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State failure in developing countries and strategies of institutional reform

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State failure in developing countries and strategies of institutional reform

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The analysis of state failure and the policy debate have been driven by two very different underlying views of what the state does. The first, which we call the "servicedelivery" view says the role of the state is to provide law and order, stable property rights, key public goods and welfarist redistributions. In failing to provide these, state failure contributes to economic under-performance and poverty. State failure of this type is in turn related to an inter-dependent constellation of governance failures including corruption and rent-seeking, distortions in markets and the absence of democracy. All of these need to be addressed to focus the state on its core servicedelivery tasks. The second locates the developing country state in the context of "social transformation": the dramatic transition these countries are going through as traditional production systems collapse and a capitalist economy begins to emerge. Dynamic transformation states have heavily intervened in property rights and devised rent-management systems to accelerate the capitalist transition and the acquisition of new technologies. State failure according to this view has been driven by the lack of institutional capacities in these respects, and more importantly, the incompatibility of institutional capacities with pre-existing distributions of power. An examination of the econometric data and historical evidence raises serious doubts as to whether the governance reforms suggested by the first view can improve growth, while the need for reforms identified by the second view are much better supported. This suggests the need for a significant shift in the focus of institutional reform, as well as identifying the importance of political reorganization in poorly performing economies.
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State Failure in Developing
Countries and Institutional
Reform Strategies
MUSHTAQ H. KHAN
Two radically different theoretical views on the role of the state in economic devel-
opment have driven policy debates on the location of state failure and the priorities
of institutional reform in developing countries. A lack of clarity on this underlying
difference has been the source of much confusion. I shall refer to the dominant view,
which has underpinned the mainstream consensus on the state, as the service deliv-
ery model, and the second view, which looks at the role of the state in the context of
the transition to capitalism, as the social transformation model.
The service delivery model focuses on a range of services that states should deliver,
in particular, public goods such as law and order, social security, and market regula-
tion, and relies on competitive markets to deliver all other goods and services. The
social transformation model looks at the more critical and problematic role the state
plays in the transformation of essentially precapitalist and pre-industrial societies
into dynamic and essentially industrial, capitalist ones. While states do deliver serv-
ices, the service delivery model of the state is misleading for poorly performing devel-
oping country states undergoing reform. Historically, success in service delivery has
generally depended on states’ success in pushing social transformation rapidly in the
direction of viable capitalist economies. The critical area of state failure has been the
absence of adequate institutional and political capacity in developing country states
to assist in and accelerate a dynamic transformation. Without strategies to enhance
this role of the state, sustained progress on service delivery is also unlikely. Many of
the consensus policies on reforming institutions to improve service delivery are based
on a partial reading of theory and evidence. They are at best unlikely to work, and
at worst could further undermine the state’s institutional and political capacity for
ensuring a dynamic transformation.
165
Mushtaq Khan is senior lecturer in economics at the University of London, Department of Economics, School of
Oriental and African Studies. This paper is a revised version of the paper presented at the ABCDE-Europe conference.
Annual World Bank Conference on Development Economics—Europe 2003
© 2004 The International Bank for Reconstruction and Development/The World Bank
166 | MUSHTAQ H. KHAN
The state’s pivotal role is based on its claim to the monopoly of legitimate vio-
lence. The state is the only body in society that can legitimately enforce institutions,
collect taxes, redistribute income and wealth, and represent and enforce social cohe-
sion or resolve conflicts, in all cases using force if necessary. All these functions are
interdependent and have a role to play in both service delivery and social transfor-
mation. This paper cannot look at all these areas, but fortunately, the role of the state
in creating and enforcing institutions shows the interdependence between many of
these functions.
Institutions are the rules of the game that set incentives, opportunities, and limita-
tions for individuals or organizations. The key institutions the state enforces include
the system of property rights; the interventions that define rents and incentive struc-
tures, which include taxes and subsidies; and the higher-level political institutions,
such as democratic or authoritarian decisionmaking bodies that set the rules for
changing rules. Because variations in this set of institutions can potentially have large
effects on the quantity and quality of investment, economists agree in general terms
that state failure can have a significant effect on growth (see, for instance, Bardhan
2000; Bates 2001; Khan 1995; Lal and Myint 1996; Migdal 1988; North 1981,
1990; Olson 2000; Shleifer and Vishny 1998; Stiglitz 1998b). Therefore adjusting for
differences in initial conditions, persistent shortfalls in growth rates compared with
similar countries provide initial evidence of state failure and its severity. While this
paper does not directly address static redistribution issues, the strong statistical rela-
tionship between growth and poverty reduction (Dollar and Kraay 2001; Lal and
Myint 1996) also implies that state failure is responsible for poverty in many devel-
oping countries. While redistribution can play an important role in any poverty
reduction strategy, this paper focuses on the necessary conditions for enabling any
economic growth strategy. This is important in a broad discussion of poverty, because
growth is a necessary component of poverty reduction in any poor country.
This paper defines state failure in the broadest terms that can loosely incorporate
both positions on the role of the state. Based on Krueger’s (1990) definition of gov-
ernment failure, state failure is defined here as consisting of both errors of omission,
that is, when the state fails to do things that could have improved economic perform-
ance, and errors of commission, which is when the state does things that worsen eco-
nomic performance. While the identification of state failure implies a judgment that
better economic performance could have been achieved, the challenge is also to iden-
tify the institutions that could achieve this better performance. The service delivery
model uses as its benchmark a model of a well-working market economy, loosely
referred to here as the liberal market consensus, without implying that everyone
within this consensus agrees in all respects. The consensus argues that to generate
growth, states have to protect stable property rights, defined by strong contract
enforcement, low expropriation risk, and low corruption; they have to ensure undis-
torted markets defined by low rents; and they have to achieve democratic accounta-
bility and civil society participation to keep the state in check. The key service delivery
functions of the state are to protect property rights and to deliver democratically
decided upon public goods efficiently. It follows that reform should aim to help devel-
oping countries attain the appropriate state capacities.
STATE FAILURE IN DEVELOPING COUNTRIES | 167
The consensus view has rapidly come to enjoy widespread support because many
of the reforms it endorses, such as the pursuit of democratization, the achievement of
greater openness and accountability, and the pursuit of anticorruption campaigns, are
rightly supported by most people as ends in themselves. However, the new consensus
is based on a partial reading of the theory and evidence, and does not address the core
issue of social transformation that is a necessary component of any strategy to accel-
erate growth. As a result, if international agencies give the impression that these
reforms are instruments that can overcome state failure and help achieve economic
takeoff, a crisis of expectations is likely to occur soon. The benchmark of good insti-
tutions described by the new consensus does indeed fit aspects of the institutional
structure of advanced countries, and poorly performing developing countries do
indeed fail to approach this benchmark. Nevertheless, the reform package that aims
to push institutions in developing countries in the direction of a generalized advanced
country model is not relevant for helping developing countries carry out the transi-
tion from essentially precapitalist societies to dynamic, capitalist ones. The social
campaigns to deepen democracy or prevent corruption are legitimate in their own
right. The concern here is only whether these reforms can contribute to a serious shift
in the growth paths of poorly performing countries.
Theory and evidence can be interpreted to suggest a different and much more
demanding reform agenda to combat state failure in developing countries. Develop-
ment is an ugly and conflict-ridden process, not primarily because of corruption and
the lack of democracy, but because social structures are rapidly changing, new classes
are emerging, and new wealth is being accumulated at historically unprecedented
rates. In the advanced countries, this social and economic transformation took place
over centuries. A shock of a similar magnitude has hit the developing countries, but
telescoped into a period of decades and, perhaps partly as a result, the transition to
capitalism has been much more patchy. Old production systems have collapsed often
well before new ones can take over, social conflicts are intense, and stable and pro-
ductive political constituencies on which viable democracies can be based are often
absent. At the same time, political and economic expectations are higher than at any
time in the past.
The real question facing developing countries is whether these processes are likely
to lead to a viable and dynamic capitalism, as they appear to have done in a few high-
growth economies, or whether they will lead merely to the theft of resources by
unproductive classes and a descent into anarchy. The institutional reforms identified
in the consensus view do not directly address these fundamental challenges facing
developing countries during the period of transformation or identify the state capac-
ities required to accelerate the transition in the direction of viable capitalism. Instead
it targets some of the symptoms of the transformation period—the prevalence of cor-
ruption and the weakness of democracy—and attempts to construct institutions that
may not be the most relevant for addressing the problems of transformation that
characterize this period. These attempts can prove to be largely irrelevant, but they
can also make matters worse by further weakening state capacities, raising unattain-
able popular expectations, or even by simply diverting attention from more pressing
problems. By referring to some of the data, the historical evidence, and the theory
168 | MUSHTAQ H. KHAN
that can be brought into play to interpret it, this paper injects a note of caution into
the interpretation of this consensus by policymakers. The consequences of yet another
round of multilateral-led reform in developing countries running out of steam do not
need to be spelled out.
