The 2,500 page long Dodd-Frank Financial Regulatory Reform Bill has passed through the United States Senate. The bill will now be signed into law by President Barack Obama.  It signals a halt to the deregulatory process that the U.S. financial system has experienced for almost fifteen years.

The bill promises to strengthen consumer protection. In principle, it raises bank capital requirements, requires more collateral and margin requirements, enables a regulator to act against a very large and risky bank, and more.

These are overdue reforms. Warts and all, and considering the political realities of legislative deals, having this bill is better than continuation of the regulatory vacuum.  But it is not a comprehensive systemic solution. This watered down bill will not effectively reverse the massive financial deregulation that took place, nor will it fully assure that the financial system will be effectively supervised and regulated so to avoid another systemic crisis…

  Despite the length of the document, the regulatory reforms in this bill are vague.  Congress was reluctant to specify clear and detailed regulatory code into the bill. This means that the detailed homework in defining, detailing and interpreting the broad regulations is being passed on to the regulators.

Regulators will have enormous latitude and discretion in specifying these regulatory details, and in interpreting them during implementation.  And the notion of ‘regulator’ ought to be viewed broadly here, since they also include senior political appointees in government, such as the Treasury secretary, who will wield enormous influence in the regulatory reshaping, interpretation and implementation.

If recent history and our empirical work are any guide, such latitude and discretion handed to regulators and politicians in government can be very costly because of the likelihood of regulatory (or ‘state’) capture by powerful financial institutions.  Recent debates on this financial reform bill tend to focus on technical aspects, largely ignoring the politically sensitive issues surrounding the power of money and influence in politics with its perverse effect on financial regulation and its implementation.

Thus, I ask: how will politicians and regulators in government have the wherewithal to withstand pressures from Wall Street enabling them to make timely and tough decisions to break a very large bank (when the risk to the systemic so warrants)?  And even if a regulator dares to do so, how will it be implemented given the international ramifications of such an action? 

We should not totally rule out that some regulators may carry out appropriate actions at times.  But we should also be mindful that the vested interests in a system captured by ‘money-in-politics’ would tend to bias decision-making against such timely and tough regulatory actions. Congress did not dare to look into this thorny issue of money in politics and its corrupting influence on political and regulatory decisions.

  In this context, errors of omission in this bill are noteworthy.  Freddie Mac and Fannie Mae, the quasi-public housing finance behemoths that important culprits in the financial crisis, have been spared. Yet again, lawmakers carefully avoided addressing these institutions, which in the past have exerted undue financial largesse on politicians to influence them so that they could operate in a financially irresponsible fashion. 

More broadly and understandably, given the interests of lawmakers and political realities, the bill is silent on the pervasive and pernicious role of money in politics influencing the whole regulatory system. Furthermore, the bill does not clearly re-erect a wall between traditional deposit banks and investment banking, which prevailed since the Glass-Steagall Act was enacted in 1933 until it was repealed in 1999.

Not that the U.S. is alone in facing challenges in regulatory reforms.  Progress on this front is even more questionable abroad: witness the time lags, lack of coordination and consensus on regulatory reforms among EU members, the U.K., the IMF and the Financial Stability Board (FSB).

The disarray in much of the continent across much of the Atlantic on these matters is also important for the effectiveness of the just passed U.S. regulatory reforms themselves.  This is because a modicum of coordination and harmonization across international financial centers is required for financial institutions not to shop around more lenient regulatory regimes.  It may be years until Europe gets its act concretely together on this. 

Worse, the way the Basel Accord is being watered down right now as a direct result of  lobbying pressure by banks is likely to further erode the impact of the U.S. Regulatory Reform Bill on U.S. banks, since the Basel international supervisory rules may end up mattering more to all banks, including the US-based ones.

Thus, daunting challenges remain and need to be addressed head on, otherwise this Bill will not substantially enhance the stability of the financial system or alter the behavior of financial institutions in a meaninful fashion.

Paradoxically, this Bill may end up having a tangible impact on oil and gas companies. In fact, in ending on a positive note, let me focus on a little noticed side initiative within this bill which nonetheless is of high relevance for global development and anti-corruption efforts.  There is a resource transparency provision in the bill spearheaded by Senators Lugar and Cardin (supported by many others).

The provision mandates oil, gas and mining companies registered with the Securities and Exchange Commission (SEC) to publicly disclose the tax and revenue payments made to any government and requires that they disclose how they ensure that their payments do not fund armed groups in some countries. The information disclosed by these companies will be independently audited.

Even if this initiative is an obscure aside for many, this is in fact a commendable provision to enhance transparency in the extractive industries and in many resource-rich governments. 

There are two priorities next on this important front.  First, transparency provisions ought to apply about full disclosure of the contracts signed between industry and governments as well.  Too often the terms of such contracts are not disclosed (let alone subject to public debate prior to their signing), which impairs the effective analysis of the disclosed data on revenues paid by oil and gas companies to governments.  

Second, in the near future these mandated transparency reforms in the extractive industries ought to also be rolled out to security exchanges in financial centers in London, Frankfurt and elsewhere.

In ancient Greece, a volcano eruption was a sign of divine disapproval.  It is unclear whether modern Greece has taken notice.

