Innovation Requires Strong Property Rights
Strong legal protection of property rights is another requirement for a business environment to be conducive to innovation and economic growth.31 Both individuals and businesses must be given the opportunity to profit from innovative ideas. Without strong property rights protection, businesses and individuals run the risk that the profits from their innovative efforts will be expropriated, either by criminal elements, or by the state itself. The state can expropriate the profits from innovation through legal means, such as excessive taxation, or through illegal means, such as demands from state bureaucrats for kickbacks in return for granting an individual or firm a license to do business in a certain area. According to the Nobel prize-winning economist Douglass North, throughout history many governments have displayed a tendency to engage in such behavior. Inadequately enforced property rights reduce the incentives for innovation and entrepreneurial activity--since the profits from such activity are "stolen"--and hence reduce the rate of economic growth.
The Required Political System
There is a great deal of debate as to the kind of political system that best achieves a functioning market economy where there is strong protection for property rights.32 We in the West tend to associate a representative democracy with a market economic system, strong property rights protection, and economic progress. Building on this, we tend to argue that democracy is good for growth.33 However, some totalitarian regimes have fostered a market economy and strong property rights protection and have experienced rapid economic growth. Four of the fastest-growing economies of the last 30 years--South Korea, Taiwan, Singapore, and Hong Kong--all have grown faster than the Western democracies. All these economies had one thing in common at the start of their economic growth-undemocratic governments! At the same time, there are examples of countries with stable democratic governments, such as India, where economic growth remained sluggish for long periods.
In 1992, Lee Kuan Yew, Singapore's leader for many years, told an audience, "I do not believe that democracy necessarily leads to development. I believe that a country needs to develop discipline more than democracy. The exuberance of democracy leads to undisciplined and disorderly conduct which is inimical to development."34 Others have argued that many of the current problems in Eastern Europe and the states of the former Soviet Union arose because democracy arrived before economic reform, making it more difficult for elected governments to introduce the policies that, while painful in the short run, were needed to promote rapid economic growth. It has become something of a cliché to argue that Russia got its political and economic reforms in the wrong order-unlike China, which maintains a totalitarian government but has moved rapidly toward a market economy.
However, those who argue for the value of a totalitarian regime miss an important point-if dictators made countries rich, then much of Africa, Asia, and Latin America should have been growing rapidly for the past 40 years, and this has not been the case. Only a certain kind of totalitarian regime is capable of promoting economic growth. It must be a dictatorship that is committed to a free market system and strong protection of property rights. Moreover, there is no guarantee that a dictatorship will continue to pursue such progressive policies. Dictators are rarely so benevolent. Many are tempted to use the apparatus of the state to further their own private ends, violating property rights and stalling economic growth. Given this, it seems likely democratic regimes are far more conducive to long-term economic growth than are dictatorships, even benevolent ones. Only in a well-functioning, mature democracy are property rights truly secure.35
Economic Progress Begets Democracy
While it is possible to argue that democracy is not a necessary precondition for establishment of a free market economy in which property rights are protected, subsequent economic growth often leads to establishment of a democratic regime. Several of the fastest-growing Asian economies have recently adopted more democratic governments, including South Korea and Taiwan. Thus, while democracy may not always be the cause of initial economic progress, it seems to be one consequence of that progress.
A strong belief that economic progress leads to adoption of a democratic regime underlies the fairly permissive attitude that many Western governments have adopted toward human rights violations in China. Although China has a totalitarian government in which human rights are abused, many Western countries have been hesitant to criticize the country too much for fear that this might hamper the country's march toward a free market system. The belief is that once China has a free market system, democracy will follow. Whether this optimistic vision comes to pass remains to be seen. Nevertheless, such a vision was an important factor in the US government's 1996 decision to grant China most favored nation trading status (which makes it easier for Chinese firms to sell products in the United States) despite reports of widespread human rights abuses in China.