In contrast with the reforms suggested by the liberal market consensus, getting
developing economies through this transformation successfully has historically
required stronger and more interventionist state capacities. To begin with, states in
high-growth countries participated in the transformation of their economies and soci-
eties by helping to create a new capitalist class and ensuring that it succeeded in
acquiring technology and entrepreneurial capacity. This involved using a range of
policies, including active interventions in property rights and management of growth-
enhancing rents (Amsden 1989; Aoki, Kim, and Okuno-Fujiwara 1997; Chang 1994;
Khan and Jomo 2000; Lall and Teubal 1998; Page 1994; Rodrik 1995, forthcoming;
Wade 1990; Woo-Cumings 1999). The conclusion is that policymakers have to focus
on these transformation capacities to enable states to push the capitalist transition if
they are to address economic underperformance.
In addition, simply describing the transforming role of state intervention in the
high-growth economies does not provide directly relevant lessons either, because most
developing country states failed to achieve similar goals despite frequent attempts.
Here much of the “developmental state” literature on developing countries is also
weak in locating the sources of state failure in pushing social transformations. An
important aspect of state failure during the transformation is the failure to enforce
any institutions, a problem Myrdal (1968) pointed out more than 30 years ago. This
paper argues that the distribution and disposition of political power in society is a key
determinant of enforcement success, and that the emergence of high-growth states is
therefore as much a task of political engineering as it is of institutional engineering to
ensure that states are able to enforce painful and socially contested decisions. This
explains why institutions that work well in one context may fail badly in another.
The evidence supports the claim that the most persistent types of state failure occur
when institutions fail because of an inappropriate match between internal political
settlements (defined as the distribution of organizational and political power between
competing groups and classes) and the institutions and interventions through
which states attempt to accelerate transformation and growth (Khan 1995; Rodrik
forthcoming).
Policies must recognize that in most cases, political conditions are not conducive
for states to acquire and exercise transformation capacities. In such cases, policy-
makers have to be concerned with how the disposition and organization of political
power need to change over time. An unfortunate misconception is that democracy is
sufficient to consolidate productive groups and undermine unproductive ones. While
direct intervention in the political organization of developing countries is outside the
remit of international agencies or researchers, opening up debate about how growth-
promoting political coalitions can be constructed is not. On the contrary, by focusing
on a set of narrow institutional reforms pertaining to service delivery, international
agencies are doing little to prevent the consolidation of unproductive groups in many
of the poorest economies.
STATE FAILURE IN DEVELOPING COUNTRIES | 169
These concerns suggest that the consensus reforms should not be uncritically sup-
ported and indicate other areas where policy-oriented research should focus. The
next section looks at the theory and evidence underpinning reforms based on the
service delivery model. The following section examines the theory and evidence sup-
porting the need to focus on the capacities of the state that ensure dynamic transfor-
mations. The paper concludes with a look at the implications.
The Service Delivery State
The standard textbook list of the state’s service delivery functions is well known.
These functions include providing law and order, correcting market failures, and, in
particular, providing essential public goods and limited welfarist redistributions.
Underpinning the service delivery concept of the state is a set of well-developed the-
ories of how a liberal market economy works. The model has three theoretical com-
ponents that have combined to produce the liberal market consensus underpinning
the service delivery view of the state. (While the post-Washington consensus defined
by Stiglitz [1998a] strongly criticizes the Washington consensus on the role of the
state, both are part of the liberal market consensus in terms of the key policy con-
clusions discussed below.)
The first component of the model is that efficient markets are rent free and have
stable property rights. The standard theory of efficiency in competitive markets has
been deepened by new institutional analysis that argues that stable and well-defined
property rights are a precondition for efficient exchange and also create incentives for
long-term investment (Bates 2001; North 1990). In contrast, rents in markets provide
prima facie evidence of restrictions on competition, and if this is achieved through
interventions in property rights, they also undermine confidence in the future. Rents
are incomes that individuals can earn that are higher than what they can earn in their
next-best opportunity, and so rents exist if those in the next-best activities are pre-
vented from acquiring access to particular resources or opportunities. This could be
because of protected rights over information, monopoly rights to supply particular
markets, rights over subsidies, or even rights over a valuable natural resource. Of all
the different types of rents, monopoly profits and special interest subsidies are typi-
cally used as examples to argue that efficiency requires rent-free markets. The new
information economics critiques this model of the market, but the simpler view still
dominates the liberal market consensus on the state. In terms of service delivery, both
errors of commission, such as the creation of monopolies, and errors of omission,
such as the failure to provide good infrastructure, can be explained in terms of suc-
cessful attempts to capture such rents.
The second component of the model is that rent-seeking creates rents and desta-
bilizes property rights. The persistence of damaging rents and the associated property
right instability is thus explained by the incentives for rent-seeking (Krueger 1974;
Posner 1975). Rent-seeking consists of such activities as lobbying and corruption that
seek to persuade states to create rents. The literature on rent-seeking has been grow-
ing (reviewed in Khan 2000b), and has been extended by a more recent subset of
170 | MUSHTAQ H. KHAN
literature addressing the causes and effects of corruption (Andvig and others 2000;
Bardhan 1997). Corruption is illegal rent-seeking whereby the rent-seeker uses bribes
to influence public officials. One of the most damaging effects of rent-seeking is the
destabilization of property rights, because the creation or reallocation of rents always
requires appropriate changes in rights.
The third component of the model is that the absence of democracy and a weak
bureaucracy allow rent-seeking to continue. To explain why damaging rent-seeking
continues even when the majority is hurt by it, the consensus identifies a number of
factors. First, the absence of democracy increases the chances that small groups can
continue with their socially damaging rent-seeking (Olson 2000, 1997; North 1990).
Second, low bureaucratic salaries, a politically appointed (hence “short-termist”)
bureaucracy, and a weak judiciary can all reduce the expected cost to public officials
of accepting bribes, thereby making rent-seeking more likely (World Bank 1997).
Figure 1 shows how these three core components of the liberal market consensus
interact to explain how developing countries can become locked into persistent state
failure, defined as poor service delivery in such key areas as the protection of stable
property rights and the provision of infrastructure, which in turn affect growth.
Causality runs in both directions between most of the factors identified. Thus the
absence of democracy not only allows rent-seeking to continue, but rent-seeking rein-
forces the power of special interest groups. In turn rent-seeking not only creates rents,
but the presence of rents induces further rent-seeking. Weak bureaucratic capacity and
State-created rents:
market distortions, unstable
property rights, poor
infrastructure, incentives
for more rent-seeking
Rent-seeking
and corruption:
individuals or groups buy
privileges and power
Absence of democracy:
small groups monopolize
political power
Absence of political will,
politically appointed
bureaucracy, low
bureaucratic salaries,
weak judiciary
Economic stagnation
and political instability:
creates further incentives for
unproductive activities in the
absence of productive ones
FIGURE 1. State Failure: The Liberal-Market Consensus
Source: Author.
STATE FAILURE IN DEVELOPING COUNTRIES | 171
low salaries not only allow corruption, but corruption makes obtaining the political
will to reform the bureaucracy difficult and can make the judiciary corrupt as well.
This interdependence means that societies can become locked into undemocratic,
highly corrupt, and highly distorted equilibriums (Andvig and Moene 1990; Bardhan
1997; Murphy, Shleifer, and Vishny 1993).
The policy implication of the consensus model is that a number of parallel good gov-
ernance reforms are required to deal with state failure. Whereas in the past the focus
would primarily have been on economic reforms to make markets competitive and
rent-free, the liberal market consensus now argues that these policies will not be sus-
tained without simultaneous political and institutional reforms.Political reforms are
understood as moves toward democracy and sometimes decentralization, together
with encouraging civil society participation, all with the aim of limiting the state’s free-
dom to create arbitrary rents. Institutional reforms include moves to “right size” the
state by focusing on service delivery, reducing the state’s institutionalcapacity to create
rents, raising bureaucratic salaries, improving civil service recruitment procedures, and
making the judiciary more independent. Fighting corruption overlaps with all these
reforms and ensures that the incentives to create rents are further reduced. Correcting
state failure, according to the liberal market consensus, requires moves on all these
fronts simultaneously, because they are preconditions for specific improvements in
states’ capacity to deliver such services as critical public goods and stable property
rights (Asian Development Bank 2000; World Bank 1997).
The Evidence
The most significant support for the consensus view comes from a formidable array
of econometric exercises (for instance, Barro 1996; Clague and others 1997; Hall and
Jones 1999; Johnson, Kaufmann, and Zoido-Lobatón 1998; Kaufmann, Kraay, and
Zoido-Lobatón 1999; Knack and Keefer 1995, 1997; Mauro 1995; World Bank
1997). These studies find that such governance variables as corruption, the stability
of property rights, and democracy are correlated with such developmental outcomes
as per capita incomes, growth of per capita incomes, investment rates, and direct
indicators of poverty (for example, child mortality rates). But has the eagerness to
establish that all good things go together colored the measurement and interpretation
of the evidence? Some of the data problems are well known and most studies add
cautionary statements, but taken together, the data problems suggest that a much
higher degree of care is required in interpreting the results.
To begin with, the indexes measuring governance quality are subjective by nature.
Corruption, democracy, stability of property rights, and even degree of policy-
induced distortion are measured by indexes based on perceptions or on judgments by
“competent” observers. Polls are subject to the problem of scaling across countries,
while competent observers can have preconceived ideas about what they expect to
see. Corruption, instability, and distortions can appear to be less serious in high-
growth countries, even to competent observers, simply because things are working
well. Finally, corruption, property right instability, and distortions can vary widely in
172 | MUSHTAQ H. KHAN
type and seriousness across sectors within an economy. In constructing a composite
index, prior expectations can bias the choice of evidence and its weights.
