The 1980s and early 1990s witnessed historic changes in the patterns of economic development that had prevailed since the end of World War II. New winners and losers emerged within what had traditionally been called the “third world.” Thus, as the new century approaches, East Asia's newly industrialized countries (NICs) are on the verge of joining the developed world. At the other extreme, a large part of the African continent has experienced an absolute decline in living standards, and its future prospects appear dim. In between, other countries in Asia, Latin America, and the Middle East are trying – with various degrees of success – to reposition themselves to take advantage of new global dynamics. Finally, a new group of third world nations has appeared as a consequence of the collapse of communism. Eastern Europe and the former Soviet republics are now facing many of the same problems as other developing countries and competing with them for available resources.

There has been a great deal of debate about the reasons for the differential success in achieving economic development. In this book, the authors stress the importance of two sets of variables: international and regional. While not denying the role of domestic economic, political, and cultural factors, we believe that recent analysis has seriously underestimated the relevance of international variables and overlooked the importance of geographic location. Moreover, there has been an interaction between international and regional factors in ways that skew an individual nation's chances of achieving rapid growth with a measure of equity.

INTRODUCTION

In both economics and political science, the study of institutions has achieved a new and increasing prominence over the past twenty years. This emphasis contrasts with economists' previous devotion to the neoclassical paradigm and, to some extent, with behavioralist and pluralist approaches to studying politics. In part this change is due to an interest in problems concerning particular institutional settings: the efficient structuring of the business firm, the nature and practice of economic regulation, the criticism or reform of democratic political institutions, and, more recently, the transition from command economies and totalitarian polities to more capitalistic and democratic forms. But, partly as a result, there has also been an increased appreciation of the need for positive economic and political theory that not only incorporates institutions and their effects, but also gives us tools to analyze institutional formation, maintenance, and change.

It is a measure of the importance of the idea of institutions in social science that the term often goes without an explicit definition in many studies to which it is central, even though writers who do define the term give it a great variety of meanings.

INTRODUCTION

This essay provides perspectives on research on regulation, identifies an agenda of research topics, and discusses approaches to some of those topics. The focus is on a set of presently identified issues on which social science research may be able to make a contribution, irrespective of how amenable the issues are to study with our present set of analytical tools. The essay thus focuses more on research opportunities and less on where progress is most likely to be made. Many of these research opportunities are suggested by regulatory practice and emerging concerns.

One approach to regulatory research focuses on the identification of market failures and on market-like mechanisms for correcting those failures. This perspective is necessarily normative and measures performance in terms of efficiency. Major advances in the theory of regulation have resulted from treating as endogenous the behavior in the regulatory relationship. This includes not only treating the behavior of the firm as endogenous, but also making the choice of a regulatory policy endogenous. The research challenge, however, is broader than that of providing advice about efficient regulatory policies and includes the prediction and explanation of actual regulatory behavior.

A second approach to regulatory research, that of political economy, adopts a positive perspective. In its simplest form, the political economy approach views regulation as demanded and supplied as a function of the interests of those who incur the distributive consequences of policy alternatives. The political economy perspective thus does not require a market failure for regulation to be supplied.

INTRODUCTION

The dramatic political and economic changes underway in Eastern Europe and the former Soviet Union present social scientists with a sobering reality and an unprecedented opportunity. The reality is that our disciplines offer very little theory of relevance to predicting the onset, course, or pace of the changes. The opportunity is a “natural experiment” that permits social scientists to study comparatively an important type of institutional transformation: in an amazingly short period of time the communist parties in a number of countries with different institutional and cultural circumstances peacefully relinquished their dominant political positions to allow democratization and the attempt to create liberal political and economic institutions. While many social scientists have been quick to offer advice about how the transformations should proceed, our purpose here is to consider how social scientists can best learn from this natural experiment.

We make two intertwined arguments about studying the postcommunist institutional transformations, specifically, and major changes in economic institutions more generally. One argument concerns what we believe to be an appropriate substantive focus for study: the evolution of property rights and their credibility. The other argument concerns the weaknesses of the disciplines as they relate to the conduct of that study and the desirability of a political economy approach for overcoming them.

An important empirical regularity motivates our focus on property rights: all our previous political experience suggests that democracy is incompatible with the centralized allocation of economic resources (Lindblom, 1977, chap. 12). A market economy with substantial private property appears to be a necessary, although not sufficient, condition for the persistence of a democratic political system.

The study of political economy typically involves individual researchers following their own instincts about productive ways to expand on the way we think about specific political and economic phenomena. At least as practiced in the United States, institutional impediments frequently stand in the way of appropriate training and research when that research is very different from traditional approaches. Such is particularly true when the new approach falls across the boundaries of existing disciplines.

