovation automatically gives the inventor a temporary technological monopoly, even in the absence of the patent law. The monopoly is due to the natural advantages accorded to the innovator, such as imitation lag (due to the time it takes for others to absorb new knowledge); reputational advantage (of being the first and so best-known producer); and the head start in ‘racing down learning curves’ (i.e., the natural increase in productivity through experience).8 The resulting temporary monopoly profit is reward enough for the innovative activity in most industries. This was indeed a popular argument against patents in the 19th century.9 This is also why patents do not feature at all in the Austrian-born American economist Joseph Schumpeter’s famous theory of innovation – Schumpeter believed that the monopoly rent (or what he calls the entrepreneurial profit) that a technological innovator will enjoy through the above mechanisms is a big enough incentive for investing in generating new knowledge.10 Most industries actually do not need patents and other IPRs to generate new knowledge – although they will be more than happy to take advantage of them, if they are offered to them. The patent lobby talks nonsense when it argues that there will be no new technological progress without patents.
Even in those industries where copying is easy and thus patents (and other IPRs) are necessary, we need to get the balance right between the interests of the patentees (and the holders of copyrights and trademarks) and the rest of society. One obvious problem is that patents, by definition, create monopolies, which impose costs on the rest of society. For example, the patentee could use its technological monopoly to exploit the consumers, as some people believe Microsoft is doing. But it is not just the problem of income distribution between the patentee and the consumers.Monopoly also creates net social loss by allowing the producer to maximize its profit by producing at a less than socially desirable quantity, creating net social loss (this is explained in chapter 5). Also, because it is a ‘winner takes all’ system, critics point out, the patent system often results in the duplication of research among competitors – this may be wasteful from the social point of view.
The unstated presumption in the pro-patent argument is that such costs will be more than offset by the benefits that flow from increased innovation (that is, higher productivity), but this is not guaranteed. Indeed, in mid-19th-century Europe, the influential anti-patent movement, famously championed by the British free-market magazine, The Economist, objected to the patent system on the grounds that its costs would be higher than its benefits.11
Of course, the 19th-century anti-patent liberal economists were wrong. They failed to recognize that some forms of monopoly, including the patent, can create more benefits than costs. For example, infant industry protection does produce inefficiency by artificially creating monopoly power for domestic firms, as free-trade economists are only too pleased to point out. But such protection may be justified, if it raises productivity in the long run and more than offsets the damages from the monopoly it creates, as I have repeatedly explained in the earlier chapters. In exactly the same manner, we advocate the protection of patents and other intellectual property rights, despite their potential to create inefficiency and waste, because we believe they will more than compensate for those costs in the long run by generating new ideas that raise productivity. But accepting the potential benefits of the patent system is different from saying that there is no cost involved. If we design it wrong and give too much protection to the patentee, the system can create more costs than benefits, as is the case with excessive infant industry protection.
The inefficiency from monopolies and the waste from ‘winner-takes-all’ competition are neither the only, nor the most important, problems with the patent system, and other similar forms of intellectual property rights protection. The most detrimental impact lies in its potential to block knowledge flows into technologically backward countries that need better technologies to develop their economies. Economic development is all about absorbing advanced foreign technologies. Anything that makes it more difficult, be it the patent system or a ban on the export of advanced technologies, is not good for economic development. It is as simple as that. In the past, the Bad Samaritan rich countries themselves understood this clearly and did everything to prevent this from happening.
John Law and the first technological arms race
As water flows from high to low, knowledge has always flowed from where there is more to where there is less. Those countries that are better at absorbing the knowledge inflow have been more successful in catching up with the more economically advanced nations. On the other side of the fence, those advanced nations that are good at controlling the outflow of core technologies have retained their technological leadership for longer. The technological ‘arms race’, between backward countries trying to acquire advanced foreign knowledge and the advanced countries trying to prevent its outflow has always been at the heart of the game of economic development.
The technological arms race started to take on a new dimension in the 18th century, with the emergence of modern industrial technologies that had much greater potential for productivity growth than traditional technologies. The leader in this new technological race was Britain. Not least because of the Tudor and Georgian economic policies that we discussed in chapter 2, it was rapidly becoming Europe’s, and the world’s, leading industrial power. Naturally, it was reluctant to part with its advanced technologies. It even set up legal barriers to technology outflows. The other industrialising countries in Europe, and the US, had to violate those laws in order to acquire superior British technologies.
This new technological arms race was started in full spate by John Law (1671–1729), the legendary Scottish financier-economist who even became France’s finance minister for just under a year. Law was named the ‘moneymaker’ by the author of his popular biography, Janet Gleeson.12 He was a moneymaker in more than one sense. He was an extremely successful financier, making huge killings on currency speculation, setting up and merging large banks and trading companies, getting royal monopolies for them and selling their shares at huge profits. His financial scheme was too successful for its own good. It led to the Mississippi Bubble – a financial bubble three times bigger than the contemporary South Sea Bubble discussed in chapter 2 – which wrecked the French financial system.* Law was also known as a great gambler with an incredible ability to calculate the odds. As an economist, he advocated the use of paper money backed by a central bank.13 The idea that we can make worthless paper into money through government fiat was a radical notion then. At the time, most people believed that only things that have a value of their own, like gold and silver, could serve as money.
John Law is today remembered mainly as the financial wheeler-dealer who created the Mississippi Bubble, but his understanding of economics went far beyond mere financial engineering. He understood the importance of technology in building a strong economy. While he was expanding his banking operation and building up the Mississippi Company, he also recruited hundreds of skilled workers from Britain in an attempt to upgrade France’s technology.14
At the time, getting skilled workers was the key to accessing advanced technologies. No one could say, even today, that workers are mindless automata repeating the same task in the manner so hilariously but poignantly depicted by Charlie Chaplin in his classic film, Modern Times. What workers know and can do matters greatly in determining a firm’s productivity. In earlier times, though, their importance was even more pronounced, since they themselves embodied a lot of technologies. Machines were still rather primitive, so productivity depended very much on how skilled the workers who operated them were. The scientific principles behind industrial operations were poorly understood, so technical instructions could not be written down easily in universal terms. Once again, the skilled worker had to be there to run the operation smoothly.
Galvanized by Law’s attempt to poach skilled workers and also by a similar Russian attempt, Britain decided to introduce a ban on the migration of skilled workers. The law, introduced in 1719, made it illegal to recruit skilled workers for jobs abroad – known as ‘suborning’. Emigrant workers who did not return home within six months of being warned to do so would lose their right to lands and goods in Britain and have their citizenship taken away. Specifically mentioned in the law were industries such as wool, steel, iron, brass, other metals and watch-making; but in practice the law covered all industries.15
With the passage of time, machines became more complex and began to embody more technologies. This meant that getting hold of key machinery started to become as important as, and increasingly more important than, recruiting skilled workers. Britain introduced a new act in 1750 banning the export of ‘tools and utensils’ in the wool and silk industries. The ban was subsequently widened and strengthened to include the cotton and linen industries. In 1785, the Tools Act was introduced to ban the export of many different types of machinery.16
Other countries intent on catching up with Britain knew that they had to get hold of these advanced technologies, whether the method used to do so was ‘legal’ or ‘illegal’ from the British point of view. The ‘legal’ means included apprenticeships and factory tours.17 The ‘illegal’ means involved the governments of continental Europe and the US luring skilled workers contrary to British law. These governments also routinely employed industrial spies. In the 1750s, the French government appointed John Holker, a former Manchester textile finisher and Jacobite officer, as Inspector-General of Foreign Manufactures.While also advising French producers on textile technologies, Holker’s main job was running industrial spies and poaching skilled workers from Britain.18 There was also a lot of machine smuggling. Smuggling was hard to detect. Because machines were still quite simple and had relatively few parts, they could be taken apart and smuggled out bit by bit relatively quickly.