For better of worse, unlike Greece, there was no ancient BP.  Oily conglomerates have only become more important than nations in recent times.  It is thus hard to tell whether an extraordinarily active hurricane summer season (expected to be upon us imminently) can be interpreted as sign of disapproval from above.

There is growing consensus that unless the pace of progress quickens, the world will be unable to achieve the majority of the Millennium Development Goals in five years.  But the devil is in the details:  does the pace of progress need to quicken everywhere, and similarly across all MDGs?  And what does progress depend on?…

Last week the Belgian agency for Development Cooperation convened its 2010 “States General” Conference, which focused on the MDGs.  In the keynote address at the Conference I emphasized the achievements and challenges in meeting targets, and focused on governance as a constraint to accelerated progress.

The key issues I focused on in the Conference presentation are summarized below.*

First, where do we stand on the MDGs?   On average the world has made progress in meeting targets, but such progress has been very uneven.

Some countries and regions are succeeding, while others are stagnating. On balance, the world as a whole appears to be currently on track to halve absolute poverty by 2015.  However, such average progress is in large measure due to dramatic poverty reduction in China.

In 1990, over half of the population in East Asia, South Asia and sub-Saharan Africa lived in extreme poverty.  In recent times, only 17 percent, or 22 percent if China were excluded, of the East Asian population  lives on less than $1.25 a day.

But, in sub-Saharan Africa and South Asia 51 percent and 40 percent of the population (respectively) still lived below the $1.25 a day poverty line recently (Figure 1).   Even more striking, even though there are always debates about the accuracy of these figures (and there is a lag in reporting), over 70 percent of the population in the two regions appear to still live on under $2 a day.

While the world’s progress on average, largely driven by a few countries, is certainly laudable, 1.4 billion people continued to live on under $1.25 a day and 2.6 billion lived on under $2 a day in recent times.  Even in East Asia, where the largest reduction in extreme poverty has been achieved, 337 million live below the $1.25 poverty line.

Achievement is within reach on some MDGs, but is out of reach on others. In addition to being on track to halve poverty, the world (but not necessarily all regions) is on track to achieve gender equality in primary education and to halve the number of people living without access to clean water.

On other goals the world has made less progress. For instance, maternal mortality ratios were expected to be reduced by three-quarters, from 480 deaths per 100,000 live births to one hundred and twenty by 2015. By 2005, the maternal mortality remained nearly constant at 450 deaths. Similarly, the share of the population without access to sanitation was expected to be 28 percent, but by 2005 virtually half of the population remained without access (Table 1).

In the years since data on most indicators was last collected the world experienced a surge in food prices and a global economic recession. Both circumstances have negatively affected progress on MDGs.  The rise in food prices is estimated to have increased the number of chronically hungry people by 75 million to a worldwide total of nearly one billion, while the recession has contributed to the impoverishment of tens of more millions.

Considering that progress on MDGs has been uneven across regions and targets, and also the quality of governance is highly variable across countries, it is important to focus on the links between governance and the MDGs.  This is also warranted because governance has not received its due  attention in the programs to support and monitor progress of the MDGs.

Governance does matter for MDGs. Our past research suggests that when governance improves, from, say, the extremely low levels of a country like Afghanistan for instance, to the subpar (yet not bottom ranked) levels of Kenya (or from the subpar levels of Kenya to the many countries in the middle group of the worldwide governance indicators, such as India, or from the middling levels of India, to the satisfatory levels of Botswana), infant mortality on average declines by almost two-thirds, and incomes rise almost three-fold in the long run.  Subpar quality of governance in many countries can be a major constraint to progress on the MDGs (Figure 2).

Non-traditional dimensions of governance also affect the MDGs. Improvements in public sector financial management alone will not ensure good governance and progress on goals. Non-traditional (for many donors) aspects of governance, such as freedom of the press and human rights, also influence development. The strong relationship between poverty and gender rights is particularly striking.

Considering the slow progress on gender-related goals, much more attention ought to be paid to gender rights (Figure 3).  Research shows that female empowerment, education and income help reduce child and maternal mortality rates. Press freedom also impacts development (also in Figure 3, below).

Thus aid is necessary, but alone is far from sufficient. Research has shown that aid can be effective when there is satisfactory governance in the recipient country, or at least governance is steadily improving.  Studies have found that, among others, primary school enrollment and child mortality outcomes are also conditioned by governance. Thus, increasing aid will not ensure progress on the MDGs.  Investment in areas that impede the effective allocation and efficient use of funds, such as governance, may also make sense.

Governance is not only paramount for recipient countries, but it is also a key factor among the richer donor countries and their aid agencies.

Honoring Aid Commitments is Important. Meeting the MDGs is not only ambitious, it is also costly. Therefore in 2000, donors pledged to increase foreign aid to 0.7 percent of their Gross National Income (GNI). By 2008, donors provided only 0.3 percent of GNI on average, and only a fraction of this is channeled to the poorer countries.

The allocation of aid is also crucial. Providing governments with aid to increase health expenditure may improve child mortality rates, but only if the money is efficiently and transparently allocated.