In addition, we do not have satisfactory time-series data for periods that are long
enough to test for causality using the same group of countries. To see how gover-
nance might affect growth, we need both high- and low-growth countries to test our
hypotheses. Most of the high-growth Asian economies began growing sometime in
the 1960s, 1970s, or early 1980s, but governance indicators are only available from
the mid-1980s onward, and the fuller data sets are only available for the 1990s or
later. As high growth is expected to improve governance indicators, to test the causal
significance of governance variables we need to have governance indexes for high-
growth countries before they began their takeoff. Because such indicators are lack-
ing, growth in the high-growth countries is often misleadingly explained using their
ex post governance indicators achieved after their growth has taken off or instru-
mental variables correlated with them.
Finally, insufficient observations of successful transformation countries are avail-
able for satisfactory econometric results. Only a handful of countries were successful
developers over the last 40 or 50 years. Even if we had ex ante governance indicators
for these countries, in any statistical exercise they are vastly outnumbered by poorly
performing developing countries with poor governance indicators on the one hand,
and by moderately performing advanced countries with good governance indicators
on the other. Thus the characteristics of the critical group of successful transformers
are lost as outliers. As a result, the regressions pick up statistical correlations or pat-
terns rather than causality. Incidentally, though small in number, the successful trans-
formers have not been small in terms of population as they include Asian giants like
China, but econometric studies do not normally weight observations by population
size. This alone might have reversed at least some of the econometric results, even
without true ex ante governance indicators being available.
The high-growth developers are particularly important, because even though gov-
ernance indexes are not available for periods prior to their takeoffs, their governance
indexes remain quite poor for a considerable period after their growth took off. For
instance, even in the mid-1980s, the averages of the Knack and Keefer (1995) indexes
of institutional quality based on quality of bureaucracy, rule of law, expropriation
risk, and contract repudiation by the government for the Asian high-growth
economies were only a little better than those for many poorly performing countries.
Rodrik (1997) points out that while growth within East Asian economies was corre-
lated with the index, only Japan, Singapore, and Taiwan (China) had high scores and
none were remotely poor by then. Indonesia scored the same as the Republic of the
Congo, Ghana, and Myanmar, while the Republic of Korea, Malaysia, and Thailand
were at the same level as Côte d’Ivoire. Nor were most high-growth developers dem-
ocratic when they began growing or for a considerable period thereafter.
As concerns corruption, table 1 shows the Transparency International corruption
index for the 54 countries for which the earliest index is available for the period
1980–85 and growth rates for these countries for 1980–90. While the median growth
rates of the East Asian developers were far higher than those of the other two groups,
their corruption scores were not significantly better than those of other developing
STATE FAILURE IN DEVELOPING COUNTRIES | 173
countries. If governance indexes were available for the periods before growth took
off in the high-growth countries, the differences may have been even smaller.
The governance data conform to the general pattern shown in figure 2. Such data
provide the typical positive coefficient estimated for governance variables in regres-
sion exercises simply because of the numbers of observations in clusters 1 and 3 and
TABLE 1. Growth and Corruption, 54 Countries, 1980–90
Developing High-growth Advanced
countries developers countries
Item (24 observations) (6 observations) (24 observations)
Median GDP growth rate, 1980–90 1.9 7.8 2.8
(range) (0.4–6.3) (5.2–9.7) (1.8–7.1)
Median corruption index, 1980–85 3.5 4.5 8.1
(range) (0.7–7.4) (0.2–6.3) (4.2–8.4)
GDP Gross domestic product.
Note: The Transparency International corruption index ranges from 0 for the most corrupt countries to 10 for the
least corrupt: High-growth developers were separated from the other country groups on the basis of long-term
growth rates.
Sources: Transparency International and Göttingen University (2002); World Bank (1999, table 11).
FIGURE 2. Interpreting the Evidence on Governance and Development
Governance
indicators
Rate of growth
Negative
Likely historical
path of capitalist
development
3. Most industrial
countries
1. Most developing
countries
2. Small number of
high-growth developers
R
egressi
on li
n
e
Positive Policy path suggested by
the econometric relationship
Source: Author.
174 | MUSHTAQ H. KHAN
the few observations in cluster 2. Taking the earlier discussion into account, two
main observations challenge the causality suggested by such a regression exercise.
First, no examples exist of any country that initially improved its governance to
advanced country levels to achieve equivalent per capita incomes, growth rates, or
other characteristics. Reading this as a possibility from the regression line is mislead-
ing. As figure 2 suggests, the route to advanced country status may be quite different.
Second, the growth rates in high-growth developers were associated with gover-
nance indicators that were insignificantly or only moderately better than developing
country averages. By the 1980s, some of the high-growth countries had been rapidly
growing for a few decades, and their relatively high per capita incomes would have
allowed governance improvements to happen anyway. In other words, we would
expect their ex ante governance indicators to be somewhat worse than the indicators
we have for the 1980s, but even using the corruption indexes for the 1980s, the high-
growth economies do not have significantly lower corruption. However, this fails to
have any effect on the regression simply because the high-growth countries were so
few in number. If there were more high-growth countries, we would probably have
observed an inverse U relationship as observed in the case of democracy (Barro 1996).
The nonlinearity of the data suggests that something else was happening in the high-
growth economies that has not been identified or that the main direction of causality
has been misunderstood. Saying that countervailing factors, such as high investment
rates or high efficiency of investment, operated in the high-growth economies is not
enough, because the institutional argument is that good governance has an economic
effect precisely by enhancing investment and its efficiency.
In this context note that not all econometric work supports the new consensus
models. In particular, Treisman (2000) finds that the effects of democracy and decen-
tralization on corruption are weak, while Burkhart and Lewis-Beck (1994) find that
rises in per capita incomes precede the emergence of democracy and not the other way
around. However, in the published literature, contrarian results are relatively rare.
These observations do not imply that governance reforms are unimportant. As
governance is what states do, and as the state plays a critical role in pushing social
transformations, I believe that governance reforms are even more important than the
good governance framework suggests. However, the state capacities identified as
being critical have little to do with the good governance characteristics derived from
an abstraction of the liberal-democratic state observed in advanced capitalist coun-
tries. Rather, far from being a precondition for rapid growth, a more consistent inter-
pretation of the historical evidence is that it shows that good governance—in the
sense of less corruption and deeper democracy—is typically an outcome of success-
ful economic development.
The correlation exercises are also misleading in a fundamental respect. The claim
that if all else remains the same, then higher levels of corruption will lead to poorer
economic performance is simply an arithmetic observation that we do not need to
question. The point is whether corruption can be reduced sufficiently in failing states
to contribute to an economic takeoff. To begin to approach the levels of development
of the advanced countries, developing economies have to grow not just at advanced
country rates, but much faster. Even if the regression line in figure 2 accurately
STATE FAILURE IN DEVELOPING COUNTRIES | 175
identified the causality from corruption to growth, reducing corruption to advanced
country levels would only allow group 3 countries to grow at group 1 rates. The his-
toric challenge is to approach group 2 growth rates, but the good governance frame-
work does not address this question.
I am not saying that corruption is costless, let alone that it is in any sense func-
tional, nor that democracy is not a fundamental right that people in developing coun-
tries strive for. The issue here concerns the degree to which sustainable reductions in
corruption or improvements in democracy can be attained before broadly based eco-
nomic prosperity has been achieved, and even more important, whether these
reforms are likely to accelerate economic growth sufficiently to make any impact on
poverty (Khan 2002a).
The Social Transformation State
States in developing countries play a much more critical role than the service delivery
model suggests. Developing societies are undergoing unprecedented social and eco-
nomic changes in which states inevitably deploy economic power and violence poten-
tial for better or for worse. As rising expectations and social mobilization destroy the
political and economic viability of traditional societies, staying still is not an option.
Far from being a service provider, the state is an instrument in the hands of con-
tending classes, groups, and political entrepreneurs, each attempting to capture
resources and steer the transformation in specific directions. State institutions and
policies are always the outcome of conflict and negotiation between contending
forces, but in advanced capitalist countries that already have a dominant capitalist
sector, democratic politics usually oscillates around a relatively narrow range of
options that seeks to conserve the dynamism of the capitalist sector, and parties
usually differ only at the margin in terms of distribution. This reflects two economic
facts. First, many of the resources for running the political system come from the
capitalist sector, which therefore has considerable influence on policymaking. Second,
and more important, the dominance of the capitalist sector means that the immedi-
ate welfare of most people, even if they are not capitalists, depends on the health of
the capitalist sector. Neither of these restrictions operate to the same extent during the
transition to capitalism, when the capitalist sector is, by definition, not dominant.
The absence of a dominating feedback loop from the performance of the capitalist
sector to the policymaking process in developing countries allows a much greater
range of variation in policies and institutions, and makes it possible for sustained
state failure to persist when it comes to organizing a dynamic capitalist transforma-
tion (Khan 2002b). During this transition period, state success or failure is not relat-
ed in any simple way to the state’s neutrality in upholding preexisting property rights
or its abstention from intervening in the economy or in social conflicts. If these were
indeed important preconditions, a minimalist service delivery state tightly constrained
by good governance reforms would begin to make sense as a policy goal.