Throughout the 18th century, the technological arms race was fought viciously, using recruitment schemes, machine smuggling and industrial espionage. But by the end of the century, the nature of the game had changed fundamentally with the increasing importance of ‘disembodied’ knowledge – that is, knowledge that can be separated from the workers and the machines that used to hold them. The development of science meant that a lot of – although not all – knowledge could be written down in a (scientific) language that could be understood by anyone with appropriate training. An engineer who understood the principles of physics and mechanics could reproduce a machine simply by looking at the technical drawings. Similarly, if a chemical formula could be acquired, medicines could be easily reproduced by trained chemists.
Disembodied knowledge is more difficult to protect than knowledge embodied in skilled workers or actual machines. Once an idea is written down in general scientific and engineering language, it becomes much easier to copy it. When you have to recruit a skilled foreign worker, there are all sorts of personal and cultural problems. When you import a machine, you may not get the maximum out of it because you may only poorly understand its operative principles.As the importance of disembodied knowledge grew, it became more important to protect the ideas themselves than the workers or machines that embody them. Consequently, the British ban on skilled worker emigration was abolished in 1825, while that on machinery export was dropped in 1842. In their place, the patent law became the key instrument in managing the flow of ideas.
The first patent system is supposed to have been used by Venice in 1474, when it granted ten years’ privileges to inventors of ‘new arts and machines’. It was also somewhat haphazardly used by some German states in the 16th century and by Britain from the 17th century.19 Then, reflecting the growing importance of disembodied knowledge, it spread very quickly from the late 18th century, starting with France in 1791, the US in 1793 and Austria in 1794.Most of today’s rich countries established their patent laws within half a century of the French patent law.20 Other intellectual property laws, such as copyright law (first introduced in Britain in 1709) and trademark law (first introduced in Britain in 1862) were adopted by most of today’s rich countries in the second half of the 19th century. Over time, there emerged international agreements on IPRs, such as the Paris Convention on patents and trademarks (1883)21 and the Berne Convention on copyrights (1886). But even these international agreements did not end the use of ‘illegal’ means in the technological arms race.
The lawyers get involved
The year 1905 is known as the annus mirabilis of modern physics. In that year, Albert Einstein published three papers that changed the course of physics for good.22 Interestingly, at the time, Einstein was not a professor of physics but a humble patent clerk (an assistant technical examiner) in the Swiss Patent Office, which was his first job.23
Had Einstein been a chemist rather than a physicist, his first job could not have been in the Swiss Patent Office. For, until 1907, Switzerland did not grant patents to chemical inventions.24 Switzerland, in fact, had no patent law of any kind until 1888. Its 1888 patent law accorded protection only to ‘inventions that can be represented by mechanical models’. The clause automatically (and intentionally) excluded chemical inventions – at the time, the Swiss were ‘borrowing’ a lot of chemical and pharmaceutical technologies from Germany, the then world leader in those fields. It was thus not in their interest to grant chemical patents.
Only in 1907, under the threat of trade sanctions by Germany, did the Swiss decide to extend patent protection to chemical inventions. However, even the new patent law did not protect chemical technologies to the degree expected in today’s TRIPS system. Like many other countries at the time, the Swiss refused to grant patents for chemical substances (as opposed to chemical processes). The reasoning was that those substances, unlike mechanical inventions, already existed in nature and, therefore, the ‘inventor’ had merely found a way to isolate them, rather than inventing the substance itself. Chemical substances remained unpatentable in Switzerland until 1978.
Switzerland was not the only country at the time without a patent law. The Netherlands actually abolished its 1817 patent law in 1869, not to introduce it again until 1912. When the Dutch abolished the law, they were in no small measure influenced by the anti-patent movement I mentioned above – they were convinced that patent, as artificially created monopoly, went against their free-trade principle.25 Exploiting the absence of a patent law, the Dutch electronics company, Philips, a household name today, started out in 1891 as a producer of light bulbs based on the patents ‘borrowed’ from the American inventor, Thomas Edison.26
Switzerland and the Netherlands may have been extreme cases. But throughout much of the 19th century, the IPR regimes in today’s rich countries were all very bad at protecting foreigners’ intellectual property rights. This was partly the consequence of the general laxity of early patent laws in checking the originality of an invention. For example, in the US, before the 1836 overhaul of its patent law, patents were granted without any proof of originality; this encouraged racketeers to patent devices already in use (‘phony patents’) and then to demand money from their users under threat of suit for infringement.27 But the absence of protection for foreigners’ intellectual property rights was often deliberate. In most countries, including Britain, the Netherlands, Austria, France and the US, patenting of imported invention was explicitly allowed. When Peter Durand took out a patent in 1810 in Britain for canning technology, using the Frenchman Nicolas Appert’s invention, the application explicitly stated that it was an ‘invention communicated to me by a certain foreigner’, then a common proviso used when taking out a patent on a foreigner’s invention.28
‘Borrowing’ ideas was not simply done in relation to inventions that could be patented. There was also extensive counterfeiting of trademarks in the 19th century – in a manner similar to what was subsequently done by Japan, Korea, Taiwan and, today, China. In 1862, Britain revised its trademark law, the Merchandise Mark Act, with the specific purpose of preventing foreigners, especially the Germans, from making counterfeit English products. The revised act required the producer to specify the place or country of manufacture as a part of the necessary ‘trade description’.29
The law underestimated German ingenuity, however – the German firms came up with some brilliant evasive tactics.30 For example, they placed the stamp indicating the country of origin on the packaging instead of on the individual articles. Once the packaging was removed, customers could not tell the product’s country of origin. This technique is said to have been particularly common in the case of imported watches and steel files. Alternatively, German manufacturers would send some articles, like pianos and bicycles, over in pieces and have them assembled in England. Or they would place the stamp indicating the country of origin where it was practically invisible. The 19th-century British journalist Ernest Williams, who wrote a book about German counterfeiting, Made in Germany, documents how ‘One German firm, which exports to England large numbers of sewing-machines, conspicuously labeled ‘Singer’ and ‘North-British Sewing Machines’, places the Made in Germany stamp in small letters underneath the treadle. Half a dozen seamstresses might combine their strength to turn the machine bottom-upwards, and read the legend: otherwise it would go unread’.31
Copyrights were also routinely violated. Despite its currently gung-ho attitude towards copyright, the US in the past refused to protect foreigners’ copyrights in its 1790 copyright law. It only signed the international copyright agreement (the Berne Convention of 1886) in 1891. At the time, the US was a net importer of copyright materials and saw the advantage of protecting only American authors. For another century (until 1988), it did not recognize copyrights on materials printed outside the US.
The historical picture is clear. Counterfeiting was not invented in modern Asia.When they were backward themselves in terms of knowledge, all of today’s rich countries blithely violated other people’s patents, trademarks and copyrights. The Swiss ‘borrowed’ German chemical inventions, while the Germans ‘borrowed’ English trademarks and the Americans ‘borrowed’British copyrighted materials – all without paying what would today be considered ‘just’ compensation.
Despite this history, the Bad Samaritan rich countries are now forcing developing countries to strengthen the protection of intellectual property rights to a historically unprecedented degree through the TRIPS agreement and a raft of bilateral free-trade agreements. They argue that stronger protection of intellectual property will encourage the production of new knowledge and benefit everyone, including the developing countries. But is this true?