Further, additional funds provided directly to MDG-related sectors, such as to cover health costs in urban settings, which many aid donors provide for,  may not always be as effective as providing some additional funding to neglected sectors, such as infrastructure or governance, which constrain progress for development in general, and for attaining those very health-related and other MDGs in particular.

In other instances communities may be more effective at implementing projects than central governments, particularly where high-level corruption is pervasive.   Under these circumstances donors should consider channeling aid to communities rather than central government agencies.  More generally, aid needs to be more selectively provided, so to enhance its effectiveness.

Development aid is not an island. The recent financial crisis has shone a spotlight on the impact of economic policies of industrialized countries on the rest of the world.  The recession has resulted in the impoverishment of millions more people in developing countries.  Responsible governance and policies in industrialized countries matter for development and the MDGs at least as much as donor aid itself.

Additionally, continued agricultural subsidies in industrialized countries continue to hamper the expansion of trade, employment and growth in many developing countries. These economic policies ought to be better integrated into development aid strategies by donors.  Further, greater attention should be paid to the important role of the private sector in meeting the MDGs.  Like governance and infrastructure, the role of the private sector has also been neglected in the MDGs.

In 2000, the international community committed itself to achieving eight lofty goals.  While the upcoming September UN Summit on the MDGs will surely highlight some of the partial successes in meeting the MDGs in some settings, there also ought to be an honest and transparent focus on the many setbacks in many settings around the world, and a frank assessment as to the reasons for such setbacks.

The evidence suggests that the uneven progress in MDGs is related to major differences in the quality of governance across nations.  Furthermore, there are dimensions of governance, such as gender rights and media freedoms, that may have been subject to particular neglect.  Yet more generally, as stated, in the recent past governance has not received the attention it deserves in the context of the MDGs.

Focus on governance by the international community is not the ‘politically correct’ thing to do, and, further, many leaders prefer to be mute about this challenge because they know that there is misgovernance in their midst.  Yet this merely helps to explain, not justify, inaction on this front.  In the next stage, emphasis on key governance dimensions, including corruption, inequality, media freedoms and gender rights, is required to help address major hurdles to progress.

Politically difficult decisions and decisive leadership are necessary, but by paying greater attention to governance, to improved aid selectivity and allocation, by targeting neglected sectors, and by supporting a larger role for the private sector, many MDGs may still be within reach for most.

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*Note:  This entry is a synthesis of the presentation I gave last week at the Conference in Brussels referred to above.  An expanded version, co-written with Veronika Penciakova, has been subsequently posted here as a Commentary piece  at the Brookings website.   This blog entry draws from the joint piece.

Right now I am committing the heresy of focusing on the link between corruption and budget deficits in industrialized countries.  After all, even if politically incorrect to admit it, there are a number of rich countries where corruption is widespread, in a variety of forms, illegal and ‘legal’, political and financial.

I explore the mechanisms by which corruption can affect the public finances of a nation, and then the extent to which corruption matters in explaining a rich country’s fiscal deficit.   As it turns out, it matters aplenty.

The Wall Street Journal picked up on this work, and used it in their cover page article on Greece.   A brief version of my research article is here at Brookings, and also reproduce in full in this entry here below as well…

“Can Corruption Adversely Affect Public Finances in Industrialized Countries?”

A number of studies have shown that corruption hinders development around the world. Such findings have elevated governance, alongside macroeconomic discipline and openness, as a determinant of growth and economic development. Less focus has been paid to possible links between corruption and macroeconomic outcomes.

Some research in past decades has focused on the political economy of macroeconomic policymaking, and some papers have suggested that corruption can affect a country’s public expenditures.  But, because studies generally view governance and macroeconomic policies as separate determinants of growth and development, there has been less research on the possible links between the two factors.  This is particularly the case in the industrialized world, where the challenges of governance and corruption tend to be underestimated.

Departing from traditional “developing country” focused studies of corruption, I ask whether corruption may adversely affect public finances in industrialized countries.  With recent data, I explore the link between corruption (and other governance variables) and the public budget deficit of industrialized countries.

Such inquiry is motivated by the simple observation that, contrary to popular belief, there are significant differences in the extent of corruption and in the quality of governance among industrialized countries.  Further, it is also well known that there are large differences in the budgetary balances (ranging from large surpluses to large deficits) of industrialized nations, even among countries within common zones or “coordinating” bodies, such at the EU and the OECD.

First I ask the a priori question:  Through which channels could corruption affect the public finances of a country?

In a forthcoming paper, I detail a number of such mechanisms, some of which are drawn from the existing literature:

1.  Corruption lowers tax revenues: Public resource mobilization can be impaired through tax evasion and creative tax avoidance schemes. Additionally, corruption opportunities provide an incentive to make (or at least keep) the tax code unduly complex, and subject to many discretionary exemptions.

Further, corruption renders the tax collection institutions less effective and efficient.  And, corruption can affect customs administrations, even if this particular challenge is more pervasive in countries which are not rich.

2.  Corruption increases public expenditures:  Corruption may be associated with bloated bureaucracies, excessive and less productive public investments, and an inefficient composition of expenditures.  For example, large wage bills may overshadow operations and maintenance expenditures.  To maximize lucrative rent-seeking, decisions can be skewed toward large capital investments at the expense of labor-intensive ones, for instance.