In connection with the potential locations of state failure during the transforma-
tion, states have differed along four dimensions. First, transformation states have
176 | MUSHTAQ H. KHAN
differed in terms of their institutions and policies. Second, they have differed in terms
of how effectively they enforced these institutions. Third, they have differed in rela-
tion to the costs of enforcement, defined as the costs of creating, operating, and
enforcing institutions. Finally, they have differed in the processes driving institutional
change. Institutions have changed in efficient directions in some cases, but not others.
This relates back to the first dimension: if damaging institutions continue to exist,
slowing down the transformation, why do they not change? In a dynamic setting,
errors of omission do not really differ from errors of commission.
Figure 3 shows how a state’s growth performance can be attributed to the first
three dimensions. Growth requires not only that the state supports institutions that
drive the capitalist transformation, but also requires effective enforcement of these
institutions and relatively low costs of enforcement. If growth is systematically low,
then the fourth factor, the process of institutional change, will have to be considered.
Institutions and Policies during Social Transformations
The liberal market consensus argues that the institutional structure for maximizing
growth is one that ensures the absence of rents. The main task for the state is
supposed to be the delivery of democratically agreed on public goods. While service
delivery is important, evidence from developing countries casts doubt on its adequacy
for ensuring rapid social transformation. Indeed, the state’s ability to carry out rela-
tively massive interventions in property rights systems and to create and manage
growth-generating rents has been critical in high-growth economies. States have also
carried out significant transfers that have contributed to political stability and thereby
made the emerging institutional structure politically viable.
Dynamic States Can Alter Property Rights in the Interests of Growth
Consensus theorists have frequently pointed out the instability of property rights in
poorly performing countries, but in dynamic countries, the rapid emergence of new
classes of capitalists has typically also entailed relatively long periods of instability of
preexisting rights. This is not surprising. All developing countries are characterized
1. Choice of institutions
and interventions
2. Effectiveness of
implementation
Potential growth
associated with
institutions and
interventions supported
by the state
3. Costs of
enforcement
minus
Observed growth associated with institutions and interventions supported by the state
FIGURE 3. Factors Determining State Success or Failure
Source: Author.
STATE FAILURE IN DEVELOPING COUNTRIES | 177
by large precapitalist sectors that have become unviable and that do not produce
enough of a surplus to pay for the protection of their rights. Some of these rights
begin to be transferred to more efficient users through the market, but in every
developing country a significant part of these necessary transfers takes place through
nonmarket mechanisms. These include politically mediated transfers of assets (land
reform, transfers through the fiscal mechanism), indirect politically mediated trans-
fers (licensing of land use, manipulation of relative prices), and illegal and quasi-legal
activities (land grabbing, staking claims on common property). The scale of non-
market transfers at this stage can be explained first by the absence of a preexisting
and already efficient capitalist sector that can purchase these rights through the mar-
ket mechanism. Second, the transaction costs of strictly legal exchanges are typically
high at this stage, because constructing a generalized institutional structure that can
ensure low transaction costs for all market participants is itself an expensive propo-
sition that is difficult to implement until the economy collectively produces a suffi-
cient surplus to pay for it. While nonmarket transfers play a necessary role at this
stage, these transfers of assets can and do contribute to the perception that property
rights are unstable and contested in developing countries.
If and when a dynamic capitalism emerges through these processes, the new prop-
erty rights system can rapidly stabilize, because dynamic emerging capitalists can
soon spend enough to control or influence the state to protect their rights. Thus a
look at property rights stability in high-growth economies once their growth has sta-
bilized can give the misleading impression that property rights stability was the cause
of growth. This is where historical evidence is important. Even superficial historical
observations show that virtually all high-growth countries undertook or allowed
dramatic reallocations of property rights in the early stages of their takeoffs. The
stability that distinguishes high-growth countries is not a stability of property rights,
but rather a more subtle commitment to growth and to transfer and protect rights in
ways that promote growth.
For instance, before the economic takeoff in Korea and Taiwan (China), their states
carried out rapid and far-reaching land reforms, in Korea between 1949 and 1950 and
in Taiwan (China) between 1949 and 1953. The state compulsorily acquired all agri-
cultural land above a low landholding ceiling at a price well below the market price
and distributed it to tenants at this artificially low price. By any account, such
enforced transfers are not consistent with well-defined property rights. In Thailand,
transfers of public and common property resources to emerging capitalists took place
in a more decentralized way through “primitive accumulation” organized by emerg-
ing capitalists who controlled local money politics and the state (Pasuk and Baker
1997). Not surprisingly, in the 1980s Thailand was characterized as one of the most
corrupt countries in the world, and yet managed to grow rapidly for decades. Failed
transformation states are also characterized by regular seizures of land and resources
by the politically connected from the weak and unconnected, but in these cases the
grabbers are not operating under a broader institutional system that induces or forces
them to become productive capitalists.
Lal and Myint (1996) point out that the most important role of the publicly-
owned banking system in the context of Korea’s industrial policy was to transfer
178 | MUSHTAQ H. KHAN
massive amounts of wealth to an emerging capitalist class much more rapidly than
might have happened in a market, while maintaining sufficient discipline to ensure
that this process was not entirely captured by inefficient groups. Indeed, the ability
of the Korean state to reallocate rights through nonmarket mechanisms contributed
significantly to the effective implementation of its industrial policy regime. Its condi-
tional subsidy scheme, which essentially subsidized technology acquisition by emerg-
ing capitalists, could have had high social costs if many subsidized plants failed to
acquire new technologies rapidly, and became bankrupt. However, the Korean state
demonstrated its ability to reallocate entire plants across industrial groups before fail-
ure had set in, using its financial muscle in the banking sector to get its way (Chang
1994; Lee 1991). By not having to respect the limitations of property rights, civil
courts, and procedures, the Korean state could credibly threaten inefficient capital-
ists with the loss of their assets if they did not meet state export targets, and the state
was able to implement these threats with little opposition from the courts or from the
losers themselves. In other words, far from weakly defined rights holding back
Korea’s development, they allowed the implementation of a hothouse strategy for
acquiring technology.
This power was often misused, for example, in 1985 when the Kukje group, the
country’s sixth largest conglomerate at the time, was brought down because it offered
insufficient paybacks to the regime (Far Eastern Economic Review April 21, 1988;
Fields 1995). The government’s ability to push the chaebol (big conglomerates) around
clearly reflected the latters’ weak property rights. This political ability on the part of
the state inevitably declined over time, so that in 1990, when President Roh Tae-Woo
ordered 49 chaebol to sell real estate holdings that he believed were speculative, he
found that obtaining compliance was extremely difficult (Fields 1995). The growing
political independence of the chaebol and the increasing technological complexity of
the Korean economy were clearly related to the decline of the Korean industrial policy
system in the 1990s (Khan 2000b), but by then Korea was already an industrialized
economy. The important observation is that when the Korean economy took off, the
chaebol did not enjoy well-defined property rights in the conventional sense.
In contemporary China, property rights in many of the most dynamic sectors are
also not well defined, and even though China’s institutions are very different from
those of Korea, they are once again assisting the capture of resources by emerging
dynamic entrepreneurs (Qian 2002; Rodrik forthcoming). China’s dynamic township
and village enterprises account for at least 40 percent of industrial employment and
exports, but observers have been puzzled about the vagueness of property rights in
relation to these enterprises’ assets (Bowles and Dong 1999). Although notionally
owned by townships or villages, they are actually controlled by dynamic managers
who own a small share of the residual. This is puzzling to those who believe that
much clearer ownership of the residuals is required for dynamic management. The
answer may be that the very vagueness of rights in China is allowing an effective
transfer of rights over public assets to an emerging class of entrepreneurs, and that
these proto-capitalists are confident that the state will formalize their de facto owner-
ship in the long run provided they remain efficient. In the meantime, this arrangement
keeps social contestation low and prevents the upheavals that straightforward
STATE FAILURE IN DEVELOPING COUNTRIES | 179
privatization might have unleashed (Qian 2002). It is the political coalition backing
growth that was new in China after the 1980s. The state’s ability to restructure
property rights in line with its changing objectives is not, and has been demonstrated
time and again since 1949.
Contemporary China scores somewhat higher than the average developing coun-
try in rule of law indexes, but these are based primarily on risk perceptions by joint
venture companies in export zones. These indexes are misleading, because while
export-oriented companies in China are fairly safe from expropriation, other holders
of rights are not. A more instructive approach would be to look at the state’s ability
to reallocate rights over land, and indeed its ability to control internal population
movements that allowed it to set up massive export zones in the first place. Such a
degree of power is, of course, not always desirable. As an example of a controversial,
state-driven reallocation of rights, consider the Three Gorges Dam project. Nearly
2 million people are to receive compulsory compensation on a scale and at a time
decided by the state, and many others who are displaced will probably never be com-
pensated. Setting aside questions about the project’s technical viability and cost-
benefit ratio, it is an example of how the Chinese state can reallocate property rights
if it believes that a project will further national development. In contrast, property
rights are much better defined in many developing countries such as India, where
projects much smaller than the Three Gorges Dam have been successfully blocked
in the courts for years. Again, whether this is in the social interest or not depends on
the specific projects, but arguing that property rights are well defined in China and
that this has driven its growth would be wrong.