Making Mickey Mouse live longer
In 1998, the US Copyright Term Extension Act extended the period of copyright protection from ‘life of the author plus 50 years, or 75 years for a work of corporate authorship’ (as set in 1976) to ‘life of the author plus 70 years, or 95 years for a work of corporate authorship’.Historically speaking, this was an incredible extension in the period of copyright protection from the original 14 years (renewable for another 14 years) laid down by the 1790 Copyright Act.
The 1998 act is derisively known as the Mickey Mouse Protection Act, from the fact that Disney was heading the lobby for it in anticipation of the 75th birthday of Mickey Mouse, first created in 1928 (Steamboat Willie). What is particularly remarkable about it is that it was applied retrospectively. As should be immediately obvious to anyone, extending the term of protection for existing work can never create new knowledge.32
The story does not end with copyrights. The US pharmaceutical industry has already successfully lobbied to extend de facto patents by up to eight years, using excuses like the need to compensate for delays in the drugs approval process by the FDA (Food and Drugs Administration) or the need for data protection. Given that US patents, like copyright, used to be for only 14 years, this means that the pharmaceutical industry has effectively doubled the patent life for its inventions.
It is not just in the US that the terms of IPR protection have been lengthening. In the third quarter of the 19th century (1850–75), the average patent life in a sample of 60 countries was around 13 years. Between 1900 and 1975, this was extended to 16 or 17 years. But recently the US has played the leading role in accelerating and consolidating this upward trend. It has now made its 20-year term for patent protection a ‘global standard’ through enshrining it in the World Trade Organisation’s TRIPS agreement – the 60-country average stood at 19 years as of 2004.33 Anything that goes beyond TRIPS, such as the de facto extension of drug patents, the US government has been spreading through bilateral free-trade agreements. I know of no economic theory that says that 20 years is better than 13 years or 16 years as the term of patent protection from social point of view, but it is obvious that the longer it is, the better it is for the patent-holders.
As the protection of intellectual property rights involves monopoly (and its social costs), extending the period of protection clearly increases those costs. Lengthening the term – like any other strengthening of IPR protection – means that society is paying more for new knowledge. Of course, those costs may be justified if the term extension produces more knowledge (by strengthening the incentive for innovation), but there is no evidence that this has been happening – at least not enough to compensate for the increased costs of protection. Given this, we need to carefully examine whether the current terms of IPR protection are appropriate and shorten them if necessary.
Sealed crustless sandwiches and turmeric
One basic assumption behind IPR laws is that the new idea that is awarded protection is worth protecting.This is why all such laws demand the idea to be original (to possess ‘novelty’ and ‘non-obviousness’, in the technical jargon). This may sound incontrovertible in abstract terms, but it is more difficult to put into practice, not least because investors have an incentive to lobby for lowering the originality bar.
For example, as I mentioned when discussing the history of Swiss patent law, many people believe that chemical substances (as opposed to the process) are not worthy of patent protection, because those who have extracted them have not done anything really original. For this reason, chemical and/or pharmaceutical substances could not be patented in most rich countries – such as Germany, France, Switzerland, Japan and the Nordic countries – until the 1960s or the 1970s. Pharmaceutical products remained unpatentable in Spain and Canada right up to the early 1990s.34 Before the TRIPS agreement, most developing countries did not give pharmaceutical product patents.35 Most countries had never given them; others, such as India and Brazil, had abolished the pharmaceutical product patents (process patent as well, in the case of Brazil) that they once had.36
Even for things whose patentability is not disputed, there is no obvious way to judge what is a worthy invention. For example, when Thomas Jefferson was the US patent commissioner – quite ironic given that he opposed patents (more on this later), but this was ex officio as secretary of state – he did a very good job of rejecting patent applications at the slightest excuse. It is reported that the number of patents granted each year trebled after Jefferson resigned from his cabinet post and thus ceased to be the patent commissioner. This was, of course, not because the Americans suddenly became three times more inventive.
Since the 1980s, the originality hurdle for patents has been significantly lowered in the US. In their important book on the current state of the US patent system, Professors Adam Jaffe and Josh Lerner point out that patents have been granted to some very obvious things, like Amazon.com’s ‘one-click’ internet shopping, the Smuckers food company’s ‘sealed crustless sandwiches’, and even things like a ‘bread refreshing method’ (essentially toasting the stale bread) or a ‘method of swinging on a swing’ (apparently ‘invented’ by a five-year-old).37 In the first two cases, the patent holders even used their new rights to take their competitors to court – barnesandnoble.com in the former case and a small Michigan catering company called Albie’s Foods, Inc. in the latter.38 While these cases are at the wackier end of the spectrum, they reflect the general trend that ‘the tests for novelty and non-obviousness, which are supposed to ensure that the patent monopoly is granted only to truly original ideas, have become largely non-operative’.39 The result of this has been what Jaffe and Lerner call a ‘patent explosion’. They document how the number of patents granted in the US grew by 1% a year between 1930 and 1982, the year when the American patent system was loosened, but grew by 5.7% a year during 1983–2002, when patents were more liberally granted.40 This increase is definitely not due to some sudden explosion in American creativity!41
But why should the rest of the world care if the Americans are issuing silly patents? They should care because the new American system has encouraged the ‘theft’ of ideas that are well-known in other countries, especially developing countries, but are not legally protected precisely because they have been so well known for such a long time. This is known as the theft of ‘traditional knowledge’. The best example in this regard is the patent granted in 1995 to two Indian researchers at the University of Mississippi for the medicinal use of turmeric, whose wound-healing properties have been known in India for thousands of years. The patent was only cancelled thanks to the challenge mounted in the American courts by the New Delhi-based Council for Agriculture Research. This patent might be still there if the wronged country had been some small and very poor developing nation that lacked India’s human and financial resources to fight such battles.
Shocking though these examples may be, the consequences of the lowering of originality bar is not the biggest problem with the recent unbalancing of the intellectual property rights system. The most serious problem is that the IPR system has begun to be an obstacle, rather than a spur, to technological innovation.
The tyranny of interlocking patents
Sir Isaac Newton once famously said, ‘if I have seen a little further, it is by standing on the shoulders of giants’.42 He was referring to the fact that ideas develop in a cumulative manner. In the early controversy around patents, some people used this as an argument against them – when new ideas emerge from a ferment of intellectual endeavour, how can we say that the person who put the ‘finishing touches’ to an invention should take all the glory – and the profit? Thomas Jefferson opposed patents on this very basis. He argued that ideas were ‘like air’ and cannot, therefore, be owned (although he saw no problem in owning people – he himself owned many slaves).43
The problem is inherent in the patent system. Ideas are the most important inputs in producing new ideas. But if other people own the ideas you need in order to develop your own new ideas, you cannot use them without paying for them. This can make producing new ideas expensive.Worse, you run the danger of being sued for patent infringement by your competitors, who may own patents closely related to yours. Such a lawsuit would not only waste your money but also keep you from further developing the technology in dispute. In this sense, patents can become an obstacle, rather than a spur, to technological development.
Indeed, patent infringement suits have been major obstacles to technological progress in US industries like sewing machines (mid-19th century), aeroplanes (early 20th century) and semiconductors (mid-20th century). The sewing machine industry (Singer and a few other companies) came up with a brilliant solution to this particular problem – a ‘patent pool’, where all the companies involved cross-licensed all the relevant patents to one another. In the cases of the aeroplanes (the Wright brothers vs Glenn Curtiss) and the semiconductors (Texas Instrument vs Fairchild), the firms concerned could not reach a compromise, so the US government stepped in to impose patent pools.Without these government-imposed patent pools, these industries could not have progressed as they have done.