Other Determinants of Development: Geography and Education
While a country's political and economic system is probably the big locomotive driving its rate of economic development, other factors are also important. One that has received attention recently is geography.36 But the belief that geography can influence economic policy, and hence economic growth rates, goes back to Adam Smith. The influential Harvard University economist Jeffrey Sachs argues that
Throughout history, coastal states, with their long engagements in international trade, have been more supportive of market institutions than landlocked states, which have tended to organize themselves as hierarchical (and often military) societies. Mountainous states, as a result of physical isolation, have often neglected market-based trade. Temperate climes have generally supported higher densities of population and thus a more extensive division of labor than tropical regions.37
Sachs's point is that by virtue of favorable geography, certain societies were more likely to engage in trade than others and were thus more likely to be open to and develop market-based economic systems, which in turn would promote faster economic growth. He also argues that, irrespective of the economic and political institutions a country adopts, adverse geographical conditions, such as the high rate of disease, poor soils, and hostile climate that afflict many tropical countries, can have a negative impact on development.
Together with colleagues at Harvard's Institute for International Development, Sachs tested for the impact of geography on a country's economic growth rate between 1965 and 1990. He found that landlocked countries grew more slowly than coastal economies and that being entirely landlocked reduced a country's annual growth rate by roughly 0.7 percent per year. He also found that tropical countries grew 1.3 percent more slowly each year than countries in the temperate zone.
Education emerges as another important determinant of economic development. The general assertion is that nations that invest more in education will have higher growth rates because an educated population is a more productive population. Some rather striking anecdotal evidence suggests this is the case. In 1960 Pakistanis and South Koreans were on equal footing economically. However, just 30 percent of Pakistani children were enrolled in primary schools, while 94 percent of South Koreans were. By the mid-1980s, South Korea's GNP per person was three times that of Pakistan's.38 More generally, a survey of 14 statistical studies that looked at the relationship between a country's investment in education and its subsequent growth rates concluded investment in education did have a positive and statistically significant impact on a country's rate of economic growth.39 Similarly, the recent work by Sachs discussed above suggests that investments in education help explain why several countries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have been able to overcome the disadvantages associated with their tropical geography and grow far more rapidly than tropical nations in Africa and Latin America.
States in Transition
Since the late 1980s there have been major changes in the political economy of many of the world's nation-states. Two trends have been evident. First, during the late 1980s and early 1990s, a wave of democratic revolutions swept the world. Totalitarian governments collapsed and were replaced by democratically elected governments that were typically more committed to free market capitalism than their predecessors had been. The change was most dramatic in Eastern Europe, where the collapse of communism bought an end to the Cold War and led to the breakup of the Soviet Union, but similar changes were occurring throughout the world during the same period. Across much of Asia, Latin America, and Africa there was a marked shift toward greater democracy. Second, there has been a strong move away from centrally planned and mixed economies and toward a more free market economic model. We shall look first at the spread of democracy and then turn our attention to the spread of free market economics.
The Spread of Democracy
One notable development of the past 15 years has been the spread of democracy (and by extension, the decline of totalitarianism). Map 2.5 reports data on the extent of totalitarianism in the world as determined by Freedom House.40This map charts political freedom in 1997, on a scale from 1 for the highest degree of political freedom to 7 for the lowest. Among the criteria that Freedom House uses to determine ratings for political freedom are the following:
Free and fair elections of the head of state and legislative representatives.
Fair electoral laws, equal campaigning opportunities, and fair polling.
The right to organize into different political parties.
A parliament with effective power.
A significant opposition that has a realistic chance of gaining power.
Freedom from domination by the military, foreign powers, totalitarian parties, religious hierarchies, or any other powerful group.
A reasonable amount of self-determination for cultural, ethnic, and religious minorities.
Factors contributing to a low rating (i.e., to totalitarianism) include military or foreign control, the denial of self-determination to major population groups, a lack of decentralized political power, and an absence of democratic elections.