Dynamic States Can Manage Growth-Enhancing Rents
and Destroy Growth-Reducing Rents
The mere emergence of proto-capitalists is not sufficient to ensure that they have the
capacity to compete. Historically, developing and maintaining competitiveness has
required interventionist and regulatory capacities on the part of the state to create, as
well as to remove, different types of rents. In an important critique of the standard
model of market competition, Stiglitz (1996) argues that a wide range of information
rents are critical for the working of an efficient market system. These information
rents create the incentives for information to be generated and properly used. A well-
established and advanced market economy would need institutions to regulate these
information rents, to ensure that information was not cornered in such a way that these
rents became monopoly rents, and to make sure that markets continue to work
efficiently. No less important are Schumpeterian rents that are essential for driving
innovation in market economies. These too require regulation to ensure that
Schumpeterian innovators do not become effective monopolists over time. In develop-
ing economies, the rent management problem is even more acute. Emerging capitalists
often lack technological capacities, and even entrepreneurial capacities, to compete in
world markets. Learning to use advanced technologies involves high risk, and the
private return can be lower than the social return. At the same time, many types of
unproductive activities can yield high returns. In such contexts, state-created “learn-
ing rents” have often accelerated the acquisition of technology and the development of
180 | MUSHTAQ H. KHAN
entrepreneurial skills, thereby enabling capitalist market economies to develop. Thus
analysis reveals the existence of a range of positive or growth-enhancing rents in devel-
oping countries, such as information rents, Schumpeterian rents, natural resource
rents, and learning rents (for more on growth-enhancing and growth-reducing rents,
see Amsden 1989; Aoki, Kim, and Okuno-Fujiwara 1997; Khan 2000a; Lall and
Teubal 1998; Page 1994; Rodrik 1995; Wade 1990; World Bank 1993).
However, in the case of almost all growth-enhancing rents, effective regulation is
essential for these rents to have a positive effect. Schumpeterian rents or learning rents
can, in theory, have limited, or even negative, effects if they last for too long or for
not long enough, suggesting an inverted U relationship between learning and the
period of protection of learning rents (Khan 2000a). The optimal period of protec-
tion is not technically determined, and learning is most rapid when transformation
states have the pragmatic capacity to observe performance and the much more diffi-
cult political capacity to reallocate rents when necessary. Incidentally, a similar invert-
ed U relationship between innovation and the degree of competition is also found in
advanced countries like the United Kingdom, suggesting that extremely competitive
markets are not always desirable (Aghion and others 2002).
In contrast, the damaging effects of such growth-reducing rents as monopoly rents
are well known. Growth-reducing rents also have to be removed through competi-
tion policy and regulation, but both theory and evidence suggest that the creation of
dynamic capitalist economies requires much more than institutional structures and
policies that ensure that no rents emerge. Because many rents are critical for rapid
entrepreneurial growth and technology acquisition while other rents are extremely
damaging, rapid growth requires a more demanding set of institutions with the reg-
ulatory capacity to distinguish between different kinds of rents and with the political
capacity to create, destroy, or manage rents to generate growth and rapid transfor-
mation. The rents that need to be managed can vary widely across developing coun-
tries depending on their initial endowments, their level of development and the
technologies being used or adapted, and their internal political settlements. As a
result, the rent management institutions and the political arrangements that have
allowed them to be effective have varied considerably across successful developers.
Nevertheless, all successful developers had states that actively intervened in markets
to create and manage rents and property rights (Aoki, Kim, and Okuno-Fujiwara
1997; Khan and Jomo 2000). In all successful countries, states manipulated changes
in property rights to accelerate the emergence of proto-capitalists and managed rents
to accelerate the acquisition of technology by these proto-capitalists while ensuring
that inefficiency was not sustained or increased. At the same time, transformations in
states that lacked these institutional and political capacities were blocked or took
place much more slowly (Khan 2000b).
The World Bank and other agencies that support the good governance and service
delivery agenda have often recognized the highly interventionist and rent-creating
role of the state among the successful developers (for instance, World Bank 1993),
but they have immediately followed this observation with the argument that these
countries were few in number and had exceptional state capacities. In the absence of
such state capacities, they argue, focusing the state on core service delivery and
STATE FAILURE IN DEVELOPING COUNTRIES | 181
relying on good governance reforms is better. My response to this is twofold. First,
while successful developers are indeed few in number and their state capacities were
exceptional, however exceptional they were, no examples exist of failed or failing
states that adopted good governance policies and then enjoyed a sustained and suc-
cessful capitalist transformation to achieve prosperity. Second, it therefore follows
that however exceptional the capacities of the successful developers, we have to learn
the lessons of how best to develop state capacities in the direction of these countries
if performance is to be improved in the less satisfactory cases. As no single model of
interventions is common across all the high-growth countries, what we are learning
are general principles that then have to be translated into specific institutions given
the political realities and initial conditions of different countries.
Dynamic States Can Organize Ring-Fenced Transfers
to Maintain Political Stability
In developing countries, no less than in advanced ones, maintaining political stability
often requires significant state-organized transfers. Massive social dislocations also
make social instability a much more serious problem in developing countries. Official
budgetary transfers are a small fraction of the overall system of hidden patron-client
transfers that are routinely deployed to maintain stability in these contexts. In theory,
transfers that cannot be contested by further rent-seeking can have relatively low
deadweight costs. In reality, transfers can actually cause serious economic damage if
fragmented groups can capture resources by creating or capturing a large number of
uncoordinated, value-reducing rents. When high-growth states like Malaysia needed
to organize significant transfers to maintain political stability, they were able to cen-
trally organize and ring-fence these transfers, which means that further rent-seeking
over the type and allocation of transfers was virtually ruled out. Distributive coali-
tions were prevented from trying to capture additional rents by capturing public good
provision systems or subsidies for industrial learners. To the extent that a state can
achieve this, a system of significant transfers can be compatible with rapid growth
(Jomo and Gomez 2000). Where it cannot, as in India, fragmented rent capture can
contribute to the poor provision of public goods and the protection of inefficiency
(Khan 2000a,b; Bardhan 1988).
These observations suggest that the creation of high-growth conditions is a much
more demanding process than the standard model suggests. Even a cursory exami-
nation of the evidence suggests that takeoffs in high-growth countries were not pre-
ceded by the achievement of property rights stability and the removal of rents.
Rather, as table 2 summarizes, high-growth transformation states intervened in prop-
erty rights to accelerate the emergence of productive capitalist classes; created and
managed rents to accelerate technology acquisition and promote entrepreneurial
capacity; and maintained political stability through transfers, often on a large scale.
They also delivered public goods efficiently as the standard theory demands, but that
is not surprising, because with growing prosperity bureaucrats could be properly
paid, and increasing fiscal resources meant that states could meet generalized, as
opposed to particularistic, demands.
182 | MUSHTAQ H. KHAN
Even when they recognize many of these theoretical and historical observations,
economists remain reluctant to trust the state, and with good reason, particularly in
developing countries. Thus after developing some powerful critiques of the liberal
market model, Stiglitz (1998b) argues that governments should be prevented from
restricting competition or intervening in areas where there are special interests, or in
other words, from creating rents. This policy caution is clearly based on a skepticism
about the capacity of the state to create and manage growth-promoting rents, a skep-
ticism that is entirely justified given the vast majority of poorly performing states. But
as their own work on financial institutions points out (Hellman, Murdock, and
Stiglitz 1997), state-created rents played an important role in explaining the success,
and not just the vulnerability, of the Asian high-growth economies. Thus Stiglitz, like
the World Bank, is implicitly saying that while high-growth economies had the capac-
ity to create and manage vital rents, most states cannot be trusted to do this.
Saying that East Asian institutions and transformation strategies are not directly
relevant to failing states that clearly lack critical capacities is entirely correct. How-
ever, the evidence of equally limited success in implementing good governance
reforms and creating liberal market economies in countries with failing states suggests
that the problem may be that even a competitive market economy may require sub-
stantial regulatory capacities. What is more, attempting to construct liberal market
economies in countries where a viable capitalist class has not yet emerged or learned
to use modern technologies is likely to fail anyway. However imperfect and partial
the process of enhancing these interventionist capacities, directly tackling the weak
transformation capacities of developing country states may be the only option.
TABLE 2. Institutions and Interventions in Transformation States
Type of Rent and
transformation Property rights competition policy Service delivery
Dynamic Protection, creation, Regulatory and industrial Efficient provision
transformation and transfers of policy to manage growth- of infrastructure by
state property rights for enhancing rents ring-fenced institutions
productive groups
Destruction or loss of Regulatory and Ring-fenced
property rights of competition policy transfers to maintain
unproductive groups to remove growth- political stability
reducing rents
Stagnating Protection, creation, Protection of growth- Service delivery systems
or failed and transfers of reducing rents captured by privileged
transformation property rights for groups
state unproductive groups
Destruction or loss of Open-ended transfers
property rights of to maintain political
productive groups stability
Source: Author.
STATE FAILURE IN DEVELOPING COUNTRIES | 183
Effectiveness of Institutional Enforcement
In advanced economies, the state’s monopoly of legitimate violence has become a
metaphor for describing the state’s ability to enforce institutions. In developing coun-
tries, states often do not have this monopoly and find enforcing any institution diffi-
cult (Bates 2001). The effectiveness of enforcement is a measure of the degree to
which agents with notional residual control rights in an institutional structure can
actually enforce their decisions. Residual control rights are rights to determine
resource allocations that are not otherwise controlled by law or assigned to others by
contract. If the owner of a property right cannot actually sell the right or make hiring
and firing decisions freely, or if an industrial policy planner with residual control
rights over the allocation of subsidies cannot actually reallocate them, the extent to
which they cannot do so is a measure of the ineffectiveness of enforcement. In the
1960s and 1970s, developing country states did not just fail to enforce dynamic trans-
formation regimes effectively, they failed to enforce even the existing structure of
rights (North 1990). How can this systematic failure be explained?