Unfortunately, the problem of interlocking patents has recently become worse.More and more minute pieces of knowledge have become patentable, down to the level of individual genes, thereby increasing the risk of patents becoming an obstacle to technological progress. The recent debate surrounding so-called golden rice illustrates this point very well.
In 2000, a group of scientists led by Ingo Potrykus (Swiss) and Peter Beyer (German) announced a new technology to genetically engineer rice with extra beta carotene (which turns into Vitamin A when digested). Because of the natural colour of beta carotene, the rice has a golden hue, which gives it its name. The rice is also considered ‘golden’ by some because it can potentially bring important nutritional benefits to millions of poor people in countries where rice is the basic staple.44 Rice is nutritionally very effective, able to sustain more people than wheat, given the same area of land.But it lacks one critical nutrient – Vitamin A. Poor people in rice-eating countries tend to eat little else other than rice and therefore suffer from Vitamin A deficiency (VAD). At the beginning of the 21st century, it is estimated that 124 million people in 118 countries in Africa and Asia are affected by VAD. VAD is thought to be responsible for one or two million deaths, half a million cases of irreversible blindness and millions of cases of the debilitating eye-disease, xerophthalmia, every year.45
In 2001, Potrykus and Beyer caused controversy by selling the technology to the multinational pharmaceutical/biotechnology firm, Syngenta (AstraZeneca at the time).46 Syngenta already had a legitimate partial claim on the technology, thanks to its indirect funding of the research through the European Union. And the two scientists, to their credit, negotiated hard with Syngenta to allow farmers making less than $10, 000 a year out of golden rice to use the technology for free. Even so, some people found the sale of such a valuable ‘public good’ technology to a profit-making firm unacceptable.
In response to the criticisms, Potrykus and Beyer said they had had to sell their technology to Syngenta because of the difficulties involved in negotiating licences for the other patented technologies they needed in order to operationalize their technology. They argued that, as scientists, they simply did not have the necessary resources or the skills to negotiate for the 70 relevant patents belonging to 32 different companies and universities. Critics countered that they were exaggerating the difficulties. They pointed out that there are only a dozen or so patents that are truly relevant for countries where the golden rice would bring about the largest benefits.
But the point remains. The days are over when technology can be advanced in laboratories by individual scientists alone. Now you need an army of lawyers to negotiate the hazardous terrain of interlocking patents. Unless we find a solution to the problem of interlocking patents, the patent system may actually impede the very innovation it was designed to encourage.
Harsh rules and developing countries
The recent changes in the system of intellectual property rights have magnified its costs, while reducing the benefits. Lowering the originality bar and the extension of patent (and other IPR) life have meant that we are, in effect, paying more for each patent, whose average quality, however, is lower than before. Changes in the attitudes of rich country governments and corporations have also made it more difficult to override the commercial interests of patent holders for the sake of the public interest, as we saw in the HIV/AIDS case. And making increasingly minute pieces of knowledge patentable has worsened the problem of interlocking patents, slowing down technological progress.
These negative impacts have been much greater for developing countries. The lower originality bar set in the rich countries, especially the US, has made the theft of already existing traditional knowledge from developing countries easier. Much needed medicines have become far more expensive, as developing countries are not allowed to make (or import) copy drugs any more, while their political weakness vis-à-vis rich country pharmaceutical companies constrains their ability to use the public interest provision.
But the biggest problem is, to put it bluntly, that the new IPR system has made economic development more difficult. When 97% of all patents and the vast majority of copyrights and trademarks are held by rich countries, the strengthening of the rights of IPR-holders means that acquiring knowledge has become more expensive for developing countries. The World Bank estimates that, following the TRIPS agreement, the increase in technology licence payments alone will cost developing countries an extra $45 billion a year, which is nearly half of total foreign aid given by rich countries ($93 billion a year in 2004–5).47 Although it is hard to quantify the impact, strengthening of copyright has made education, especially higher education that uses specialized and advanced foreign books, more costly.
This is not all. If it is to comply with the TRIPS agreement, each developing country needs to spend a lot of money building up and implementing a new IPR system. The system does not run itself. Enforcement of copyright and trademarks requires an army of inspectors. The patent office needs scientists and engineers to process the patent applications and the courts need patent lawyers to help sort out disputes. Training and hiring all these people costs money. In a world with finite resources, training more patent lawyers or hiring more inspectors to hunt down DVD pirates means training fewer medical doctors and teachers while hiring fewer nurses or police officers. It is obvious which of these professions developing countries need more.
The wretched thing is that developing countries are going to get hardly anything in return for paying increased licensing fees and incurring additional expenditures to implement the new IPR system.When rich countries strengthen their IPR protection, they can at least expect some increase in innovation, even if its benefits are not enough to cover the increased costs arising from strengthened protection. In contrast, most developing countries do not have the capabilities to conduct research. The incentive to conduct research may have been increased, but there is no one to take advantage of it. It is like the story of my son, Jin-Gyu, which I discussed in chapter 3. If the capability is not there, it does not matter what the incentives are. This is why even the renowned British financial journalist Martin Wolf, a self-proclaimed defender of globalization (despite his full awareness of its problems and limitations), describes IPR as ‘a rent-extraction device’ for most developing countries, ‘with potentially devastating consequences for their ability to educate their people (because of copyright), adapting designs for their own use (ditto) and deal with severe challenges of public health’.48
As I keep emphasizing, the foundation of economic development is the acquisition of more productive knowledge. The stronger the international protection for IPRs is, the more difficult it is for the follower countries to acquire new knowledge. This is why, historically, countries did not protect foreigners’ intellectual property very well (or at all) when they needed to import knowledge. If knowledge is like water that flows downhill, then today’s IPR system is like a dam that turns potentially fertile fields into a technological dustbowl. This situation clearly needs fixing.
Getting the balance right
One common question that I am asked when I criticize the current IPR system in my lectures is: ‘seeing that you are against intellectual property, would you let other people steal your research papers and publish them under their own names?’ This is symptomatic of the simplistic mentality that pervades our debate on intellectual property rights. Criticizing the IPR regime as it exists today is not the same as arguing for the wholesale abolition of intellectual property itself.
I am not arguing that we should abolish patents, copyrights or trademarks. They do serve useful purposes. But the fact that some protection of intellectual property rights is beneficial, or even necessary, does not mean that more of it is always better. An analogy with salt may be useful in explaining this point more clearly. Some salt is essential to our survival. Some more of it makes our eating more pleasurable, even though it may do some harm to our health. But, above a certain level, the harm that salt does to our health outweighs the benefits we get from tastier food. Protection of intellectual property rights is like this. Some minimum amount of it may be essential in creating incentives for knowledge creation. Some more of it may bring more benefits than costs. But too much of it may create more costs than benefits so that it ends up harming the economy.
So the real question is not whether IPR protection is good or bad in principle. It is how we get the balance right between the need to encourage people to produce new knowledge and the need to ensure that the costs from the resulting monopoly do not exceed the benefits that the new knowledge brings about. In order to do that, we need to weaken the degree of IPR protection prevailing today – by shortening the period of protection, by raising the originality bar, and by making compulsory licensing and parallel imports easier.
If a weaker protection leads to insufficient incentives for potential inventors, which may or may not be the case, the public sector can step in. This may involve the direct conduct of research by public bodies – national (e.g., the US National Institutes of Health) or international (e.g., the International Rice Research Institute that developed the Green Revolution varieties of rice). It may be done by means of targeted R&D subsidies to private-sector companies, with a condition attached regarding public access to the end product.49 The public sector, at the national and international level, is already doing these things anyway, so it would not be a radical departure from existing practice. It would simply be a matter of stepping up and redirecting existing efforts.