This volume represents a first step in altering some of these existing institutional impediments. The essays contained here were commissioned for presentation at the Inaugural Conference of the W. Allen Wallis Institute of Political Economy at the University of Rochester. The Wallis Institute was the natural outgrowth of the efforts of the economics and political science departments at the University of Rochester to foster closer intellectual ties than usually exist across these disciplines. The research lines sketched in this book constitute a starting point for the development of new approaches to research and training. This development has been supported and encouraged by the University of Rochester, which has dedicated resources to the development of the Wallis Institute.

The Wallis Institute is named in honor of W. Allen Wallis. He is a former president of the University, but more than that, his career is a personal model of political economy in action. Trained as a statistician, he achieved wide acclaim for innovative statistical approaches – achievements recognized, for example, by his election as President of the American Statistical Association. His career, however, was not narrowly defined by statistics. He ranged from academe to government while maintaining close relations with business and industry.

The Cambridge series on the Political Economy of Institutions and Decisions is built around attempts to answer two central questions: How do institutions evolve in response to individual incentives, strategies, and choices, and how do institutions affect the performance of political and economic systems? The scope of the series is comparative and historical rather than international or specifically American, and the focus is positive rather than normative.

An earlier volume of essays on the state of the field in this series, Perspectives on Positive Political Economy, mainly addressed organizational development. Now, Banks and Hanushek have assembled an exciting collection of papers in which formal theories of political economy are applied to the interaction between institutions and public policy. The chapters cover regulation, privatization, and the construction of credible property rights in economic transformations, as well as the political economy of economic policy in industrial societies (trade policy, macro policy, and budget policy). All of these are significant areas where politics and markets – or political and economic forces – interact. Each of these chapters summarizes a recent research program, integrating a variety of approaches and findings while pointing out the need and direction for future research. Additionally, two chapters address theoretical developments relating to the role of equilibria in institutional choice. Both of these chapters, one on the political economy of law and the other on institutions more generally, focus on problems of cooperation and coordination, and point the way to rigorous microfoundations for institutional analysis.

INTRODUCTION: LEGISLATION AND LAW

The study of politics is dominated by what might be called a “legislative” view of government. In this view government proceeds largely through enacting general rules to channel social and economic conduct and then using more mundane administrative means to enforce them. This emphasis on legislation encourages us to see other institutions and practices in terms of their connection to or similarity to the legislature. Thus, electoral studies are frequently justified or motivated by their consequences for selecting lawmakers or expressing “mandates” for new laws; presidents are often seen and judged in terms of their role in the legislative process; and administrative agencies and courts are seen as quasilegislative bodies, promulgating general rules and regulations. If the Founding Fathers were wrong to fear congressional dominance of other national institutions, they were perhaps prescient in foreseeing how the legislative model would dominate the way we have come to understand government.

This focus on legislation while, perhaps, natural enough in a democratic nation – statutes are, after all, the principal normatively sanctioned route by which public opinion is translated into public action – produces a distorted description of governmental activity. The centrality of legislative studies suggests that there is a simple relationship between statutes and the law by which we live.

The view that politics plays an important part in determining trade policy is widely accepted among international trade economists. Evidence of this can be seen in the recent surge of research activity focusing on a variety of questions concerning how the political decision-making process affects the determination of trade policy (e.g., Hillman 1989, Magee, Brock, and Young 1989, Grossman and Helpman 1992,1994). This essay attempts to assess the problems and prospects for this literature. We begin by discussing the origins of this literature from an economist's point of view. In this discussion, we try to indicate why economists have become interested in considering the effects of politics on trade policy and what they hope to learn from this effort. We then discuss how the literature has progressed in explaining the existence of protection and what important trade policy facts need to be explained in future research. Surveys of much of this literature have been done by Nelson (1988) and Hillman (1989). Rather than provide another survey, we highlight the types of questions that have been considered and the types of models that have been used.

Unlike traditional economic theory, progress in this area will require improvements in the modeling of both economic and political activities. We discuss elements of an optimal model, describe several important trade policy issues to which such a model should be applied, and illustrate some of the key elements of the optimal model by sketching a specific illustrative model and using it to address some of the issues raised earlier.

An important area where political and economic considerations intersect involves government fiscal policy. Most economists feel that government budget deficits reduce national saving, which in turn reduces the longterm capital intensity of an economy and its standard of living. Hence, controlling budget deficits is one way, perhaps the best way, for present generations to protect the economic interests of future generations. At the same time, to control budget deficits politicians must vote for either tax increases or spending reductions, both of which are politically unpopular and increase politicians' chances of being voted out of office. Hence, the deficit control issue sets up an immediate tension between the policies that might be necessary for long-term economic expansion and the votes that might be necessary for political survival.

Given this tension, one might ask why real-world governments would ever balance their budgets. Part of the answer is that there are natural economic costs to letting budget deficits get out of control. If governments try to finance deficits by printing money, inflation will rise. If governments try to finance deficits by borrowing, interest costs will rise and, indeed, beyond some level, borrowers will not hold the government securities at any interest rate.