The conventional explanation is that this was a problem of credible commitment
on the part of the state. Because the state has no higher enforcer, in principle it can
subvert property rights ex post to appropriate the investments of others (Bardhan
2000; Bates 2001; Stiglitz 1998b). If this was the major source of enforcement failure
in developing countries, having democratic or other constraints on the state that made
it difficult for state leaders to change their ex ante commitments easily would be nec-
essary. But as already noted in the context of both property rights transfers and rent
management, growth during the capitalist transition has required a great deal of ex
post flexibility (a term suggested by Okuno-Fujiwara 1997) on the state’s part. Far
from protecting the property rights inherited from the precapitalist past, dynamic
transformation states in say China or Korea have been the agency through which
massive property rights transfers were organized and the necessary rents created,
maintained, and changed as required. As a result, history suggests a much more
demanding commitment on the part of the high-growth states. Instead of committing
ahead of time not to intervene in property rights and markets, high-growth states have
to commit to disrupting property rights and creating rents, but in ways that promote
growth. Of course, commitment here is another metaphor, because in reality the state
is not an agent that can commit or not commit to do anything. Rather its ability to
enforce critical rights and rents depends on the interests and organization of power-
ful groups in society and the balance of power between them.
Effective enforcement requires both institutional capacity and institutions com-
patible with the interests of powerful social groups. When the state is engaged in
managing rents and intervening in property rights to promote a capitalist transfor-
mation, enforcement is more difficult than in an advanced capitalist economy, both
from the perspective of institutional capacity (because the state has to have the capac-
ity to do positive things), and because social resistance and rent-seeking are likely to
be more intense. Obviously institutional capacity is important: enforcing or trans-
forming a property rights system is impossible without the appropriate bureaucratic
capacity. At the same time, however, institutional capacity is insufficient without
184 | MUSHTAQ H. KHAN
effective political capacity to overcome the resistance of powerful social groups who
are opposed to particular property rights transformations or the implications of par-
ticular rent-management strategies.
Institutional and political factors are closely intertwined, because the political fail-
ure to enforce productive rights and rents can often rapidly lead to a loss of morale
and personnel in the bureaucracy and persuade the remaining public officials to share
unproductive rents as a second-best strategy. One of the worrying trends in many
developing countries has been the worsening institutional capacity of the state and
the quality of public officials. By contrast, the achievement of better enforcement
capacity can often make previously predatory leaders commit themselves to dynamic
transformation strategies that can offer them higher personal payoffs if they can be
enforced. Consider the case of Chiang Kai Shek before and after 1949. In pre-1949
China, the relative weakness of the Kuomintang and its failure to control competing
warlords led the Chiang Kai Shek regime to follow highly predatory policies, but in
post-1949 Taiwan (China), the same party and leader organized an exemplary devel-
oping state, largely because the balance of power between state and society in Taiwan
(China) allowed the state to engage in effective enforcement of transformation
strategies. Case studies of high-growth transformation states suggest that improving
enforcement capacity has been based on a range of political strategies, including the
neutralization of unproductive groups, the creation of political organizations of pro-
ductive groups to counter the power of unproductive groups, or even the accommo-
dation of some unproductive groups through less damaging transfers (Khan 2000b;
Wade 1990; Woo-Cumings 1999).
In Korea, the enforcement of its industrial policy regime from above relied on the
absence of well-organized factions that could protect inefficient industrial interests.
The fragmentation of organized, middle-class political factions by Japanese colonial-
ism and of traditional landed elites by far-reaching land reforms meant that recipients
of subsidies could not easily buy protection from organized factional politics. This
power structure ensured that the state could allocate rights and rents to whomever it
liked, and this in turn ensured that the state had no interest in accepting payoffs
from the inefficient, because it was better served by promoting the efficient and
thereby captured even bigger payoffs (Amsden 1989; Chibber 1999; Kohli 1994;
Woo-Cumings 1997).
In Thailand in the 1980s, industrial policy was less important, but the intense
primitive accumulation organized by a more dispersed class of emerging capitalists
drove growth. The latter aggressively captured valuable common property and public
resources. They were able to enforce their captured rights effectively, because unlike
in most developing countries, Thai capitalists directly controlled many of the factions
involved in competitive politics and could buy themselves access to state power. At
the same time, intense competition between capitalist factions prevented any poten-
tially monopolistic faction from capturing the state for long. Thus the enforcement
of emerging capitalist property rights from below reflected the capture of political
factions by emerging capitalists (Doner and Ramsay 2000; Pasuk and Baker 1997;
Rock 2000).
STATE FAILURE IN DEVELOPING COUNTRIES | 185
Yet another pattern is discernable in Malaysia, where the state’s ability to attract
multinational investors by credibly promising to protect their rights drove growth in
the 1980s. Its ability to do this was based on a unique, internal, ethno-political
arrangement that created massive, but ring-fenced, transfer rents that bought off
those who would otherwise have contested the state’s policies. Thus the compatibil-
ity between institutional enforcement and political forces was brought about by the
state’s organization of politics in a way that allowed it to buy off potential opposi-
tion through a form of highly centralized clientelism (Jomo and Gomez 2000). This
assured investors, including multinationals, that internal distributive conflicts would
not spill over to affect them.
Thus while the growth-promoting transformation interventions varied across coun-
tries, enforcement was effective in all the high-growth countries, because the institu-
tions of social transformation enforced by the state were compatible with, or could not
be opposed by, powerful, organized interests within these societies (Khan 2000b).
In contrast, an inability by the state to suppress or accommodate interests opposed
to transformation is frequently observed in cases of ineffective enforcement.
Pakistan’s industrial policy regime of the 1960s failed, even though the quality of its
planning personnel was moderately good and its military leadership was committed
to export-led growth. Control over enforcement was, as in Korea, formally central-
ized in the president’s office. Yet institutional enforcement failed, because unproduc-
tive subsidy recipients discovered that they could easily purchase protection in a
society with many fragmented but powerful political organizations (Khan 1999).
Centralized industrial policy was not compatible with this fragmented distribution of
social power. While subsequent liberalization and privatization did attack some
aspects of the rent capture that had become entrenched under statist strategies in
South Asian countries (Bhaskar and Khan 1995), during the liberalization of the
1980s, these countries also discovered that their states could not properly enforce any
property rights and were unable to make a significant dent in growth-reducing rent-
seeking by unproductive groups (Bardhan 1988). Thus enforcement capacity of any
variety has a political dimension, and in most developing countries this is the critical
dimension where state failure is frequently located.
These observations suggest that policy to improve enforcement in developing
countries is unlikely to succeed if it simply focuses on the institutional capacity of
enforcement institutions, such as anticorruption bureaus or judiciaries. A compatible
package of institutional reform and political restructuring of organized power is need-
ed that may allow better enforcement of a dynamic transformation strategy in the
future. Here the notion of feasibility is important, as Qian (2002) suggests in the case
of China. Ambitious transformation strategies as used in Korea that promise high
growth if properly enforced are only potential options; if compatible political arrange-
ments are unfeasible, such strategies will fail. Fortunately, alternative transformation
strategies do exist, as the cases of Malaysia, Thailand, and other high-growth devel-
opers show, but even these require specific internal political settlements to ensure their
enforcement. No country is likely to be an exact replica of any of the high-growth
economies of the past in terms of the mix of policies, institutions, and political
186 | MUSHTAQ H. KHAN
settlements. Nevertheless, the lesson is that poorly performing countries have to take
much more deliberate steps than conventional policy advice suggests to construct
compatible packages of institutions and political settlements to achieve even second-
best transformation success. A starting point must be a much better understanding of
the experience of transformation in the dynamic transformation economies.
Costs of Enforcement
The effectiveness of enforcement should not be confused with the costs of enforce-
ment. Enforcement costs include the costs of policing, regulating, and lobbying; the
resources spent on economic and political corruption; and the costs of all types of
political activity, from maintaining patron-client networks to contributions to politi-
cal parties. Indeed, enforcement costs include all expenditures and activities, regard-
less of their legality or morality, that aim to protect or change rights or rents. Thus
enforcement costs are nothing but rent-seeking costs defined in the broadest possible
way. In theory, lower enforcement costs are obviously better for the economy, but in
practice, enforcement costs are likely to be significant even in countries with effective
enforcement of transformation strategies.