Above all, the international IPR system should be reformed in a way that helps developing countries become more productive by allowing them to acquire new technical knowledge at reasonable costs. Developing countries should be allowed to grant weaker IPRs – shorter patent life, lower licensing royalty rates (probably graduated according to their abilities to pay) or easier compulsory licensing and parallel imports.50
Last but not least, we should not only make technology acquisition easier for developing countries but also help them develop the capabilities to use and develop more productive technologies. For this purpose, we could institute an international tax on patent royalties and use it to provide technological support to developing countries. The cause may also be promoted by a modification to the international copyright system, which makes access to academic books easier.*
Like all other institutions, intellectual property rights (patents, copyrights and trademarks) may or may not be beneficial, depending on how they are designed and where they are used. The challenge is not to decide whether to scrap them altogether or strengthen them to the hilt, but to get the balance right between the interests of the IPR-holders and the rest of the society (or the rest of the world, if you like). Only when we get the balance right will the IPR system serve the useful purpose it was originally set up to serve – that is, encouraging the generation of new ideas at the lowest possible costs to society.
* Lincoln received US Patent #6, 469 for ‘A Device for Buoying Vessels Over Shoals’ on May 22 1849. The invention consists of a set of bellows attached to the hull of a ship just below the waterline. On reaching a shallow place, the bellows are filled with air and the vessel, thus buoyed, is expected to float clear. It was never marketed, probably because the extra weight would have increased the probability of running onto sandbars more frequently.
* Law was born into a banking family in Scotland. In 1694, he had to flee to the Continent after killing a man in a duel. In 1716, after years of lobbying, Law was given a licence by the French government to set up a note-issuing bank, Banque Générale. His main backer was the Duc d’Orléans, Louis XIV’s nephew and the then regent for the child king, Louis XV, the great-grandson of Louis XIV. In 1718, Banque Générale became Banque Royale, with its notes guaranteed by the king. In the meantime, Law bought the Compagnie du Mississippi (the Mississippi Company) in 1717 and floated it as a joint-stock company. The company absorbed other rival trading companies and, in 1719, became Compagnie Perpetuelle des Indes, although it was still commonly called Compagnie du Mississippi. The company had a royal monopoly on all overseas trading.With Law launching high-profile settlement schemes in Louisiana (French North America) and generating rumours vastly exaggerating their prospects, a speculative frenzy on the company’s stocks started in the summer of 1719. The share price rose by more than 30 times between early 1719 and early 1720. So many large fortunes were made so quickly – and subsequently lost in many cases – that the term millionaire was coined to describe the new mega-rich. In January 1720, Law was even made the finance minister (the Controller General of Finances). But the bubble soon burst, leaving the French financial system in ruins. The Duc d’Orléans dismissed Law in December 1720. Law left France and eventually died penniless in Venice in 1729.
* Access to academic books is crucial in enhancing the productive capabilities of developing countries, as my own experience with pirate-copied books, described in the Prologue, suggests. Rich country publishers should be encouraged to allow cheap reproduction of academic books in developing countries – they are not going to lose much by this, because their books are too expensive for developing country consumers anyway. We could also set up a special international fund to subsidize the purchase of academic books by developing country libraries, academics and students. A similar argument can put the current hysteria in the rich countries about counterfeit products from developing countries into perspective. As I pointed out in the Prologue, it is not as if those people who buy counterfeit products in developing countries (including many tourists who buy them there) can afford the genuine articles. So, as long as they are not smuggled into the rich countries and sold as the genuine articles (which rarely happens), the original manufacturers lose little actual revenue from the counterfeit goods. One could even argue that the developing country consumers are, in effect, doing free advertising for the original manufacturers. Especially in high-growth economies, today’s counterfeit consumers are going to be tomorrow’s consumers of the genuine articles.Many Koreans who used to buy fake luxury goods in the 1970s are now buying the real things.

CHAPTER 7
Mission impossible?
Can financial prudence go too far?
Most people who have watched the blockbuster movie Mission Impossible III must have been mightily impressed by the urban splendour that is Shanghai, the centre of the Chinese economic miracle. They would also remember the frantic final chase set in the quaint but shabby neighbourhood by the canal, which seems to be stuck in the 1920s. The contrast between that district and the skyscrapers in the city centre symbolizes the challenge that China faces with soaring inequality and the discontent it is producing.
Some who have watched previous episodes of Mission Impossible may also have had a small source of curiosity satisfied. For the first time in the series, we were told the meaning of the acronym IMF, the formidable intelligence agency for which the movie’s leading character, Ethan Hunt (Tom Cruise), works. It is called the Impossible Mission Force.
The real IMF, the International Monetary Fund, may not send secret agents to blow up buildings or assassinate undesirables, but it is much feared by developing countries all the same, for it plays the role of gatekeeper vis-à-vis the these countries, controlling their access to international finance.
When developing countries get into a balance of payments crisis, as they often do, signing an agreement with the IMF is crucial. The money that the IMF itself lends is only a minor part of the story, for the IMF does not have much money of its own. More important is the agreement itself. It is seen as a guarantee that the country will mend its ‘profligate’ ways and adopt a set of ‘good’ policies that will ensure its future ability to repay its debts. Only when such agreement is made do other potential lenders – the World Bank, rich country governments and private-sector lenders – agree to continue their supplies of finance to the country concerned. The agreement with the IMF involves accepting conditions on a wide (and, indeed, ever-widening, as I discussed in chapter 1) range of economic policies, from trade liberalization to the adoption of new company law. But the most important and feared of IMF conditions concern macroeconomic policies.
Macroeconomic policies – monetary policy and fiscal policy – are intended to change the behaviour of the whole economy (as distinct from the sum total of the behaviours of the individual economic actors that make it up).1 The counter-intuitive idea that the whole economy may behave differently from the sum total of its parts comes from the famous Cambridge economist John Maynard Keynes. Keynes argued that what is rational for individual actors may not be rational for the entire economy. For example, during an economic downturn, firms see the demand for their products fall, while workers face increased chances of redundancy and wage cuts. In this situation, it is prudent for individual firms and workers to reduce their spending. But if all economic actors reduced their expenditure, they will all be worse off, for the combined effect of such actions is a lower aggregate demand, which, in turn, further increases everyone’s chances of bankruptcy and redundancy. Therefore, Keynes argued, the government, whose job it is to manage the whole economy, cannot simply use scaled-up versions of action plans that are rational for individual economic agents. It should always deliberately do the opposite of what other economic actors do. In an economic downturn, therefore, it should increase its spending to counter the tendency of the private sector firms and workers to reduce their spending. In an economic upturn, it should reduce its expenditure and increase taxes, so that it can prevent demand from outstripping supply.
Reflecting this intellectual origin, until the 1970s, the main aim of macroeconomic policies was reducing the magnitude of the swings in the level of economic activity – known as the business cycle. But since the rise of neo-liberalism, and its ‘monetarist’ approach to macroeconomics, in the 1980s, the focus of macroeconomic policies has radically changed. The ‘monetarists’ are called as such because they believe that prices rise when too much money is chasing after a given quantity of goods and services. They also argue that price stability (i.e., keeping inflation low) is the foundation of prosperity and, therefore, that monetary discipline (which is required for price stability) should be the paramount goal of macroeconomic policy.