The number of democracies in the world has increased from 69 nations in 1987 to 118 today, the highest total in history. Almost 55 percent of the world's population now lives under democratic rule. Many of these new democracies are to be found in Eastern Europe and Latin America, although there have also been some notable gains in Africa during this time period, such as in South Africa.
There are three main reasons for the spread of democracy.41 First, many totalitarian regimes failed to deliver economic progress to the vast bulk of their populations. The collapse of communism in Eastern Europe, for example, was precipitated by the growing gulf between the vibrant and wealthy economies of the West and the stagnant economies of the Communist East. In looking for alternatives to the socialist model, the populations of these countries could not have failed to notice that most of the world's strongest economies were governed by representative democracies. Today, the economic success of many of the newer democracies, such as Poland and the Czech Republic in the former Communist bloc, the Philippines and Taiwan in Asia, and Chile in Latin America, has helped strengthen the case for democracy as a key component of successful economic advancement.
Second, new information and communications technologies, including shortwave radio, satellite television, fax machines, desktop publishing, and now the Internet, have broken down the ability of the state to control access to uncensored information. These technologies have created new conduits for the spread of democratic ideals and information from free societies. The 1989 collapse of East Germany's Communist government was in part due to unrest among a population who for years had been exposed via TV to the affluent lifestyles of West Germans. Today the Internet is allowing democratic ideals to penetrate closed societies as never before. In response, some governments have tried to restrict citizens' access to the Internet; for example, China limits access to government employees and those affiliated with universities.42
Third, in many countries the economic advances of the last quarter century have led to the emergence of increasingly prosperous middle and working classes who have pushed for democratic reforms. This was certainly a factor in the democratic transformation of South Korea. Entrepreneurs and other business leaders, eager to protect their property rights and ensure the dispassionate enforcement of contracts, are another force pressing for more accountable and open government.
Having said this, it would be naive to conclude that the global spread of democracy will continue unchallenged. There have been several reversals. In the former Soviet republic of Belarus, for example, the president, Alexander Lukashenko, dissolved a democratically elected parliament and harassed the press. In the African nation of Niger, a military coup deposed a democratically elected government. In Asia, Singapore's Lee Kuan Yew and China's Marxist - Leninist leaders continue to advocate the virtues of authoritarian paths to democracy and to denounce Western democracies as an unacceptable model.
Map 2.5 see
Political Freedom in 1997
Source: Map data from Freedom Review 28, no. 1, p. 26.
Also, democracy is still rare in large parts of the world. In Africa, just 18 nations, one-third of those on the continent, are electoral democracies. Among the 12 countries that are full or associated members of the Commonwealth of Independent States (i.e., the republics of the former Soviet Union minus the Baltic states) there are only four electoral democracies. And there are no democracies in the Arab world.
Universal Civilization or a Clash of Civilizations?
The end of the Cold War and the "new world order" that followed the collapse of communism in Eastern Europe and the former Soviet Union, taken together with the collapse of many authoritarian regimes in Latin America, have given rise to intense speculation about the future shape of global geopolitics. Authors such as Francis Fukuyama have argued that "we may be witnessing . . . the end of history as such: that is, the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of human government."43 Fukuyama goes on to argue that the war of ideas may be at an end and that liberal democracy has triumphed.
Others have questioned Fukuyama's vision of a more harmonious world dominated by a universal civilization characterized by democratic regimes and free market capitalism. In a controversial book, the influential political scientist Samuel Huntington argues that there is no "universal" civilization based on widespread acceptance of Western liberal democratic ideals.44 Huntington maintains that while many societies may be modernizing-they are adopting the material paraphernalia of the modern world, from automobiles to Coca-Cola and MTV-they are not becoming more Western. On the contrary, Huntington theorizes that modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of Islam in many traditionally Muslim societies:
The Islamic resurgence is both a product of and an effort to come to grips with modernization. Its underlying causes are those generally responsible for indigenization trends in non-Western societies: urbanization, social mobilization, higher levels of literacy and education, intensified communication and media consumption, and expanded interaction with Western and other cultures. These developments undermine traditional village and clan ties and create alienation and an identity crisis. Islamist symbols, commitments, and beliefs meet these psychological needs, and Islamist welfare organizations, the social, cultural and economic needs of Muslims caught in the process of modernization. Muslims feel a need to return to Islamic ideas, practices, and institutions to provide the compass and the motor of modernization.45
Thus, the rise of Islamic fundamentalism is portrayed as a response to the alienation produced by modernization.