Clearly the elements of rent-seeking most relevant to a particular case will depend
on the institution and on the country and its stage of development, but given that every
right, rent, and intervention is valuable for someone, the overall costs of rent-seeking
are likely to be high in every economy, regardless of its success or failure (Samuels and
Mercuro 1984). Crude estimates of overall transaction costs in advanced economies
confirm this (North and Wallis 1987), as do observations of widespread rent-seeking
in all developing countries, including the high-growth ones (Khan 2000b). Every act
of attempted enforcement has a cost regardless of the type of intervention, the right or
the rent that is being enforced, and the success of the enforcement. Thus as a simpli-
fication, the intervention and the effectiveness of its enforcement can be viewed as
determining the gross or potential output, with the deduction of the cost of enforce-
ment giving the net or actual output (see figure 3). This is a simplification, because
enforcement costs are not really a deduction from output, but represent costs that pre-
vent economic activity in the first place. Nevertheless, this simplification helps us
understand why the share of enforcement costs in gross domestic product is likely to
be high even in efficient and dynamic transformation economies. If the degree of inter-
vention and rent creation is high, then the aggregate enforcement costs as a share of
gross domestic product will also be high. What is different about the successful trans-
formation economy is simply the types of interventions and the effectiveness of
enforcement.
The Location of State Failure
Figure 4 summarizes the discussion so far. Societies can differ both in terms of the
rents and rights they effectively enforce and their enforcement costs. Nonperforming
states score badly on both counts. The service delivery and good governance model
assumes that the solution is to eliminate all rents as a way of reducing enforcement
STATE FAILURE IN DEVELOPING COUNTRIES | 187
costs, using strengthened property rights and anticorruption strategies as a way to
reduce the state’s capacity to create rents. Such reforms attempt to achieve an unat-
tainable goal that has no convincing historical precedents. Instead successful trans-
formation states have intervened heavily in property rights and rents, and while their
aggregate rent-seeking and enforcement costs have been high, the internal disposition
of political power has allowed them to effectively enforce critical changes in rights and
rents essential for a capitalist transformation. If lessons from history are to be learnt,
the reforms suggested (see figure 4) are entirely different. Instead of trying to reduce
enforcement costs by stabilizing property rights and reducing rents, reformers should
focus on identifying in each case the critical state capacities needed to enable the inter-
ventions in rights and rents necessary for accelerating a capitalist transformation.
Enforcement costs are likely to remain high under such a strategy, including perhaps
illegal enforcement costs such as corruption. In many cases progress along these lines
will also require a discussion on how issues of political and organizational power need
to be addressed, something that has received little attention so far.
The argument presented here explains why high-growth states do not score signifi-
cantly better than the developing country average in terms of conventional governance
indicators. Most indicators of good governance, such as corruption or expropriation
risk, are primarily imperfect measures of perceived enforcement costs. The theoretical
expectation in the liberal market model is that high enforcement costs and bad inter-
ventions or policies go together. In reality, because many rents and property rights
interventions are growth enhancing, particularly during the transition to capitalism,
(low growth quadrant) (highest growth quadrant)
(intermediate growth quadrant)(lowest growth quadrant)
Theoretical service delivery state
(liberal market consensus) Theoretical developmental state
High-growth transformation states
Most failed and failing states
Range of
historical observations
High rent-
seeking
costs, high
corruption
Low rent-
seeking
costs, low
corruption
Growth-reducing rents and rights
and/or ineffective enforcement
Effective enforcement of
growth-enhancing rents and rights
Costs of enforcement
Institutions and interventions
(institutional choice and effectiveness of enforcement)
Service delivery reforms
Transformation state reforms
FIGURE 4. Social Transformations and the Location of State Failure
Source: Author.
188 | MUSHTAQ H. KHAN
and because such interventions are likely to provoke high enforcement costs, it is not
surprising that we find at best a weak correlation between most governance indicators
and developing country performance. The correlation that is picked up between
governance and economic performance only reflects the fact that most developing
countries lack dynamic transformation capacities, so that high enforcement costs and
poor governance as defined in the service delivery sense appear to correlate with poor
growth. The huge jump in growth in the high-growth economies with insignificantly
better governance indicators (figure 2) suggests that the relationship between gover-
nance and growth in the consensus approach is mis-specified and that the missing vari-
ables are those that measure the state’s dynamic transformation capacity.
From a policy point of view, this analysis suggests why an uncritical application of
the good governance and service delivery framework may potentially do more harm
than good. Everything else remaining the same, lower enforcement costs, in particu-
lar, lower levels of corruption, are always preferable to higher enforcement costs. This
is simply arithmetic in terms of the logic outlined in figure 3. Hence it is not surpris-
ing that when countries with similar economic policies and levels of development are
compared, or when these factors are fully controlled for, economic performance is
better when corruption is lower (Rodrik 1997; Wei 2000).
Lowering any cost is always beneficial, and this result is important, but not par-
ticularly profound. Not only that, the result can be misleading, because enforcement
costs can be associated with completely different state interventions in property rights
and rents during the transformation period and beyond. If reformers attempt to
reduce corruption by reducing the state’s capacity to intervene in general (in the direc-
tion of the service delivery reforms shown in figure 4), they may reduce corruption
marginally in the short run, but they may also fatally damage the possibility of cre-
ating a developmental transformation state. This is because destroying a state’s
capacity to create bad rents through downsizing, decentralizing, subcontracting to
nongovernmental organizations, and attracting the best talents away from the state
all rapidly add up to a state that is incapable of creating, maintaining, or regulating
any growth-enhancing rents either. Without such a capacity, the possibility of dra-
matic growth, and therefore of a sustainable and lasting impact on corruption and
democracy, is also fatally delayed. Thus while anticorruption and democracy are vital
goals, a critical first step is to focus on developing state capacity for a capitalist trans-
formation in the direction of the very different reform path shown as the dynamic
transformation path in figure 4.
Transforming the State
Finally, if the state is not already a dynamic transformation state, the state itself has
to be transformed. Are the critical variables here political will and political institu-
tions or the organization of social power?
Political Will and Political Institutions
Political will is the least likely explanation of sustained differences in performance,
not because it is not necessary, but rather because it is not as scarce as often thought.
STATE FAILURE IN DEVELOPING COUNTRIES | 189
Committed reformers with considerable political will have often failed in many coun-
tries because accommodating social conditions were absent. Nor do political institu-
tions provide a sufficient explanation of transition success. North (1990) made the
case for democracy as an institution that facilitates efficient transitions, arguing that
democracy would best accelerate the creation of efficient institutions by providing an
efficient way of organizing transfers to compensate losers. This is a theoretical possi-
bility, but almost none of the significant path changes in high-growth developers over
the last century took place through formally democratic institutions. Nor did coun-
tries with formal democracy, such as India, do well in organizing growth-enhancing
institutional change. In contrast, Olson (1982) points out that special interest groups
that have an advantage in organizing rent-seeking compared with the rest of society
are likely to dominate democracies, a perspective developed in Bardhan’s (1984) work
on rent-seeking in India. Democracy is an end in itself, but historically it has been nei-
ther necessary nor sufficient for ensuring growth-enhancing institutional change.
Social Power
When developing countries become mired in low growth or in stagnant transforma-
tion processes, the failure is widely perceived and understood in these countries, not
just by policymakers and politicians, but by society at large as well. Any investiga-
tion of why the state cannot introduce growth-enhancing strategies leads quickly to
the identification of powerful interests opposed to change who can impose unac-
ceptable costs on others or on the state. In this sense, the problem of transition is no
different from that of enforcement, except that the former concerns the formal intro-
duction of institutions and the latter concerns their real operation. Not surprisingly,
the distribution of power between social factions and classes provides a good histor-
ical explanation of the pace and direction of institutional change in many countries
(Bardhan 2000; Brenner 1976, 1985).
The service delivery approach to the state also recognizes the importance of build-
ing constituencies to support state reform processes (see, for instance, World Bank
1997). However, what is involved in the two approaches is quite different. In the lib-
eral market consensus, state failure is related to rent capture by unproductive groups
who play no role in the dynamism of the market economy. Society as a whole could
potentially be mobilized against them if only democracy, civil society participation,
and other desirable political institutions could be deepened. In contrast, the trans-
formation perspective provides less comforting prescriptions. Both productive and
unproductive groups are involved in rent and resource capture, and the enforcement
of growth-enhancing changes can also be strongly contested and be of much greater
benefit to minorities in the first instance.
The Challenge for Policy
The discussion presented here raises a number of policy issues and throws up new
questions for research and policy discussion. To begin with, developing country
reformers and their policy advisers need to question the claims being made for
190 | MUSHTAQ H. KHAN
governance reforms of the types that follow from the service delivery model and the
underlying liberal market good governance consensus. There is no historical evidence
to indicate that these reforms were a precondition for growth or that they can
be effectively implemented in transformation economies. But there is obviously
support for this reform agenda in developing countries, where anticorruption and
democracy are legitimately pursued as ends in themselves. However, competing polit-
ical factions have also found anticorruption slogans useful, for instance, in factional
political conflicts. What is worrying is the lack of evidence that emerging capitalist
coalitions have coalesced around these reforms as genuine demands, except in the
same opportunistic and factional way, but this should not be surprising given that the
service delivery model does not address the key property rights, rent management,
and accumulation issues facing emerging capitalists in their relationship with the
state. Much more seriously, a real danger exists that disillusionment will grow even
further in the developing countries if, as is likely, no significant economic progress is
achieved in the end. A reasonable question is whether the multilateral agencies are
spending public resources properly in pushing major reforms on the basis of dubious
evidence linking these reforms to growth improvements.