INTRODUCTION

Utilities' privatization has become a booming industry. From Latin America, to Europe, to Asia and now to Africa, Utilities' privatization has become a key element of reform-minded governments. Global ideological changes, fiscal concerns, and the recognition that there may not be any visible advantage for government ownership are behind this global reconsideration of the ownership role in the provision of utility services. But with privatization comes the recognition, often belatedly, that utilities are not like any other sector of the economy, where an appropriate tax treatment and a stable economic environment is enough to develop private investment in utilities. In case after case, it is being recognized that the private sector has to be “encouraged” to undertake all the investments that the public and the government expected from the utility. The need for this encouragement, however, is often seen by many governments and the public in general as a further example of the private monopolies ripping off customers, of collusion between the private companies and the governments, of the need to renationalize, and so on.

The purpose of this essay is to discuss what seems to be the crux of success for privatized utilities and what research is needed to further our understanding of the ability to succeed in regulating newly privatized utilities. In this essay I discuss the experience of some countries that have undertaken, or attempted to undertake, utility privatizations. I do not claim, however, that the discussion here is exhaustive, as I focus on a few selected countries on which I have undertaken primary research.

INTRODUCTION

In 1987 I wrote an article entitled “Macroeconomics and politics” (Alesina 1988a), which highlighted new research in “political macroeconomics.” At that time, this literature was still relatively small: It had developed from applications of game theory to problems of monetary policy. Since then, this field has literally exploded: The “new political economics” is one of the most active areas of research in economics. A major contribution to the development of this field comes from a closer interaction between economists and political scientists.

Recent research in political macroeconomics has covered a large number of topics: political business cycles, the politics of the government budget, the political economy of growth, the politics of inflation and stabilization policies, problems of external debt and capital flight in less developed countries, the effect of institutions (such as the degree of Central Bank independence) and different electoral systems on economic policy, the performance of coalition and minority governments relative to single-party governments, the relationship between domestic political competition and international policy coordination, and the politics of international agreements such as the European monetary system, just to name a few.

Even this incomplete list makes it quite clear that it is impossible to assess the progress and shortcomings of all of this body of research in one essay. Therefore, here I concentrate on two broad issues: the economic and political cycle; the effect of electoral systems and party structure on the economy, with particular reference to the issue of “divided government.”

Political economy, to paraphrase the editors of an earlier volume in this series, is the study of rational decisions in a context of political and economic institutions. Its central tenent is that a comprehensive understanding of economic phenomena requires knowledge of the political institutions, actors, and incentives present in the decision-making process. Conversely, these same political variables are best studied with the rational actor orientation of economics and with a continual eye toward the economic consequences of political choices.

While politics and economics coexisted as the single discipline of political economy for much of the period of modern scholarship, these fields were formally split in the late nineteenth century. It is now apparent that this split, while advantageous for certain scientific developments, has biased the way in which economists and political scientists think about many issues. The separate disciplines, with their own views on appropriate methods and the most productive lines of research, place artificial constraints on the study of many important social issues. The reconstitution of political economy is designed to reunite the separate perspectives in those areas where the interaction of individuals, institutions, and markets is paramount.

The division of economics and political science into separate disciplines can be traced back to a variety of factors. To take one prominent example, the development of the neoclassical model in economics emphasized behavior of individual consumers and firms in perfectly competitive markets, at the expense of any sort of political considerations. Indeed, one of the founders of the neoclassical movement, Stanley Jevons, was an early advocate of replacing “the old troublesome double-worded name for our science,” namely, political economy, with the much more concise label of “economics.”

INTRODUCTION

On the independence of the imperial Japanese courts, most scholars turn a bit agnostic: The courts were sort of independent, they conclude, and sort of not. Political scientist Chalmers Johnson captures the mood. The Tsuda incident (described at Section 3.1) accomplished “the legitimation of judicial independence in Japan,” he writes (1972: 29). But “the judiciary still came under intense pressure to insure that the interests of the state … and the interests of justice were never incompatible” (id., 160).

Legal scholars show a similar ambivalence. Kenzo Takayanagi insists that turn-of-the-century judges “scrupulously guarded their independence” (1964: 10), but suggests that the “rule of law” never took hold before the war (id., 14). Hiroshi Oda (1993: 65–66) argues that “the independence of the court was guaranteed to a certain extent,” but concludes that “the Ministry of Justice was in charge of the overall administration of the courts.”

By contrast, on the probability of judicial independence in the abstract, most scholars are more positive. Some suggest, for example, that rational politicians will keep courts independent so that they can credibly promise contributors rent-extracting statutes (Landes and Posner, 1975). Others suggest politicians will keep courts independent so that they can use them to monitor their bureaucrats (McCubbins and Schwartz, 1984). Even to autocrats, some scholars champion judicial independence. Without independent courts, they explain, autocrats will be unable to make any promises they give credible.