What if it is the other way round!

The chicken and egg problem of economic development and corruption.

Mohamed Bouazizi was a fruit vendor in Tunisia. On 17 December 2010, he set himself on fire in protest against unjust behaviour and corruption. What followed toppled at least four entrenched dictatorships—Egypt, Libya, Yemen and, of course, Tunisia—and triggered massive protests in more than 18 countries against autocracy and human rights violations. Year 2011 was marked by massive movements against corruption across the globe. India too saw its share of protests in 2011 with Anna Hazare’s fast and subsequent arrest becoming the rallying point of this movement.

By and large developed countries are perceived to have lower levels of corruption than developing countries, though the developed world has seen its share of scandals and shaming—the IRS scandal in the US, the Lagarde List in Greece, the phone-hacking controversy in the UK, and the series of corruption allegations that led to Italy’s setting up the National Anti-Corruption Authority.[ii]  Chart 1 below reproduced from Transparency International provides intuitive evidence of the possible link between economic development and level of corruption. The correlation between the Corruption Perception Index (Transparency International) and per capita GDP (IMF) in 2012 turns out to be 0.77.

Chart 1: The developed world appears to have lower levels of corruption

Source: Transparency International, http://cpi.transparency.org/cpi2012/results/

Such a high level of correlation between economic development and corruption across countries has naturally led to the growing consensus that corruption negatively impacts growth and development. The biggest challenge for growth in an environment of corruption comes from the lack of predictability in policy and outcomes, which is essential for investment and growth. To some extent, India is witnessing this, specifically with respect to the Telecom and Coal sectors. In the long-term, corruption distorts incentive structures, delays reforms, imposes overly restrictive regulatory structures and imposes heavy implicit taxes on businesses. Finally, it can exacerbate social inequality that can bring economic progress to a sudden halt through violent or peaceful mass movements.

A number of studies suggest that eliminating corruption is a precondition for economic development. What if it is the other way round? What if economic progress purges corruption! There are a number of studies that point in this direction, too. Essentially, we know that economic development is negatively correlated with perceived corruption, but are we certain which way the causality runs?[i]

One of the overriding processes by which economic development can reduce corruption is by creating clear property rights and enabling mechanisms for contract enforcement. Secured property rights are definitely beneficial for economic development, as borne out by the rise of Western Europe/ England.[ii] However, as economies progress, they get better at enforcing property rights.[iii] When people/businesses have clear property rights, they have increased mobility. That’s just one way clear property rights can help reduce corruption—firms are freer to relocate more easily from a region where corruption and associated rent-seeking activities are high to another with fewer corruption issues.[iv]

Rising affluence and increased awareness among citizens also create the will to fight against state’s efforts to confiscate private property and generate rents for public servants. Crony capitalism is not really a good idea for businessmen in the long term, as gains, if any, to private business are limited to very short term. Over time, all agents (businesses and households and their groups) in the economy may begin to agree that a coercive and confiscatory state does not benefit anyone and so “vote out” any government that is overly abusive of property rights.

There are many variables other than economic development, also closely correlated with the perception of corruption. The time taken to set up a business and unexpected inflation are positively associated with the perception of corruption. Religion (especially, Protestantism), democracy, freedom of press and participation of women in government are all negatively associated with corruption. The participation of women in the workforce is, in fact, highly correlated with economic development.

While all variables point to steps that can be taken to eliminate corruption, economic development has a clear association to the perception of corruption. It’s more like an antibiotic relationship—increased corruption affects economic development adversely, while increased economic development can reduce corruption. By influencing factors that stimulate economic development, such as controlling inflation, reducing fiscal deficit, better enumeration and enforcement of land rights and investing in human capital, a virtuous cycle can be kickstarted—increasing economic development can help lower corruption that, in turn, could attract more investment and fuel economic development, which in turn could bring corruption down further until some kind of equilibrium is reached. This cycle can be helped along further by influencing factors that could reduce corruption—strengthening the democratic process, ensuring freedom of speech, easier processes for setting up and exiting business or even greater participation of women in politics.