3.  Corruption affects public sector debt and financial sector risk:  Where corruption exists and transparency is lacking, decisions regarding the composition of public debt may be more risky, and debt servicing may become more expensive for the national treasury (and may unduly reward outside private counterparts).

More generally, misgovernance, as well fraud and corruption, in financial instruments can jeopardize the whole financial system.   As I have written previously, some of this corruption may not be strictly illegal, such as the subtler forms of capture of the financial sector regulatory or policy regime (which we labeled as state capture).

When the financial system falters, private liabilities may become public, as occurred during the U.S. bailout of Wall Street.  These bailouts indirectly affected the fiscal balance through the rise in public liabilities and directly affected it through the stimulus packages that aimed to mitigate the recessionary impact of the financial crisis.

4.  Corrupt data matters for a fiscal crisis: The more a country distorts, hides and delays disclosure of the true status of its financial and national statistics, the more likely this will introduce destabilizing uncertainty into financial markets, and the higher the probability that a financial and fiscal crisis may result.  Accurate and early disclosure of a country’s financial and economic situation is crucial for ensuring that remedial measures are enacted.

A faltering country may enact necessary reforms on its own once its situation is disclosed.   However, even if a national government is unprepared to take the necessary remedial steps, the international market and/or neighboring countries and international institutions may pressure it to resolve budding fiscal crises in a timely manner.

5.  The underground economy affects the fiscal balance: Public misgovernance may also be associated with a larger unofficial (or shadow) economy.  A large shadow economy reduces tax revenues, as alluded to in the first item. F urther, large unofficial economies shrink the tax base and may force higher official tax rates, which in turn may feed into the vicious cycle of expanding shadow economies and high statutory taxes (which often go uncollected).  Also, a large underground economy hampers growth, FDI, exports and overall productivity, all of which further reduce overall tax revenues.

6.  Corruption affects productivity, competitiveness (including in exports) and growth:  Corruption impairs productivity, competitiveness and growth more generally, through mechanisms other than the underground economy.  Specifically, corruption increases the cost of doing business and results in lower efficiency of investments and business decisions.  In fact, I find a very close relationship between corruption in a country and its global competitiveness index.  If productivity, exports and growth are impaired, so are the country’s public finances.

It is expected that corruption, through the aforementioned six mechanisms, is linked to defective public finances and high fiscal deficits. The extent to which any of these mechanisms may dominate the rest is difficult to determine, and likely varies from country to country. Nonetheless, as a whole, these mechanisms are hypothesized to significantly influence industrialized countries’ fiscal balances.

What are the main findings?  Utilizing governance and budgetary data from over 35 industrialized countries, and controlling for other factors, I find that:

1.  Industrialized countries vary in their ability to control corruption. According to the Worldwide Governance Indicators (WGI), by the end of 2008 Finland ranked number one for controlling corruption (with a rating of 2.3 out of a maximum of 2.5),  while the Netherlands ranked 7th (rating of 2.2), the U.K. ranked 16th (rating of 1.8), the U.S. ranked 18th (rating of 1.5). Spain ranked 31st (rating of 1.2), Portugal ranked 36th (rating of 1.1) and Greece ranked 82nd (rating of 0.1).

Thus, the difference between Greece and Spain, or the difference between Spain and the Netherlands, is one standard deviation, and the difference between Greece and the top ranked Finland exceeds two standard deviations, a vast difference.

2.  There is a strong relationship between corruption and fiscal deficits in industrialized countries. An improvement by one standard deviation in corruption control in 2005 is associated with about a 3.5 percentage point reduction in the average fiscal deficit between 2006 and 2009 (controlling for other factors), while a larger improvement in corruption control, by two standard deviations, is associated with a seven percentage point reduction in the fiscal deficit (see the chart below for the simple correlation).

.                                                                               .

3. “Legal Corruption,” or state capture (which also varies substantially among industrialized countries), is also significantly associated higher fiscal deficits. The econometric estimates suggest that the impact of lowering the extent of legal corruption (and capture) on the fiscal deficit is very similar to that of lowering traditional forms of corruption.

4. Membership in the Eurozone does not guarantee a lower fiscal deficit. Controlling for many factors, including governance and income levels, I do not find evidence that belonging to the Eurozone helped countries improve their fiscal position in recent years. In fact, there is no evidence that being a member of the Eurozone results in convergence toward higher levels of governance and corruption control either.

Likewise, being an OECD member also does not appear to guarantee an improved fiscal situation. By contrast, being an oil producing nation does help the country’s fiscal stance (naturally, yet there are obvious exceptions in countries such as Venezuela, which are not included in this study).

A number of implications emerge from this analysis—all of which are discussed in detail in a forthcoming paper. Here I highlight the following:

First, an increased focus on the challenges of corruption—in its legal and illegal manifestations— in industrialized countries is long overdue. Corruption is far from an exclusive problem afflicting some poor countries.

Second, more analysis is needed how governance failures and corruption affect macroeconomic and financial outcomes. The proximate determinants of macroeconomic and financial instability may be technical, economic and financial in nature. But political and governance dimensions can distort the design and implementation of such macroeconomic policies in fundamental ways, both in the short and long term.