In contrast to Fukuyama, Huntington sees a world that is split into different civilizations, each of which has its own value systems and ideology. In addition to Western civilization, Huntington sees the emergence of strong Islamic and Sinic (Chinese) civilizations, as well as civilizations based on Japan, Africa, Latin America, Eastern Orthodox Christianity (Russian), and Hinduism (Indian). Moreover, Huntington sees the civilizations as headed for conflict, particularly along the "fault lines" that separate them, such as Bosnia (where Muslims and Orthodox Christians have clashed), Kashmir (where Muslims and Hindus clash), and the Sudan (where a bloody war between Christians and Muslims has persisted for decades). Figure 2.1 summarizes his views as to which civilizations are most likely to come into conflict in the future. Huntington predicts conflict between the West and Islam, and between the West and China. He bases his predictions on an analysis of the different value systems and ideology of these civilizations, which in his view tend to bring them into conflict with each other.
Figure 2.1
The Global Politics of Civilizations
Source: Reprinted with permission from Simon & Schuster, Inc. from The Clash of Civilizations and the New World Order, by Samuel P. Huntington (New York) p. 245. Copyright © 1996 by Samuel P. Huntington.
If Huntington's views are even partly correct, they have important implications for international business. They suggest many countries may be increasingly difficult places in which to do business, either because they are shot through with violent conflicts or because they are part of a civilization that is in conflict with an enterprise's home country. Bear in mind, however, that Huntington's views are speculative. It is by no means a sure thing that his predictions will come to pass. More likely is the evolution of a global political system that is positioned somewhere between Fukuyama's universal global civilization based on liberal democratic ideals and Huntington's vision of a fractured world. That would still be a world, however, in which geopolitical forces periodically limit the ability of business enterprises to operate in certain foreign countries.
The Spread of Market-Based Systems
Paralleling the spread of democracy since the 1980s has been the transformation from centrally planned command economies to market-based economies. More than 30 countries that were in the former Soviet Union or the Eastern European Communist bloc are now engaged in changing their economic systems. A complete list of countries would also include Asian states such as China and Vietnam, as well as African countries such as Angola, Ethiopia, and Mozambique.46 There has been a similar shift away from a mixed economy. Many states in Asia, Latin America, and Western Europe have sold state-owned businesses to private investors (privatization) and deregulated their economies to promote greater competition. India's experience is detailed in the next Country Focus.
The underlying rationale for economic transformation has been the same the world over. In general, command and mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As a consequence, even more states have gravitated toward the market-based model.
Map 2.6, based on data from the Heritage Foundation, a conservative United States research foundation, gives some idea of the degree to which the world has shifted toward market-based economic systems. The Heritage Foundation has constructed an index of economic freedom that is based on 10 indicators such as the extent to which the government intervenes in the economy, trade policy, the degree to which property rights are protected, foreign investment regulations, and taxation rules. A country can score between 1 (most free) and 5 (least free) on each of these indicators. The lower a country's average score across all 10 indicators, the more closely its economy represents the pure market model. According to the 1998 index, which is summarized in Map 2.3, the world's freest economies are (in rank order) Hong Kong, Singapore, Bahrain, New Zealand, Switzerland, the United States, Luxembourg, Taiwan, and the United Kingdom. By way of comparison, Japan is ranked 12, France at 34, Indonesia at 65, Poland at 65, Brazil at 90, Russia at 106, India at 120, China at 124, while the command economies of Cuba, Laos, and North Korea prop up the bottom of the rankings.47
Economic freedom does not necessarily equate with political freedom, as detailed in Map 2.5. For example, the top three countries in the Heritage Foundation index, Hong Kong, Singapore, and Bahrain, cannot be classified as politically free. Hong Kong was reabsorbed into Communist China in 1997, and the first thing Beijing did was shut down Hong Kong's freely elected legislature. Singapore is ranked as only "partly free" on Freedom House's index of political freedom due to practices such as widespread press censorship, while Bahrain is classified as "least free" due to the monopolization of political power by a hereditary monarchy (see Map 2.2). The Nature of Economic Transformation
The shift toward a market-based economic system typically entails a number of steps-deregulation, privatization, and creation of a legal system to safeguard property rights. We shall review each before looking at the track record of states engaged in economic transformation.