In contrast, the transformation state perspective identifies critical state capacities
for managing and regulating rents and for organizing changes in property rights sys-
tems. The experience of the high-growth economies suggests that if growth and sus-
tained poverty reduction are the objectives, these capacities have to become the focus
of institutional and political reform. Engagement in a political restructuring of the
organization of power within countries is formally outside the remit of multilateral
agencies, but they could begin by concentrating on the simplest and least contentious
regulatory capacities. Central banks and securities markets have received much atten-
tion, but transformation capacities are broader regulatory capacities that states
require during this period, and these have not, in general, been widely recognized.
One problem for the transformation approach is that the critical capacities that need
to be focused on will vary from country to country as discussed, but this is a reality
that has to be accepted. At a general level, the transformation approach would focus
on institutional and political capacities that would be required for creating capitalists,
transforming property rights in their favor, providing them with conditional support
for acquiring and learning the appropriate technology, negotiating trade and technol-
ogy deals in international agreements to protect national capitalists, attracting multi-
nationals and inducing them to transfer technology to domestic capitalists through
subcontracting and licensing, and so on. To assume that all this will happen sponta-
neously through the market is making an enormous, theoretical leap of faith that the
historical evidence does not justify. Most damaging of all, because of its concentration
on reducing the costs of intervention, a focus on the service delivery model can actu-
ally weaken states’ interventionist capacities, because the simplest way of reducing the
cost of enforcing interventions is to reduce the scope of interventions.
Finally, the effectiveness of institutional capacities depends on their compatibility
with the underlying distribution of power. In many cases of state failure in develop-
ing countries, institutional capacity building has to proceed in parallel with political
STATE FAILURE IN DEVELOPING COUNTRIES | 191
interventions that aim to restructure the distribution of political and organizational
power. The challenge is to suggest feasible reforms for particular countries, taking
into account preexisting political settlements, prior capitalist development, and cap-
italists’ technological capacities. Institutional reform is deeply political and should be
explicitly recognized as such. The proper role of international agencies should be to
transfer knowledge of the experiences of successful transformations, offer support in
enhancing dynamic transformation capacities, and encourage the construction of
productive coalitions to support these reforms, even if interventions in politics must
remain an internal matter for developing countries. In turn the challenge for research
is to proceed further with the analysis of how the distribution and disposition of orga-
nizational power has helped or hindered different transformation strategies and how
this information can be used to suggest feasible institutional and political reform
strategies for countries that have not done well.
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... Moreover, "a feedback mechanism from low growth to high corruption and high growth to low corruption means the growth process cannot begin unless well-functioning institutions are in place" [5,6,23]. Khan [25] reviews the typical economic analysis of corruption in developing countries, arguing that policies from countries with robust regulations and institutions are unsuitable for developing countries involved in high-level of corruption. This implies that a high level of regulatory quality is a precursor for economic growth. ...
... We have looked at many seminal political economy studies in Section 2.1 [20][21][22][23][24][25][26][27][28][29][30][31][32][33][34][35][36] that developed measures and emphasised the importance of institutions in fighting corruption. This section looks at recent econometric studies to identify the interrelated institutional factors controlling corruption. ...
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Political and bureaucratic corruption is a societal threat in every country. It allows organised crime to flourish, slows economic growth, increases income inequality, reduces government effectiveness, and threatens citizens’ confidence in the rule of law. This study uses a “System Dynamics model” from a framework based on econometric analysis wherein the causal relationships between the economic and governance institutions were established. The calibrated model uses the data on institutional quality from 1996 to 2020 from “the World Bank and the World Economic Forum” to project institutional quality and control corruption in the future. The control of corruption was trending downward in the nations studied. The model shows that improving institutional quality can reverse this downward trend. However, improving institutional quality and controlling corruption requires a country-specific approach. This model suggests the most efficient ways that national leaders and policymakers can improve institutional quality and thereby control corruption in their country.
... The countries which developed lately are believed to owe to rents and interventions which were meant to acquire new technologies. Not only that, these are believed to have contributed to restoring political stability, which is again an essential factor for economic development (Khan, 2002(Khan, , 2002bRodrik, 1995Rodrik, , 2003Amsden, 1992;Wade, 1991;Khan and Jomo, 2000). ...
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This study engages with new kinds of policies to combat corruption with real-life examples. Most of the corruption literature concentrates on the impact of corruption and is done at the macro-level. Studies on the causes and remedies are few. This article has focused on remedial measures as well as theoretical issues, measurement issues, types of corruption, causes and effects. Using a descriptive method of research this study introduces some innovative ideas. I have redefined the actors in the agency structure, which is absolutely novel. Existing definitions are unclear or confusing. I suggest that tools have to be set up so that bureaucrats or politicians cannot be corrupt even if they want to. Policy makers and experts will be able to develop insights from this article.
... Moreover, "the absence of adequate institutional and political capacity in developing countries to assist and accelerate a dynamic transformation" (Khan, 2002, p. 1) are serious obstacles to the achievement of the UN SDGs. Thereby, these obstacles reduce the capacity of governments of developing countries to be efficient in providing basic social good and services, implementing policies to correct market imperfections, and promoting sound business practices (Khan, 2002;Rotbert, 2003) as well as limiting the environmental damages caused by multinational corporations that impede sustainable development (Akiwumi, 2014;Wilson, 2015). Under such circumstances, it is unrealistic to think that the poorly governed nations will be able to achieve SDGs within the next decades, say onwards 2030. ...
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... Chercher à subvenir à ses besoins dans de telles situations implique souvent des comportements qui -même s'ils sont légitimes et nécessaires -sont formellement « illégaux » au regard de la loi, ce qui contribue à la vulnérabilité de ces communautés. Si les pauvres n'ont pas de droits, leur pouvoir de négocier pour obtenir des résultats conformes à leurs intérêts en souffre et ils pâtissent en outre de leur incapacité à défendre les droits qu'ils détiennent (Khan 2006). ...
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We are observing a significant increase in the deployment of large scale solar and wind technologies in the global south, and it is therefore a strategically and academically important focus of inquiry to understand context-specific spaces for locally-embedded actors to initiate energy transitions. This paper examines the linkages between the energy transition and economic development, and has attempted to do this by developing an approach that brought into focus the institutional micro-economics of four key dimensions of the economic development process, namely (a) the impact of the auction mechanism; (b) the key role MNCs play in the global value chain; (c) how developmentally-oriented states have attempted to harness the resulting investment flows by using LCRs; and (d) the local-level development impacts of utility-scale renewable energy power plants on local communities. Drawing from the South African energy transition as a case we argue that the complex interaction between highly globalized value chain actors, path dependent local institutions and interests of incumbent local actors sheds new light on the dynamics of rapid institutional change during energy transitions in a global South context. We use the South African case to develop a framework for analysing the energy transition in the global south that brings into relief the complex dynamics of change, learning and experimentation. Our focus is on the way rule-setting and the actions of actors within institutions (dis-)enables financial flows, institutional change and socio-technical adaptation in a fast-changing environment driven by responses to climate change and the challenge of rapid decarbonisation.
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ABSTRACT This research has analyzed how the institutions of the merit-based bureaucratic system in the Korean Government changed from 1948 to 1963, applying the gradual institutional change theory of Mahoney and Thelen (2010). Though copious research has been produced on Korean economic development, little analysis has been made on the emergence of the Korean developmental state. This research aimed to fill in the analytical gap by examining how effective bureaucratic institutions was established in the Korean developmental state to draw out implications for the institutional change theory as well as the discussion on the developmental sate and state capacity. This research has found that the merit-based bureaucratic institutions of the Korean Government positively changed in a piecemeal approach from 1948 to 1963, though once disturbed from 1955 to 1959. Contrary to the existing literature, this research also has found that the institutional setting for the merit-based bureaucracy was set from the very beginning of the Syngman Rhee Administration; however, the selective implementation and enforcement of the rules in the Syngman Rhee period hindered the Weberian bureaucracy. This research has, therefore, drawn out that for positive institutional change, the role of the change agents is critical especially the vertical chain of reformative leadership and capable practitioners. The low level of opposition is beneficial for not only positive but also negative change. In the end, in the case of Korea, the initially ambiguous institutions provided the actors with considerable discretion to manipulate or misuse rules. As a result of the institutional reform the rules and regulations became detailed reducing the gap between what the rules say and how the rules are implemented. The empirical tests of this research have confirmed the basic assumptions of the gradual institutional change theory of Mahoney and Thelen (2010). Firstly, the empirical results have shown that the institutional change has more to do with a piecemeal internal process than to do with any external shock or event. Secondly, the gap between the existence and the enforcement of an institution has also been proved valid. Thirdly, the empirical tests have confirmed the influence of three change factors producing different types of change in the theory. Based on the empirical findings, this research has identified important implications for the institutional change theory with three key areas for improvement. The first is the validity of the three modes of change in the theory. The test has identified the need to address the different magnitudes of the three factors affecting change. This research has also identified the need to clarify the definition of gradualness and the concept of the change agents to solidify the theory. This research has also enriched the discussion on the developmental state and state capacity by identifying the limitations of the merit-based institution in different contexts. Based on the analysis, this research has drawn out four key lessons for developing countries and for the donors: the importance of the enforcement of rules; the synchronized reform coalition between committed leadership and competent practitioners; the importance of understanding local contexts; and the relationship between dictatorship and development. By analyzing the emergence of the bureaucratic institutions, this research has not only broadened our understanding of development and state capacity but also presented a practical policy solution to overcome the persistent state of incapacity in the developing countries today.