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Erik Berglof: State Capacity and Structural Transformation of the Economy

DATE: 2020-09-28

        Transition countries have gone through a particularly profound transformation of its economic structures and institutions. Part of that structural transformation is about redefining the role of the state to allow markets to operate. But the state must continue its transformation to facilitate the development of the private sector. And my focus is gonna be on that broader transformation of the state and how it can fill its role.

        Many countries have gone through dramatic transformations, and we should ask ourselves why are we interested in understanding this transformation? And I think the basic purpose is to understand how we can achieve growth and increase prosperity, and of course, address inequalities. There is an empirical observation that will be the basis for this presentation is that countries that grow more rapidly at lower levels of income also tend to grow faster at higher levels of income. So rather than this middle-income trap, which suggests that countries get trapped at middle-income levels are not questioning at this point that this does exist, but what seems to be a pattern is that countries that grew faster at low levels of income actually tend to grow faster also later in their development. So my conjecture is that this comes from a superior ability of the state to adapt. And this what I call transformational capacity, in turn, is held by the pressure stemming from its engagement with the private sector. You can think of pressures from the private sector that are deleterious or undermine institutional development and economic growth. But I will try to point to aspects of this relationship that can be much more favorable to economic growth.

        Structural transformation, we use as a term to look at how economic structures change the shift from agriculture to industry to services, the technological changes moving to higher value-added products and so on, increasing skill levels. All these economic structures have to be matched by institution. So when we talk about structural transformation, it's a combination of these changes in economic structures and the changes in institutions. And of course, as an economy moves towards the world technology frontier, it must change the institution. It must change or the it will change the economic structures. For example, you move towards smaller firms, and more important for smaller firms in technological development. But if you take a country now that faces this gradual approach to the world technology frontier, it also has to consider how technology evolves at the frontier. So all these changes now going on in terms of artificial intelligence and robotics and so on, that will affect what kind of industry, what kind of structure, what kind of institutions countries need to have once they reach that frontier or once they come close to it. But there's also another aspect which makes the situation for developing, emerging countries now more difficult is that they also face, I think, much more binding environmental and social constraints than maybe countries that try to make this transition 20 years or so ago. So a very rapidly change in technology at the frontier and more binding environmental and social constraints. And what we are looking for to explain or to generate and see how we can build is this transformational capacity, this ability of economies to transform their institutions and at the same time, change economic structures. I don't think I can say that it goes one way you can use your institution to help promote structural change in the economy, but vice versa, you need to adjust your institution. So we are trying to understand this transformational capacity of institutions and all the economic structures. And it's really the ability of an economy to transform itself and what I'm gonna focus on is the capacity of the state to transform itself. And the argument I'm gonna make is that we need to build in these transformational pressures on the state and the private sector and construct institution that respond to these pressures.

        And I'm gonna use infrastructure investment as an illustration. Every society needs many forms of infrastructure investment, differing in complexity and risk to deliver key public goods like health care, transport, housing and so on. And to do that, we need many forms of contracts. So some of them involve full state ownership. Some involve partnerships between the public and the private sector. In a sense, you can also say that socialism was the kind of extreme form of state ownership. And you are then trying to move to a mixed economy so that the transition is also very much a kind of shift in the nature of contracts. Of course, what contacts are feasible depends on the state capacity and the state capacity to raise revenues and to enforce contracts. And the private sector capacity also matters. How well can they manage assets? How well can they innovate in terms of how they develop different projects and so on? And the infrastructure investment is interesting because it's an opportunity to look at how we can use the private sector's engagement to enhance the performance of individual projects, but also to use that as a way to reform entire sectors and economies. So if I go back and look at transition, this was really about developing the private sector, but it was also about developing the state.

        We do remember the credo from the 1980s and 1990s was all about privatise, privatise, privatise. I remember sitting through meetings in the early nineties in Moscow and there was this representative from the IFC of the World Bank. And he would say in every meeting he would end with these three privatise, privatise, privatise. I think in retrospect, I think it's sort of understandable that there were these sorts of simplistic messages because it was very much about addressing inefficiencies in public infrastructure that was sort of obvious to everybody. They were not really actually unique to socialism, even though they were maybe most extreme there. But I think there was much less attention paid at a time to how to make privatization and success. If anything, the focus was on incentives, how to compensate performance and make sure that the rewards were related to performance. And there was this view that the market liberalization would solve everything. But it became clear that it wasn't enough. We just regulation on capital market discipline. You also needed a competition. And you needed, in particular, I would say, functioning governance, including a functioning state capacity.

        And when we look back at the transition experience, I think that's what was missing at the beginning. Of course, there is a very important role of the state there to enable the private sector and force competition policy to improve corporate governance, to strengthen border governance and transparency and those things, to deliver important public goods, infrastructure, health, and education, and to invest in R&D or to build a broader ecosystem for its capital. All that was the role of the state. Of course, there was also need sometimes to have more vertical industrial policies really trying to build individual sectors or address sector-specific challenges like in finance or human capital or in an individual sector. So all these were responsibilities of the state. And we needed to build the capacity.

        So people have thought about what is state capacity? There's a very instinct framework developed by Tim Besley and Torsten Persson to understand state capacity. And they talk about two essential features of state capacity. One is the fiscal, or what they call extractive capacity. When you look around the world, what is truly remarkable is how countries have been able or governments have been able to improve and increase their capacity to raise taxes. And this is really at the heart of creating any effective state. It's also absolutely important to move from kind of redistribute states that just transfers income from one part of the economy to another, or from one part of the population to another, to really fund public goods and invest in public goods. And that for that you need fiscal and extractive capacity. The second part of the state capacity in the Besley- Persson framework is legal or productive capacity. It's really about protection of property rights and contracts. And this is to enable growth-inducing activities. So on the one hand, in order to be able to extract, you want the economy to grow so you can you know what the same capacity to extract you can extract more. It's also to promote innovation, productivity and growth, but what I find is that fiscal and legal capacity are complements, and it's really also this complementarity been, on the other hand, what explains tax compliance and the quality of institutions. People are more willing to pay taxes if they get quality from institution, so they go about to measure this.

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