Is best practice always best?

Encouraging developing countries to learn from many decades worth of experience from elsewhere in the world may seem to be an obviously good idea, but CEPR Research Fellow Dani Rodrik argues in a new paper that spreading what the IMF, World Bank and other multilateral institutions call 'best practice' can be unhelpful, and even damaging. Sometimes, he argues, second-best may actually be better.

Creating the institutions that help free markets to develop - such as courts, regulators, social safety nets and so on - has become a fashionable theme in contemporary economic development; but they take widely varying forms across different developed countries, which underlines the difficulty of applying a one-size-fits all approach in the developing world.

Rodrik argues that finding the right institutions in developing countries may instead require a 'second-best mindset,' which works within the specific context of a particular country, instead of trying to transplant a blueprint from elsewhere.

He discusses four policy areas to flesh out his argument. First, it can seem obvious that in countries where firms cannot depend on their contracts being enforced in a court of law - because courts are slow, inefficient, or too easily corruptible, for example - it would be a good idea to reform and improve the court-system, perhaps using a model from elsewhere. In sub-Saharan Africa, for example, many small entrepreneurs are forced to depend on so-called 'relational' contracts, through repeated interactions with partners and clients, often over many years, so that they can build up trust.

However, Rodrik points to the example of Vietnam, which has achieved extraordinarily strong economic growth of 8% a year, and is widely seen as a development success story; yet where the courts are just as unreliable as in sub-Saharan Africa, and exactly these kinds of relational contract prevail.

Improving the court-system might make these countries look more like a text-book model of best practice, but it is not necessarily what is holding back growth in Africa.

Second, barriers to entry for up-and-coming firms are often cited as bad for economic development - by the World Bank in its 'Doing Business' reports, for example - because they create excess profits for the incumbents, which would be eroded away if new entrants were able to come into the market.

But where there are few existing businesses in a particular sector, pioneering entrepreneurs may perform what Rodrik calls a 'cost-mapping' function, demonstrating that new types of enterprise can be successful and profitable. Without these rents, the rewards of taking the risk of entering a new industry may simply be too small.

Lowering entry requirements may actually backfire, then, if the result is that no one wants to put their livelihood on the line for such measly rewards. Again, it's important to know what the binding constraint is - what exactly is holding back economic growth. Just because the institutions of a particular country do not mirror those of the affluent north, this does not mean that introducing them would suddenly create a successful economy.

Third, cutting tariffs on imports and removing state subsidies from domestic industries is actively promoted - in the multilateral World Trade Organisation negotiations, for example. It is regarded as an essential tool for stimulating domestic industries, by exposing them to outside competition and helping developing economies to specialise in industries where they have a comparative advantage.

However, Rodrik argues that few countries that have made a success of export-led development have actually followed this model of leaving domestic firms to face the full force of global competition alone. South Korea and Taiwan targeted specific industries with subsidies in the 1960s, to help them develop and become ready to compete internationally. Malaysia and Thailand created export-processing zones, with special support for firms; and China had export incentives and Special Economic Zones.

This gradual approach also had political benefits, Rodrik argues - because as the economies shifted to become more outward-facing, and imports began to flow in, the tariffs and subsidies helped to protect jobs, rather than creating the risk that local demand was satisfied by cheap goods from outside before exporting firms were ready to pick up the slack. Moving piecemeal in this way helped to maintain public support for free trade in these countries.

Finally, developing countries have been encouraged to adopt the model of an independent, inflation-targeting central bank, to win credibility for their monetary policy. However, Rodrik argues that tackling inflation is not always the key challenge for developing economies in transition. In fact, an under-valued currency - which makes inflation higher than otherwise - can actually be an advantage for an economy such as China, which is keen to stimulate export-led demand as it moves towards full integration with the global economy.

Creating an independent central bank can be a hostage to fortune if there are good reasons, at a later stage, for the government to exert control over monetary policy - for example to bring down the value of the currency. The problem with this kind of 'pre-commitment,' is that it can box in policymakers when what they really need is flexibility. Rodrik gives the extreme example of Argentina, which suffered an economic and political crisis after it pegged the peso to the dollar, but then watched in horror as a slew of Asian countries, and then Brazil, devalued. Instead of bringing credibility, the currency-peg simply made Argentina unsustainably uncompetitive.

Distilling the experience of hundreds of countries around the world to design financial, legal and economic institutions for the best of all possible worlds seems sensible, and governments are often keen to learn from each other. But Rodrik shows that this cut-and-paste approach fails to take account of the specific context in a given country. That means many of the recommendations of the IMF and World Bank can simply be ineffectual; and others can even be counterproductive, because they conflict with the reality on the ground. Sometimes, second best can actually be better.

CEPR DP6764 Second-Best Institutions
Dani Rodrik
CEPR 6654 Should the Euro-Area Be Run as a Closed Economy?
Carlo Favero and Francesco Giavazzi