Third, and as a logical corollary, countries where macroeconomic instability and misgovernance coexist may need to map the particular channels through which corruption affects public finances in that country, and subsequently implement a strategy for improving those key governance dimensions.

I outlined above six main channels (and a number of subcomponents in each) through which misgovernance and corruption can affect a country’s public finances. The first set (taxes and expenditures in particular) exemplifies the direct links between corruption and the fiscal deficit, while the latter channels are more indirect, but not necessarily less important. The specific diagnosis for which channels matter the most, and whether legal or illegal forms of corruption and capture dominate, ought to be country-specific, since they will be different in Greece, Italy or the U.S., for instance.

Finally, global governance bodies, such as the EU, the G-20 and the IMF may need to pay more attention to enhancing incentives that encourage their member states to improve both their governance and fiscal standing. Required improvements include the production and disclosure of transparent, timely and unaltered data on public finances, economic activities and prices, as well as further dissemination and use of governance indicators.

International Financial Institutions, such as the International Monetary Fund (IMF), need to refocus (as they did a decade ago) on the serious challenges of corruption that afflict a number of its borrowers, undermining the country’s macroeconomic stability.   Also, these global institutions ought to review afresh the distortive tax, public expenditure and public indebtedness regimes in many countries and their links to subpar governance and corruption.

Merely focusing on crisis coordination and externally funded bailouts, or demanding statutory tax hikes—rather than expanding the tax base and cutting “pork”—is unlikely to lead to sustained improvements.

Global economic and financial institutions increasingly shy away from addressing governance and corruption issues.   This can be explained by the political sensitivities associated with these, as well as the perverse incentives for many government leaders to mask such problems in their midst. Yet the cost of preventive inaction on governance issues is enormous and far beyond the confines of the misgoverned country, as illustrated in recent financial crises.

All with limited success, other than getting some articles published in journals and a sprinkle of accolades from a few development specialists.  The skepticism tended to be exponentially higher in rich industrialized countries than in developing and post-transition countries.

That started to change a bit at the outset of the financial crisis, yet the few of us who were writing about corruption and capture in Wall Street, and the perverse role played by money in politics, were vastly outnumbered by those providing technocratic explanations of the crisis — whether misunderstanding of risk, low interest rates, leverage ratios, or macro-economic imbalances.  Few were asking probing questions as to the extent to which such technocratic factors were driven by politics, including various forms of capture.  In the interim, more has been written about this, yet skepticism remains regarding non-technocratic explanations…

Today an unorthodox blog entry in the Baltimore City Paper mentions the previous work on capture (identifying me as ‘the Brookings guy’…), suggesting that it does apply not just to the Wall Street (or US generally), but also to Baltimore.   In his ‘Crash Course’ blog, The blogger, Edward Ericson Jr. aims at writing (by his own admission) ‘annoyingly didactic musings on the financial meltdown’.

In his blog entry today he picked up on the whole issue of corruption because he saw the lead Wall Street Journal (WSJ) story today on the link between corruption and macro-economic stability, which focused on Greece.  That WSJ piece discusses my ongoing research which suggests that among industrialized countries, those with higher levels of (legal and illegal) corruption are likely to exhibit a much higher fiscal deficit than those with very low levels of corruption, the difference in their budgetary balance being in the order of 7-to-8 percentage points of GDP.  In the coming days I will be having more detailed entries  on this.

For now I wanted to emphasize instead on an aspect that the City Paper ‘Crash Course’ article focuses on, namely the claim I make that an obsession with ordinary measures of corruption (e.g. coarse forms of bribery) has been counterproductive, hiding the true extent of corruption in many industrialized countries (including the US, Greece and others).  Such corruption in rich countries may take subtler forms than in Equatorial Guinea (and not always strictly illegal), but nonetheless they are enormously costly for society and the world’s welfare, as witnessed in the aftermath of the Wall Street debacle.

Which leads to the last, and most important, reason to write about this today:  Obama going all out to push for Wall Street Reform.  Many of us (millions, in fact) received his letter on this issue today in our email inbox.  I reproduce it in full below for those who did not receive it and are interested.   The battle lines are already drawn, as they were during the health care reform debate, between those vested interests that oppose regulating the banks, versus those that see some modicum of reform as essential for future financial stability and protecting the vulnerable.

Coincidentally, today the Securities and Exchange Commission (SEC) accused Goldman Sachs of mortgage-related securities fraud in the lead up to the financial crisis.  This stunning development (with an SEC daring to sue Goldman!) is now to weigh heavily on the financial reform debate.

Let us mince no words:  the proposed reform package is far from ideal, even if vastly superior to ‘business as usual’ inaction.  A major missing pillar of the financial reform package refers to regulating money in politics, including campaign finance, which nowadays still abets capture.  The US Supreme Court took a step backwards in their 5-4 split decision in late January in the Case of Citizens United v. Federal Election Commission, which further enable corporations to exert undue influence on the state and its policies, laws and regulations through political funding.  These issues will have to be revisited at some point in the future if the US is to make inroads on its own quality of governance and regain world class status.

But for now, adopting the proposed package of Wall Street reforms would constitute an auspicious start.