When it comes to developing countries, the need for monetary discipline is even more emphasized by the Bad Samaritans. They believe that most developing countries do not have the self-discipline to ‘live within their means’; it is alleged that they print money and borrow as if there were no tomorrow. Domingo Cavallo, a famous (or infamous, after the financial collapse in 2002) former finance minister of Argentina, once described his own country as a ‘rebel teenager’ who could not control his behaviour and needed to ‘grow up’.2 Therefore, the firm guiding hand of the IMF is seen as crucial by the Bad Samaritans in securing macroeconomic stability and hence growth in these countries. Unfortunately, the macroeconomic policies promoted by the IMF have produced almost the exact opposite effect.
‘Mugger, armed robber and hit man’
Neo-liberals see inflation as public enemy number one.Ronald Reagan once put it most graphically: ‘inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man’.3 They believe that the lower the rate of inflation is, the better it is. Ideally, they want zero inflation. At most, they would accept a very low single-digit rate of inflation. Stanley Fischer, the Northern-Rhodesia-born American economist, who was the chief economist of the IMF between 1994 and 2001, explicitly recommended 1–3% as the target inflation rate.4 But why is inflation considered so harmful?
To begin with, it is argued that inflation is a form of stealth tax that unjustly robs people of their hard-earned income. The late Milton Friedman, the guru of monetarism, argued that ‘inflation is the one form of taxation that can be imposed without legislation’.5 But the illegitimacy of ‘inflation tax’, and the ‘distributive injustice’ arising out of it, is only the beginning of the problem.
Neo-liberals argue that inflation is bad for economic growth as well.6 Most of them would hold that the lower a country’s rate of inflation, the higher its economic growth is likely to be. The thinking behind this is as follows: investment is essential for growth; investors do not like uncertainty; so we must keep the economy stable, which means keeping prices flat; thus low inflation is a prerequisite of investment and growth. This argument has had a particularly strong appeal in those Latin American countries, where memories of disastrous hyperinflation in the 1980s combined with collapse in economic growth were strong (especially Argentina, Bolivia, Brazil, Nicaragua and Peru).
Neo-liberal economists argue that two things are essential in achieving low inflation. First, there should be monetary discipline – the central bank should not increase the money supply over and above what is absolutely necessary to support real growth in the economy. Second, there should be financial prudence – no government should live beyond its means (more on this later).
In order to achieve monetary discipline, the central bank, which controls the money supply, should be made to pursue price stability single-mindedly. Fully embracing this argument, for example, New Zealand in the 1980s indexed the central bank governor’s salary to the rate of inflation in inverse proportion, so that he/she would have a very personal interest in controlling inflation. Once we ask the central bank to consider other things, like growth and employment, the argument goes, the political pressure on it would be unbearable. Stanley Fischer argues: ‘A central bank given multiple and general goals may choose among them and will certainly be subject to political pressures to shift among its goals depending on the state of the electoral cycle’.7 The best way to prevent this from happening is to ‘protect’ the central bank from politicians (who do not understand economics very well and, more importantly, have short time-horizons) by making it ‘politically independent’. This orthodox belief in the virtues of central bank independence is so strong that the IMF often makes it a condition for its loans, as, for example, it did in the agreement with Korea following the country’s currency crisis in 1997.
In addition to monetary discipline, neo-liberals have traditionally emphasized the importance of government prudence – unless the government lives within its means, the resulting budget deficits would cause inflation by creating more demands than the economy can meet.8 More recently, following the wave of developing country financial crises in the late 1990s and the early 2000s, it was recognized that governments do not have a monopoly in living beyond their means. In those crises, much of the over-borrowing was by private-sector firms and consumers, rather than by governments. As a result, an increasing emphasis has been put on the ‘prudential regulations’ of the banks and other financial-sector firms. The most important among these is the so-called capital adequacy ratio for banks, recommended by the BIS (Bank for International Settlements), the club of central banks based in the Swiss city of Basel (more on this later).*
There is inflation and there is inflation
Inflation is bad for growth – this has become one of the most widely accepted economic nostrums of our age. But see how you feel about it after digesting the following piece of information.
During the 1960s and the 1970s, Brazil’s average inflation rate was 42% a year.9 Despite this, Brazil was one of the fastest growing economies in the world for those two decades – its per capita income grew at 4.5% a year during this period. In contrast, between 1996 and 2005, during which time Brazil embraced the neo-liberal orthodoxy, especially in relation to macroeconomic policy, its inflation rate averaged a much lower 7.1% a year. But during this period, per capita income in Brazil grew at only 1.3% a year.
If you are not entirely persuaded by the Brazilian case – understandable, given that hyperinflation went side by side with low growth in the 1980s and the early 1990s – how about this? During its ‘miracle’ years, when its economy was growing at 7% a year in per capita terms, Korea had inflation rates close to 20%–17.4% in the 1960s and 19. 8% in the 1970s. These were rates higher than those found in several Latin American countries, and totally contrary to the cultural stereotypes of the hyper-saving, prudent East Asian versus fun-loving, profligate Latinos (more on cultural stereotypes in chapter 9). In the 1960s, Korea’s inflation rate was much higher than that of five Latin American countries (Venezuela, Bolivia, Mexico, Peru and Colombia) and not much lower than that infamous ‘rebel teenager’, Argentina.10 In the 1970s, the Korean inflation rate was higher than that found in Venezuela, Ecuador and Mexico, and not much lower than that of Colombia and Bolivia.11 Are you still convinced that inflation is incompatible with economic success?
With these examples, I am not arguing that all inflation is good. When prices rise very fast, they undermine they very basis of rational economic calculation. The experience of Argentina in the 1980s and the early 1990s is quite illustrative in this regard.12 In January 1977, a carton of milk cost 1 peso. Fourteen years later, the same container cost over 1 billion pesos. Between 1977 and 1991, inflation ran at an annual rate of 333%. There was a twelve-month period, ending in 1990, during which actual inflation was 20, 266%. The story has it that, during this period, prices rose so fast that some supermarkets resorted to using blackboards rather than price tags. There is no question that this kind of price inflation makes long-range planning impossible. Without a reasonably long time-horizon, rational investment decisions become impossible. And without robust investment, economic growth becomes very difficult.
But there is a big logical jump between acknowledging the destructive nature of hyperinflation and arguing that the lower the rate of inflation, the better.13 As the examples of Brazil and Korea show, the inflation rate does not have to be in the 1–3% range, as Stanley Fischer and most neo-liberals want, for an economy to do well. Indeed, even many neo-liberal economists admit that, below 10%, inflation does not seem to have any adverse effect on economic growth.14 Two World Bank economists, Michael Bruno, once the chief economist, and William Easterly, have shown that, below 40%, there is no systematic correlation between a country’s inflation rate and its growth rate.15 They even argue that, below 20%, higher inflation seemed to be associated with higher growth during some time periods.
In other words, there is inflation and there is inflation. High inflation is harmful, but moderate inflation (up to 40%) is not only not necessarily harmful, but may even be compatible with rapid growth and employment creation.We may even say that some degree of inflation is inevitable in a dynamic economy. Prices change because the economy changes, so it is natural that prices go up in an economy where there are lots of new activities creating new demand.