Deregulation
Deregulation involves removing legal restrictions to the free play of markets, the establishment of private enterprises, and the manner in which private enterprises operate. For example, before the collapse of communism, the governments in most command economies exercised tight control over prices and outputs, setting both through detailed state planning. They also prohibited private enterprises from operating in most sectors of the economy. Deregulation in these cases involved removing price controls, thereby allowing prices to be set by the interplay between demand and supply, and abolishing laws regulating the establishment and operation of private enterprises.
Map 2.6 see
Global Distribution of Economic Freedom
Source: Heritage Foundation. 1999 Index of Economic Freedom. http://www.heritage.org:so/index/countries/maps&charts/list1.gif
In mixed economies, deregulation has involved abolishing laws that either prohibited private enterprises from competing in certain sectors of the economy or regulated the manner in which they operated. For example, as outlined in the Country Focus feature on India, deregulation there has involved reforming the industrial licensing system that made it difficult to establish private enterprises, opening up areas that were once closed to the private sector such as electricity generation, parts of the oil industry, steelmaking, air transport, and some areas of the telecommunications industry; and removing restrictions to foreign investment. In another case, the Japanese government is trying to abolish some of the 11,000 regulations and 10,000 administrative guidelines that regulate and restrict private enterprise in that economy. Some of these regulations are very restrictive. For example, if a private enterprise wants to open a retail store with floor space of more than 1,000 square meters, it must first gain the consent of a government advisory panel charged with limiting the influence on the local shops against which the new retail store wants to compete! In addition, the average large retailer must file over 150 documents to gain permission to sell everyday items such as meat, tofu, and electronic appliances. In an effort to unravel such restrictions, the Japanese government plans to deregulate a diverse range of industries including power generation, gasoline retailing, financial services, retail, telecommunications, and transportation.48 How quickly this can be achieved, however, depends on the ability of a weak government to impose its wishes on Japan's traditionally powerful civil service bureaucracies, which can be expected to resist any attempt to diminish their influence on the economy.
Privatization
Hand in hand with deregulation has come a sharp increase in privatization activity during the 1990s. Privatizationtransfers the ownership of state property into the hands of private individuals, frequently by the sale of state assets through an auction.49 Privatization is seen as a way to unlock gains in economic efficiency by giving new private owners a powerful incentive--the reward of greater profits--to search for increases in productivity, to enter new markets, and to exit losing ones.
The privatization movement started in Britain in the early 1980s when then-Prime Minister Margaret Thatcher started to sell state-owned assets, such as the British telephone company, British Telecom (BT). In a pattern that has been repeated around the world, this sale was linked with the deregulation of the British telecommunications industry. By allowing other firms to compete head-to-head with BT, deregulation ensured that privatization did not simply replace a state-owned monopoly with a private monopoly.