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President Obama letter received today, April 16, 2010:

Daniel –

It has now been well over a year since the near collapse of our entire financial system that cost the nation more than 8 million jobs. To this day, hard-working families struggle to make ends meet.

We’ve made strides — businesses are starting to hire, Americans are finding jobs, and neighbors who had given up looking are returning to the job market with new hope. But the flaws in our financial system that led to this crisis remain unresolved.

Wall Street titans still recklessly speculate with borrowed money. Big banks and credit card companies stack the deck to earn millions while far too many middle-class families, who have done everything right, can barely pay their bills or save for a better future.

We cannot delay action any longer. It is time to hold the big banks accountable to the people they serve, establish the strongest consumer protections in our nation’s history — and ensure that taxpayers will never again be forced to bail out big banks because they are “too big to fail.”

That is what Wall Street reform will achieve, why I am so committed to making it happen, and why I’m asking for your help today.

Please stand with me to show your support for Wall Street reform.

We know that without enforceable, commonsense rules to check abuse and protect families, markets are not truly free. Wall Street reform will foster a strong and vibrant financial sector so that businesses can get loans; families can afford mortgages; entrepreneurs can find the capital to start a new company, sell a new product, or offer a new service.

Consumer financial protections are currently spread across seven different government agencies. Wall Street reform will create one single Consumer Financial Protection Agency — tasked with preventing predatory practices and making sure you get the clear information, not fine print, needed to avoid ballooning mortgage payments or credit card rate hikes.

Reform will provide crucial new oversight, give shareholders a say on salaries and bonuses, and create new tools to break up failing financial firms so that taxpayers aren’t forced into another unfair bailout. And reform will keep our economy secure by ensuring that no single firm can bring down the whole financial system.

With so much at stake, it is not surprising that allies of the big banks and Wall Street lenders have already launched a multi-million-dollar ad campaign to fight these changes. Arm-twisting lobbyists are already storming Capitol Hill, seeking to undermine the strong bipartisan foundation of reform with loopholes and exemptions for the most egregious abusers of consumers.

I won’t accept anything short of the full protection that our citizens deserve and our economy needs. It’s a fight worth having, and it is a fight we can win — if we stand up and speak out together.

So I’m asking you to join me, starting today, by adding your name as a strong supporter of Wall Street reform:

http://my.barackobama.com/StandForWallStreetReform

Thank you,

President Barack Obama

In fact, crime and corruption do not always co-exist, share the same determinants, or respond to the same strategies and measures. A corrupt and authoritarian police state can control common crime, as in North Korea. Conversely, common crime can be a challenge to countries with satisfactory anti-corruption track records, like Chile.

Crime rates tend to be higher where there is high unemployment, high socio-economic inequality, and lax gun laws.

Corruption thrives where civil liberties, free press, transparency, and contestable politics are absent…

A functioning rule-of-law matters for controlling both crime and corruption, but again differences emerge: an independent judiciary is crucial for combating political corruption; an effective police is important for fighting petty corruption as well as common crime.

There are also differences between the determinants of common crime and organized crime, since the latter does relate to corruption more closely—for instance, drug traffickers and underground arms dealers thrive in collusion with corrupt authorities in weak states.

Unfortunately, most of the research on corruption focuses on developing countries. When corruption indices measure cruder forms of corruption, such as bribery, they mask one of the most serious governance challenges facing countries like the United States today—so-called legal corruption and state capture by powerful corporations.

For evidence of this, one need only look at the the undue influence exerted by Wall Street and mortgage giants over regulations leading up to the financial crisisu exerted by Wall Street and mortgage giants over regulations leading up to the financial crisis, or by giant carmakers over automobile safety regulators.  Indeed, research suggests that the extent of legal corruption and state capture in the United States is very high when compared with most countries in the world, and higher than any other industrialized OECD country.

Thus, contrary to popular notions, both developing and rich countries face corruption challenges, although their form may differ. The strategies to combat different manifestations of crime and corruption will differ from each other, and must be tailored to country context.

To combat common crime, it is important to focus on shared socio-economic progress and reduced unemployment among the youth, police effectiveness, and effectively banning guns in civilian hands. To address legal corruption and state capture, reforms in transparency, as well as restrictions on corporate political finance and lobbying is needed.

Yet crime and corruption do share one important aspect in common. To address them, and to be prepared to take on powerful vested interests, and address the challenges of money in politics, political will, leadership, and integrity are required at the top.

Ultimately, a final commitment that is well below US$ 100 billion would not only restrict the Bank’s ability to lend to Latin American and Caribbean countries at its current very high levels, but it could also be interpreted as a vote of no confidence on its leader, Luis Alberto Moreno from Colombia (even if government shareholders are now tightening the purse strings anyway, in the aftermath of the financial crisis).  All of the focus on capital increase commitments and their perceived value on the IaDB’s leadership will draw even more attention and prominence at the Cancun meeting since it will take place against the backdrop of the impending decision of whether to renew Mr. Moreno’s term for another five years when it expires in a few months.

Yet, a crucial issue that will get much less attention at the annual meeting than it deserves is transparency, of course.  Let us hope that it gets at least some attention at this weekend’s meeting.