But, if moderate inflation is not harmful, why are neo-liberals so obsessed with it? Neo-liberals would argue that all inflation – moderate or not – is still objectionable, because it disproportionately hurts people on fixed incomes – notably wage earners and pensioners, who are the most vulnerable sections of the population. Paul Volcker, the chairman of the US Federal Reserve Board (the US central bank) under Ronald Reagan (1979–87), argued: ‘Inflation is thought of as a cruel, and maybe the cruellest, tax because it hits in a many-sectored way, in an unplanned way, and it hits the people on a fixed income hardest’.16
But this is only half the story. Lower inflation may mean that what the workers have already earned is better protected, but the policies that are needed to generate this outcome may reduce what they can earn in the future. Why is this? The tight monetary and fiscal policies that are needed to lower inflation, especially to a very low level, are likely also to reduce the level of economic activity, which, in turn, will lower the demand for labour and thus increase unemployment and reduce wages. So a tough control on inflation is a two-edged sword for workers – it protects their existing incomes better, but it reduces their future incomes. It is only the pensioners and others (including, significantly, the financial industry) whose incomes derive from financial assets with fixed returns for whom lower inflation is a pure blessing. Since they are outside the labour market, tough macroeconomic policies that lower inflation cannot adversely affect their future employment opportunities and wages, while the incomes they already have are better protected.
Neo-liberals have made a big deal out of the fact that inflation hurts the general public, as we can see from the earlier quote from Volcker. But this populist rhetoric obscures the fact that the policies needed to generate low inflation are likely to reduce the future earnings of most working people by reducing their employment prospects and wage rates.
The price of price stability
Upon taking power from the apartheid regime in 1994, the new ANC (African National Congress) government of South Africa declared that it would pursue an IMF-style macroeconomic policy. Such a cautious approach was considered necessary if it was not to scare away investors, given its leftwing, revolutionary history.
In order to maintain price stability, interest rates were kept high; at their peak in the late 1990s and the early 2000s, the real interest rates were 10–12%. Thanks to such tight monetary policy, the country has been able to keep its inflation rate during this period at 6.3% a year.17 But this was achieved at a huge cost to growth and jobs. Given that the average non-financial firm in South Africa has a profit rate of less than 6%, real interest rates of 10–12% meant that few firms could borrow to invest.18 No wonder the investment rate (as a proportion of GDP) fell from the historical 20-25% (it was once over 30% in the early 1980s) down to about 15%.19 Considering such low levels of investment, the South African economy has not done too badly – between 1994 and 2005, its per capita income grew at 1.8% a year. But that is only ‘considering …’
Unless South Africa is going to engage in a major programme of redistribution (which is neither politically feasible nor economically wise), the only way to reduce the huge gap in living standards between the racial groups in the country is to generate rapid growth and create more jobs, so that more people can join the economic mainstream and improve their living standards. Currently, the country has an official unemployment rate of 26–8%, one of the highest in the world*; a 1.8% annual growth rate is way too inadequate to bring about a serious reduction in unemployment and poverty. In the last few years, the South African government has thankfully seen the folly of this approach and has brought the interest rates down, but real interest rates, at around 8%, are still too high for vigorous investment.
In most countries, firms outside the financial sector make a 3–7% profit.20 Therefore, if real interest is above that level, it makes more sense for potential investors to put their money in the bank, or buy bonds, rather than invest it in a productive firm.Also taking into account all the trouble involved in managing productive enterprises – labour problems, problems with delivery of parts, trouble with payments by customers, etc. – the threshold rate may even be lower. Given that firms in developing countries have little capital accumulated internally, making borrowing more difficult means that firms cannot invest much. This results in low investment, which, in turn, means low growth and scarce jobs. This is what has happened in Brazil, South Africa and numerous other developing countries when they followed the Bad Samaritans’ advice and pursued a very low rate of inflation.
However, the reader would be surprised to learn that the rich Bad Samaritan countries, which are so keen to preach to developing countries the importance of high real interest rates as a key to monetary discipline, themselves have resorted to lax monetary policies when they have needed to generate income and jobs. At the height of their post-Second-World-War growth boom, real interest rates in the rich countries were all very low – or even negative. Between 1960 and ’73, the latter half of the ‘Golden Age of Capitalism’ (1950–73), when all of today’s rich nations achieved high investment and rapid growth, the average real interest rates were 2.6% in Germany, 1.8% in France, 1.5% in the USA, 1.4% in Sweden and -1.0% in Switzerland.21
Monetary policy that is too tight lowers investment. Lower investment slows down growth and job creation. This may not be a huge problem for rich countries with already high standards of living, generous welfare state provision and low poverty, but it is a disaster for developing countries that desperately need more income and jobs and often are trying to deal with a high degree of income inequality without resorting to a large-scale redistribution programme that, anyway, may create more problems than it solves.
Given the costs of pursuing a restrictive monetary policy, giving independence to the central bank with the sole aim of controlling inflation is the last thing a developing country should do, because it will institutionally entrench monetarist macroeconomic policy that is particularly unsuitable for developing countries. This is all the more so when there is actually no clear evidence that greater central bank independence even lowers the rate of inflation in developing countries, let alone helps to achieve other desirable aims, like higher growth and lower unemployment.22
It is a myth that central bankers are non-partisan technocrats. It is well known that they tend to listen very closely to the view of the financial sector and implement policies that help it, if necessary at the cost of the manufacturing industry or wage-earners. So, giving them independence allows them to pursue policies that benefit their own natural constituencies without appearing to do so. The policy bias would be even worse if we explicitly tell them that they should not worry about any policy objectives other than inflation.
Moreover, central bank independence raises an important issue for democratic accountability (more on this in chapter 8). The flip side of the argument that central bankers can take good decisions only because their jobs do not depend on making the electorate happy is that they can pursue policies that hurt the majority of people with impunity – especially if they are told not to worry about anything other than the rate of inflation. Central bankers need to be supervised by elected politicians, so that they can be, even if at one remove, responsive to the popular will. This is exactly why the charter of the US Federal Reserve Board defines its first responsibility as ‘conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates [italics added]’23 and why the Fed chairman is subject to regular grilling by Congress. Ironic, then, that the US government acts internationally as a Bad Samaritan and encourages developing countries to create an independent central banks solely focused on inflation.
When prudence isn’t prudent
Gordon Brown, who was UK chancellor of the exchequer (finance minister) before becoming Prime Minister, prided himself on having earned the nickname the iron chancellor. This sobriquet used to be associated with the former German chancellor (prime minister), Otto von Bismarck, but, unlike Bismarck’s ‘ironmongery’, which was in foreign policy, Brown’s ‘ironmongery’ was in the area of public finance. He has been praised for his resolve in not giving in to the demand for deficit spending, coming from his supporters in the public sector, who were understandably clamouring for more money after years of Conservative budget cuts. Brown constantly emphasized the importance of prudence in fiscal management, so much so that William Keegan, a leading British financial journalist, called his book on Brown’s economic policy The Prudence of Mr.Gordon Brown. Prudence, it seems, has become the supreme virtue in a finance minister.
Emphasis on fiscal prudence has been a central theme in the neo-liberal macroeconomics promoted by the Bad Samaritans. They argue that government should not live beyond its means and must always balance its budget. Deficit spending, they argue, only leads to inflation and undermines economic stability, which, in turn, reduces growth and diminishes the living standards of people on fixed income.
Once again, who can argue against prudence? But, as in the case of inflation, the real question is what exactly it means to be prudent. For one thing, being prudent does not mean that the government has to balance its books every year, as is preached to developing countries by the Bad Samaritans. The government budget may have to be balanced, but this needs to be achieved over a business cycle, rather than every year. The year is an extremely artificial unit of time in economic terms, and there is nothing sacred about it. Indeed, if we followed this logic, why not tell governments to balance its books every month or even every week? As Keynes’s central message had it, what is important is that, over the business cycle, the government acts as a counterweight to the behaviour of the private sector, engages in deficit spending during economic downturns and generates a budget surplus during economic upturns.
