See How Rulers Mismanage in Their Own Interest
Feb 22, 1999
Hilton L. Root
Publisher: International Herald Tribune

International Herald Tribune


Conferences and seminars involving hundreds of experts have been held to diagnose the financial distress that began in Thailand in July 1997 and spread through East Asia, Russia and Latin America. Yet world leaders agree only on the need for rigorous accounting standards requiring banks to reveal their assets, liabilities and loan-loss provisions.

That sensible point begs a critical question: Why have otherwise competent governments in the affected economies not produced well-regulated banking systems on their own?

One answer is that the interests of those countries' leaders are often entirely different from those of the public.

In fact, financial mismanagement, culminating in the plundering of the banks and the suppression of alternative capital markets, is often part of a political survival strategy.

Unless reformers recognize this fundamental misalignment of interests and find ways to overcome it, reforms are bound to be frustrated.

It should hardly be news that many of the world's leaders maintain their grip on power by manipulating access to economic resources (capital, technology, infrastructure), ensuring that key supporters are rewarded. The resulting waste is often ignored by those who plead for international financial support for discredited regimes.

Defending the $4.8 billion dollar IMF loan to Russia that went sour last summer, Larry Summers, U.S. deputy secretary of the Treasury, reasoned that the United States took a calculated risk "because it was vastly better that Russia succeed than not succeed." The cash was intended to foster financial sector reform.

Instead, according to the IMF official who brokered the deal, the $4.8 billion was squandered, only propping up the currency long enough to "let the oligarchs get their money out of the country."

What Mr. Summers apparently did not grasp was that the rulers and the interests of Russia are not the same, and that institutions to make Russia's rulers accountable to the people do not exist.

A quarter-century ago, leaders of East Asia's high performers, preoccupied with the question of national survival in an era of Communist expansionism, made sure that resources were invested in development and growth. But the evolution of China from threat to economic competitor undermined the imperative to maximize the efficiency of investment. As wealth and prosperity increased, maintaining political power became an end in itself, and supervision of national financial systems declined.

The evolution of the South Korean economy illustrates the consequences. Politicization of the banking sector effectively guaranteed gigantic conglomerates, known as chaebols, access to cheap capital. This allowed the chaebols to pursue market size as an end in itself, even as they poured money into loss-making business units.

The resulting overcapacity brought the South Korean economy to the brink of disaster. But even the financial crisis has not derailed the conglomerates. In fact, the top five have actually consolidated their grip, dumping worthless assets and consolidating the jewels as part of a much heralded industrial rationalization plan.

Political favoritism in bank lending similarly allowed the friends and relatives of Indonesia's former President Suharto to loot the economy of one of the world's potentially richest nations. Now the entire banking system must be recapitalized.

If Indonesia follows the path that Mexico took two decades ago, we can expect that, once the banks have been nationalized, they will be sold back to their original owners at scandalous discounts.

Japan, like South Korea, features a financial system in which loan decisions are not disciplined by market forces. The cost of capital for Japanese firms has been artificially reduced by a combination of government policy and cozy relationships with banks.

Since the big firms financed development with borrowed funds rather than equity, they were able to measure performance by market share rather than profitability. The Japanese government has dragged its feet on full disclosure of the assets and liabilities of the banking system out of fear that political malfeasance will be exposed.

While international organizations supported by Japan promote transparency as a universal medicine for misallocation of capital, Japan's own Ministry of Finance has found a way to circumvent good accounting practices. It caps the amount that a private firm can spend on outside audits. Then, if fraud is later exposed, the accountants, handicapped from the outset, can be blamed.

The crises in public finance of the world's most promising emerging markets are often rooted in their political culture and institutions. Throughout the world, badly regulated banking is often part and parcel of a failed system of governance. The obstacle to international growth once posed by central planning has been replaced by a subtler threat: deliberate mismanagement.

There is no better indicator of rule by mismanagement than the failure to identify and enforce tax liability. Is it any surprise that the great debtor countries in the world collect so small a percentage of the taxes they are owed?

Of the estimated 73 million Brazilians in the work force, only 7.6 million pay income tax. And out of a population of 140 million in Pakistan, just a million pay income tax.

These debtor countries share another dubious distinction: Their citizens have stashed vast amounts overseas, often more than the total international debt owed by their governments. Meanwhile, ordinary citizens hide their fortunes under mattresses, and so the banking system cannot effectively mobilize national capital reserves. An estimated $60 billion is secreted this way in Russia.

The countries that lead the world economy today did not always pass the basic test of fiscal accountability. It is not long since the distinction between public and private had little meaning in France, England or Japan. In time, rulers desperate for revenue were driven into the hands of their own citizens, who insisted on oversight in exchange for their taxes.

The separation of the leader's private interests from the interests of the state was thus driven by fiscal imperatives. The state became a separate power, and the age-old identification of the ruler and the state was surmounted.

By contrast, the financial architecture used to solve today's global economic crises lets leaders draw support from international organizations without engaging the will of the people who must ultimately pay back the loans. This form of taxation without representation is an anachronism that reinforces governance without accountability, and contributes to a fundamental misalignment of economic incentives: The benefits are largely private, the debt is public and sovereign.

International intervention contributes to the private economic fortunes that perpetuate the political domination of the world's emerging markets by the individuals who benefit most from their country's ruin. Is it any wonder, then, that the populist opposition in emerging markets typically sees the IMF as an enemy? Any reform of the world's financial architecture is virtually certain to fail unless it establishes the rights of citizens as stakeholders in their nation's future.

Hilton L. Root is the Milken Institute's Acting Director of Global Studies. This op-ed appeared in the February 22 edition of the International Herald Tribune. The views presented here are his own.