Transparency has never been one of the IaDB’s strong points, in fact. The standards of public disclosure and access to information about basic financial information of the Bank, the projects it funds, and its dealings with its client countries has been generally low. But there are four reasons why the issue of enhanced transparency should get some prominence in Cancun.

First, enhanced transparency should get some attention at the IaDB meeting because of the controversy regarding the requested capital increase from the member countries and the reckless financial losses by the Bank’s treasury last year. As a result, some member governments may demand commitments to some internal transparency reforms by the Bank leadership before pledging capital.

Second, at their own headquarters a few blocks away in downtown Washington, DC, the World Bank has just adopted a new disclosure policy, following years of internal debate, work and consultation.

Whether due to the customary competition among financial aid institutions or as a result of pressure from overlapping shareholder governments, regional development banks tend to follow suit after reforms at the World Bank take place.

In fact, some work toward a new disclosure policy is already taking place at the Asian Development Bank. Even the IMF, historically a secretive organization, has been making some strides regarding its own disclosure standards.  And some developing countries already have higher standards of disclosure than the development banks.

At the World Bank, the challenge of implementing this new disclosure policy still lies ahead. And its new transparency policy has some drawbacks, such as the ability by member governments to veto public disclosure of important documents and information. But by having moved away from excessive confidentiality to a policy of presumption of disclosure, the World Bank has taken a transparency leap forward compared with its previous standards — at least in paper.  As usual, the devil will be in the implementation details, but the World Bank is now far ahead the IaDB in terms of disclosure.

Third, in the coming years, the IaDB will have to step up its work on supporting many Latin American countries on their own institutional reforms related to improved governance, anti-corruption and transparency. The region is falling behind others in this respect, and neglecting this dimension would be costly.

While the Latin American region has made inroads in terms of macro-economic policies over the past decade, as we observe in the chart below, on average Latin America has fallen behind the industrializing countries in East Asia, as well as the former Eastern European socialist countries (now part of the new Europe), in terms of key dimensions of governance. Yet to be credible in these important areas of pending reforms, the IaDB will need to implement transparency reforms – the example starts at home.

And the fourth reason for enhanced transparency is Haiti. The vast aid package that Haiti will require is already the subject of much homework and debate among donors who will congregate at the UN in New York for a major meeting on March 31st. Some bilateral aid donors will demand satisfactory transparency and accountability from the Haiti side before making firm commitments. As important, however, will be to observe the initiatives that donors themselves take regarding making its own programs and funding details in Haiti much more transparent than customary.

The Inter-American Development Bank covets having some leadership role in the Haiti reconstruction effort. To consolidate such a role in the eyes of the rest of the donor community, it can’t afford to stay far behind in terms of its own transparency.

For these reasons, it may make sense for the Inter-American Development Bank to publicly commit this weekend to the design of a far-reaching disclosure policy, one which could build on (and even improve upon) the World Bank’s and which would be consistent with modern transparency standards in such organizations.

In particular, the IaDB ought to pledge working toward very concrete mechanisms for access to detailed financial and technical data on all its projects. And it could pledge to make its operations in Haiti as an early model test case of the broader and deeper transparency policies and disclosure measures to come.

For good measure, the IaDB may also wish to disclose the price tag of the Cancun meeting.

* IaDB en castellano es el BID, o Banco Interamericano de Desarrollo.

[Note:  this is a cross-posting from the Upfront blog at Brookings, here].

Country 1: Its approach to industrialization has relied heavily on a very large public sector that accounts for well over 40 percent of GDP, and on aid financing from richer countries. The country has no fiscal discipline, running a deficit exceeding 13 percent of GDP. Rather, leaders have focused more on ensuring adequate compensation for civil servants and providing a generous social safety net, including retirement at a young age. And transparency and integrity have not been a top priority, contributing to high corruption. This financial mis-governance has resulted recently in the downgrading of their sovereign risk ratings by commercial risk rating agencies.

Country 2: Like Country 1, it also has had numerous governments from the left-of-center; but in contrast, it pays attention to good governance, anti-corruption, and integrity. The state owns some of the country’s large corporations and commercial banks. It has also focused on improvements in health, education and poverty alleviation. Further, fiscal discipline is prioritized more highly than in Country 1 (even if that is not saying much). Consistent with its strategy, the country instituted a very aggressive and generous fiscal stimulus plan during the global crisis, which amounted to over 2 percent of GDP…

Country 3: Like Country 2 (but unlike Country 1), it emphasizes governance and integrity. But unlike the other countries, it promotes free trade, openness, competition, FDI and global competitiveness, as well as private ownership (including pensions and schools). It pursues a very conservative macroeconomic policy—in fact fiscal responsibility is enshrined in law. Moody’s, the commercial risk-rating agency, upgraded its sovereign debt ratings last year in the midst of a global financial crisis…

There are two ways to classify these three countries. One option is to classify them by their ideology-in-government: the first two countries pursue left-of-center polices, while the third pursues policies that are right-of-center. The second option is to classify these three countries according to their institutional quality/governance: while the second and third countries have good governance, the first has weak governance.