For a developing country, it may even make sense to run a budget deficit on a permanent basis in the medium term, as long as the resulting debt is sustainable. Even at the level of individuals, it is perfectly prudent to borrow money when you are studying or raising a young family and to re-pay the debt when your earning power is higher. Similarly, it makes sense for a developing country to ‘borrow from future generations’ by running budget deficits in order to invest beyond its current means and thereby accelerate economic growth. If the country succeeds in accelerating its growth, future generations will be rewarded with higher standards of living than would have been possible without such government deficit spending.
Despite all this, the IMF is obsessed with developing country governments balancing the books every year, regardless of business cycles or longer-term development strategy. So it imposes budget balancing conditions, or even the requirement to run a surplus on countries in macroeconomic crisis that could actually benefit from deficit spending by the government.
For example, when Korea signed an agreement with the IMF in December 1997 in the wake of a currency crisis, it was required to generate budget surplus equivalent to 1% of GDP. Given that a huge exodus of foreign capital was already pushing the country into a deep recession, it should have been allowed to increase government budget deficits. If any country could afford to do this, it was Korea – at the time, it had one of the smallest stocks of government debt as a proportion of GDP in the world, including all the rich nations. Despite this, the IMF barred the country from using deficit spending. Little wonder that the economy nose-dived. In the early months of 1998, over 100 firms a day were going bankrupt and the unemployment rate nearly trebled – no surprise, then, that some Koreans dubbed the IMF ‘I’M Fired’. Only when this uncontrollable downward economic spiral looked set to continue did the IMF relent and allow the Korean government to run a budget deficit – but only a very small one (up to 0.8% of GDP).24 In a more extreme example, following its financial crisis in the same year, Indonesia was also instructed by the IMF to cut government spending, especially food subsidies. When combined with a rise in interest rates to 80%, the result was widespread corporate bankruptcy, mass unemployment and urban riots. As a result, Indonesia saw a massive 16% fall in output in 1998.25
If they were in similar circumstances, the rich Bad Samaritan countries would never do what they tell the poor countries to do. Instead they would cut interest rates and increase government deficit spending in order to boost demand. No rich country finance minister would be stupid enough to raise interest rates and run budget surplus during economic downturns. When the US economy was reeling from the aftermath of the burst of the so-called dot.com bubble and the September 11 bombing of the World Trade Center at the beginning of the 21st century, the solution taken by the supposedly ‘fiscally responsible’, anti-Keynesian republican government of George W. Bush was – you’ve guessed it – government deficit spending (combined with a monetary policy of unprecedented laxity). In 2003 and 2004, the US budget deficit reached nearly 4% of its GDP. Other rich country governments have done the same. During 1991–1995, a period of economic downturn, the ratio of government deficit to GDP was 8% in Sweden, 5.6% in the UK, 3.3% in the Netherlands and 3% in Germany.26
The ‘prudent’ financial sector policies recommended by the Bad Samaritans have also created other problems for macroeconomic management in developing countries. The BIS capital adequacy ratio, which I explained above, has been particularly important in this regard.
The BIS ratio requires that a bank’s lending changes in line with changes in its capital base. Given that the prices of the assets that make up a bank’s capital base go up when the economy is doing well and fall when it is not, this means that the capital base grows and shrinks along with the economic cycle. As a result, banks are able to increase their loans in good times even without any inherent improvement in the quality of the assets that they hold, simply because their capital base expands due to asset price inflation. This feeds into the boom, overheating the economy. During a downturn, the capital base of the banks shrinks, as asset prices fall, forcing them to call in loans, which, in turn, pushes the economy down further. While it may be prudent for individual banks to observe the BIS capital adequacy ratio, if all the banks follow it, the business cycle will be greatly magnified, ultimately hurting the banks themselves.*
When the economic fluctuations become bigger, the swings in fiscal policy have to become bigger too, if they are to play an adequate counter-cyclical role. But big adjustments in government spending generate problems. On the one hand, a big increase in government spending during an economic downturn makes it more likely that the spending goes into ill-prepared projects. On the other hand, making large cuts in government spending during an economic upturn is difficult due to political resistance. Given this, the greater volatility created by strictly enforcing the BIS ratio (and the opening-up of capital markets, as discussed in chapter 4) has actually made good fiscal policy more difficult to conduct.27
Keynesianism for the rich, monetarism for the poor
Gore Vidal, the American writer, once described the American economic system as ‘free enterprise for the poor and socialism for the rich’.28 Macroeconomic policy on the global scale is a bit like that. It is Keynesianism for the rich countries and monetarism for the poor.
When the rich countries get into recession, they usually relax monetary policy and increase budget deficits. When the same thing happens in developing countries, the Bad Samaritans, through the IMF, force them to raise interest rates to absurd levels and balance their budgets, or even generate budget surplus – even if these actions treble unemployment and spark riots in the streets. As noted above, during Korea’s financial crisis in 1997, the IMF allowed the country to run budget deficits equivalent to only 0.8% of GDP (and, at that, after trying the opposite for several months, with disastrous consequences); when Sweden had a similar problem (due to the ill-managed opening-up of its capital market, as was the case with Korea in 1997) in the early 1990s, its budget deficits were, in proportional terms, ten times that (8% of its GDP).
Ironically, when the citizens of developing countries voluntarily tighten their belts, they are derided for not understanding basic Keynesian economics. For example, when some Korean housewives campaigned for voluntary austerity measures, including serving smaller meals at home in the wake of the 1997 financial crisis, the Financial Times correspondent in Korea sneered at their stupidity, saying that such actions ‘could deepen the country’s plunge into recession since it would further reduce the demand needed to bolster growth’.29 But what is the difference between what these Korean housewives were doing and the spending cuts imposed by the IMF, which the FT correspondent thought were eminently sensible?
The Bad Samaritans have imposed macroeconomic policies on developing countries that seriously hamper their ability to invest, grow and create jobs in the long run. The categorical – and simplistic – denunciation of ‘living beyond one’s means’ has made it impossible for them to ‘borrow to invest’ in order to accelerate economic growth. If we categorically denounce people for living beyond their means, we should, amongst other things, condemn young people for borrowing to invest in their career development or in their children’s education. That cannot be right. Living beyond one’s means may or may not be right; it all depends on the stage of development that the country is in and the use to which the borrowed money is put.
Mr Cavallo, the Argentine finance minister, may have been right in saying that developing countries are like ‘rebel teenagers’ who need to ‘grow up’. But acting like a grown-up is not really growing up. The teenager needs to get an education and find a proper job; it is not enough just to pretend that he is grown up and quit his school so that he can increase his savings. Similarly, in order really to ‘grow up’, it is not enough for developing countries to use policies that suit ‘grown-up’ countries.What they need to do is to invest in their future. In order to do that, they should be allowed to pursue macroeconomic policies that are more pro-investment and pro-growth than the ones used by the rich countries, and that are a lot more aggressive than those they are allowed to pursue today by the Bad Samaritans.
* This ratio recommends that the total lending of a bank should not be more than a certain multiple of its capital base (12.5 is the recommended ratio).
* Unemployment rates in developing countries underestimate the true extent of unemployment, as many poor people cannot afford to remain unemployed (as there is no welfare state) and, therefore, end up working in extremely low-productivity jobs (e.g., selling trinkets on the street, catching doors for people for small changes). This is known as ‘disguised unemployment’ among economists.
* More recently, the BIS has suggested an even more ‘prudent’ system called BIS II, where the loans are weighted by their risk rating. For example, riskier loans (e.g., corporate lending) need to be supported by a larger capital base than safer loans (e.g., mortgaged loans for house purchase) of the same nominal value. This will be particularly bad for developing countries, whose firms have low credit ratings, as this means that banks would have a particular incentive to reduce their lending to developing country corporations.