The opening case to this chapter details the extent of privatization activity in Brazil, and the Country Focus feature discusses privatization in India. As these two examples suggest, privatization has become a worldwide movement. In Africa, for example, Mozambique and Zambia are leading the way with very ambitious privatization plans. Zambia has put over 145 state-owned companies up for sale, while Mozambique has already sold scores of enterprises, ranging from tea plantations to a chocolate factory. The most dramatic privatization programs, however, have occurred in the economies of the former Soviet Union and its Eastern European satellite states. In the Czech Republic, three-quarters of all state-owned enterprises were privatized between 1989 and 1996, helping to push the share of gross domestic product (GDP) accounted for by the private sector up from 11 percent in 1989 to 60 percent in 1995. In Russia, where the private sector had been almost completely repressed before 1989, 50 percent of GDP was in private hands by 1995, again much as a result of privatization. And in Poland the private sector accounted for 59 percent of GDP in 1995, up from 20 percent in 1989.50 However, Poland also illustrates how far some of these countries still have to travel. Despite an aggressive privatization program, Poland still had 4,000 state-owned enterprises that dominate the heavy industry, mining, and transportation sectors.
Legal Systems
As noted earlier in this chapter, laws protecting private property rights and providing mechanisms for contract enforcement are required for a well-functioning market economy. Without a legal system that protects property rights, and without the machinery to enforce that system, the incentive to engage in economic activity can be reduced substantially by private and public entities--including organized crime--that expropriate the profits generated by the efforts of private-sector entrepreneurs. As noted earlier, this has become a problem in many former Communist states, such as Russia, where organized crime has penetrated deeply into the fabric of many business enterprises. When communism collapsed, many of these countries lacked the legal structure required to protect property rights, all property having been held by the state. Although many states have made big strides toward instituting the required system, it will be many more years before the legal system is functioning as smoothly as it does in the West. For example, in most East European nations, the title to urban and agricultural property is often uncertain because of incomplete and inaccurate records, multiple pledges on the same property, and unsettled claims resulting from demands for restitution from owners in the pre-Communist era. Also, while most countries have improved their commercial codes, institutional weaknesses still undermine contract enforcement. Court capacity is often inadequate, and procedures for resolving contract disputes out of court are often inadequate or poorly developed.51
The Rocky Road
In practice, the road that must be traveled to reach a market-based economic system has often turned out to be rocky.52This has been particularly true for the states of Eastern Europe in the post-Communist era. In this region, the move toward greater political and economic freedom has sometimes been accompanied by economic and political chaos.53 Most East European states began to liberalize their economies in the heady days of the early 1990s. They dismantled decades of price controls, allowed widespread private ownership of businesses, and permitted much greater competition. Most also planned to sell state-owned enterprises to private investors. However, given the vast number of such enterprises and how inefficient many were, making them unappealing to private investors, most privatization efforts moved forward slowly. In this new environment, many inefficient state-owned enterprises found that they could not survive without a guaranteed market. The newly democratic governments often continued to support these money-losing enterprises in an attempt to stave off massive unemployment. The resulting subsidies to state-owned enterprises led to ballooning budget deficits that were typically financed by printing money. Printing money, along with the lack of price controls, often led to hyperinflation. In 1993 the inflation rate was 21 percent in Hungary, 38 percent in Poland, 841 percent in Russia, and a staggering 10,000 percent in the Ukraine.54 Since then, however, many governments have instituted tight monetary policies and brought down their inflation rates.
Another consequence of the shift toward a market economy was collapsing output as inefficient state-owned enterprises failed to find buyers for their goods. Real gross domestic product fell dramatically in many post-Communist states between 1990 and 1994. However, the corner has been turned in several countries. Poland, the Czech Republic, and Hungary now all boast growing economies and relatively low inflation. But some countries, such as Russia and the Ukraine, still find themselves grappling with major economic problems.
A study by the World Bank suggests that the post-Communist states that have been most successful at transforming their economies were those that followed an economic policy best described as "shock therapy." In these countries--which include the Czech Republic, Hungary, and Poland--prices and trade were liberated fast, inflation was held in check by tight monetary policy, and the privatization of state-owned industries was implemented quickly. Among the 26 economies of Eastern Europe and the former Soviet Union, the World Bank found a strong positive correlation between the imposition of such shock therapy and subsequent economic growth. Speedy reformers suffered smaller falls in output and returned to growth more quickly than those such as Russia and the Ukraine that moved more slowly.55