Quite a few ideas are being debated in India and some bills along these lines have either been passed or are being considered by the Indian parliament. Examples include the land acquisition bill and women’s reservation bill, while there is growing clamour for controlling inflation and fiscal deficit. Even if the direct purpose of these bills and debates may differ from the goal of eliminating corruption, it could be a fallout. India seems to be moving in the right direction.

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[i] For an interesting review see Daniel Treisman, “What have we Learned about the Causes of Corruption from Ten Years of Crossnational Empirical Research”, November 2006 < http://www.sscnet.ucla.edu/polisci/faculty/treisman/Papers/what_have_we_learned.pdf>.

[ii] D. North and B. Weingast , “Constitutions and Commitment: The Evolution of Institutional Governing Public Choice in Seventeenth-Century England,” The Journal of Economic History, 49(4), 1989, pp. 803-832.

[iii] One simple reason for this may be growing revenues and, therefore, ability of the state to incur costs associated with enforcing property rights. Mark Gradstein, “Governance and Growth”, Journal of Development Economics, 73, 2004, pp. 505-518.

[iv] Jie Bai, Seema Jayachandran, Edmund J. Malesky, and Benjamin A. Olken, “Does Economic Growth Reduce Corruption?: Theory and Evidence from Vietnam”, April 11, 2013 < http://economics.mit.edu/files/8777>.

The UK: Will it rebalance in time?

The UK is on an earnest path to rebalance its economy away from government spending and domestic consumption towards business investment and exports. The recovery so far appears to suggest that it is well on its path to do so. Most of the growth since the recession induced by the financial crisis has come from private investment and exports. Consumers have been playing safe: the declining trend in consumer loan, which started in 2003 but accelerated after the financial crisis, is yet to reverse. The housing market is still caught in the doldrums. Meanwhile, cuts in government spending are expected to bite from the latter half of 2011. The Comprehensive Spending Review stipulates that the budget will record a surplus of 0.4% in 2014-15 and public debt will peak at 70.9% of GDP in 2013-14.

The targets do appear ambitious. Consumer spending has been the primary driver of economic growth in the UK, contributing 69% of the annual growth in GDP between 1990 and 2008. Recovery from the previous recession in the early 1990s was closely linked to the sharp rise in household consumption. With household disposable income expected to decline for the first time in three decades due to rising taxes and decline in real wages, consumer confidence will likely remain weak through 2011. At best, we can hope that private consumption will not subtract from economic growth.

In the face of weak growth in consumption and substantial spare capacity, it is a debatable whether positive investment intentions, as expressed in surveys conducted by the British Chambers of Commerce, will translate into actual investment. There are two factors that may support a fairly strong recovery in business investment despite weak domestic demand: refurbishing and exports. Both these factors are, however, uncertain. Refurbishing cannot continue forever. At some point, it has to translate into rising employment, wages and consumer spending for investment to continue to grow. Exports, going by past trends, are highly volatile. The advantage of a weaker currency can dissipate quickly. Further, the current economic uncertainty in UK's primary exports markets--especially, the issue of a potential sovereign debt crisis--also gives cause for concern. Estimates also suggest that manufacturing faces severe supply side constraints and may not be able to sustain its good performance for long.

There are some who are still upbeat about the UK economy. Goldman Sachs and UBS have projected 2% growth in 2011. This sounds a bit too optimistic. It is likely that the UK will continue its recovery through 2011, but may grow only around 1.5%. There are also several downside risks and so another recession is not completely out of the cards. If the economy stabilizes in 2011, it may grow 2% or slightly higher in 2012.

The Bank of England will likely not begin to raise interest rates before September 2011. The uncertain economic recovery is one issue. The other is to keep the government's debt burden under check. With continued easy monetary policy and rising crude and food prices, CPI inflation will likely be 4% this year. RPI inflation may be higher than CPI inflation. The risk is that inflationary pressures may grow if high RPI inflation starts getting reflected in rising wages.

Overall, how the UK performs over the next couple of years and beyond will likely depend on how quickly the economy begins to rebalance. It is not easy to manage a shift in the economic structure in a short period. It is likely that the economic trajectory in the medium term will remain volatile, unless the UK is helped by some extraneous factors, such as an extremely benign global economic environment.