So, which countries are we depicting here? The first is Greece, and both the second and the third are actually the same country—Chile—during the past two decades.

Greece’s deteriorating performance on governance is depicted here, while Chile’s performance, compared with Greece, is depicted below. The results motivate us to challenge conventional wisdom about global development and governance. Let us focus briefly on six particular myths:

Myth 1: Initial conditions and external factors determine governance outcomes. Wrong. The contrast between Greece and Chile demonstrates the importance of domestic factors and cautions against exaggerating external factors and initial conditions. Greece’s history, its location, EU membership and aid received all provide favorable initial and external conditions for the emergence of strong institutions. In contrast, Chile’s geographical location and geological faults (and not belonging to the EU), points to less auspicious initial and external conditions.

Yet, Chile has stronger governance and thus pursues better policies. More generally there is growing evidence that concurrent domestic factors are highly significant determinants of country success, initial conditions, history, and external factors notwithstanding. Unfortunately, historical and cultural determinism, as well as external factors, are often used to excuse countries’ failures. Similarly, many continue to believe that large (and often indiscriminate) infusions of external financial assistance will make help countries achieve development outcomes and sustained growth.

Myth 2: Economic ideology still matters. Not very much. The riddle about Chile at the outset may have suggested the existence of two countries (originally in the FT) pursuing different economic policies. However, Chile is an example of one country simultaneously implementing market-led strategies, macro-economic discipline, and progressive social policies with a substantial state role. In Chile nowadays, basic principles of good governance dominate tired ideological divides.

For two decades, left-of-center governments in Chile have successfully implemented hard-nosed and conservative economic reforms, coupled with strong social programs and poverty alleviation, showing that we can transcend ideological divides. There is a consensus among the recent generation that macroeconomic stability, economic efficiency, poverty alleviation and good governance are not substitutes for each other but can be integrated together, and that they are key to achieving sustained growth and development. Disagreement about details on the role of the state vis-à-vis social programs and some regulations may persist across the main political coalitions, but they do so at the margin.

Myth 3: In today’s globalized world, states no longer matter; the focus ought to be on regions and global institutions. At least not for a while. Both Greece and Chile illustrate the dangers of focusing excessively on global and regional governance at the expense of national-level governance. Also, they illustrate that regional generalizations are misleading. Denmark and Greece may both be members of the EU, but they are light-years apart in terms of governance, for instance. Likewise, generalizations about Latin America are not telling.

Myth 4: The quality of a country’s governance is not as important as other factors in determining its long-term success. Wrong. The evidence to the contrary is substantial; including the research work that has been done showing that improved governance is a crucial and causal determinant of sustained growth and socio-economic development. We have found that on average there is about a 300 percent development dividend for good governance: a country that substantially improves, say, the effectiveness of its government, rule of law, and/or corruption control, can expect a tripling of its per capita income in the long run. In the case of Chile, for example, such tripling in per capita income, and enormous reduction in poverty, has taken place over a couple of decades.

Myth 5: Good governance is a luxury good. Not at all. Higher incomes or financial resources cannot ”buy” good governance. The contrast between Greece and Chile also shows that a country’s membership to the ”rich” nations club is not an assurance of sustaining good governance, or of high integrity and strong leadership. Conversely, mis-governance and corruption are not synonymous with emerging and developing economies. There is enormous variation in the quality of governance across neighboring emerging economies and developing countries.

Myth 6: One fights corruption by “fighting corruption:” creating more Anti-Corruption Commissions and redrafting laws and regulations. Not really. Many Anti-Corruption (A-C) strategies are ill advised, focusing on A-C campaigns, new A-C commission, and redrafted A-C laws (which lack enforcement). Instead, as in Chile, the focus ought to be on improving institutions and governance more generally, both on the supply side (e.g. procurement, civil service, financial management) and on the demand side (democratic accountability and integrity of elections, free press, civil society and private sector involvement). Notably, while Chile’s efforts have contributed to its low-level corruption (see chart comparison with Greece), it lacks an A-C Commission. Good governance is not embedded in particular anti-corruption commissions (there is none), rather it is embedded in the core institutions of the state.

Challenging these myths about governance and growth result in a few reflections.

The good news is that no country is a prisoner of its history—yes, history, culture and external factors do matter, but they are not the main determinants of country success. Having strong leadership, good governance, and adequate reforms makes a huge difference.

The challenging news is that while countries may not be prisoners of their past, they do have to be active stewards of their future, which implies hard and continuous efforts to improve institutions, governance, civil society activism, transparency, and leadership. These are not merely technocratic solutions but deeply political phenomena.

Lastly, let us conclude with a reminder of the ”Chilean Miracle,” a common description of Chile’s achievements. Over the past decade, Chile’s poverty rate has declined from 44 percent of the population living below the poverty line to 12 percent. The country just joined the ranks of the OECD. It routinely ranks in the top 20-30 countries in the world, not only in terms of governance and anticorruption but also in global competitiveness, contrasting Greece, for instance, whose global competitiveness index ranking has deteriorated from 47^th in 2006, to 71^st in 2009 among 134 countries ranked in 2009 by the World Economic Forum.

And in terms of corruption control, for instance, Greece rank position in last year’s WGI was 82, while Chile’s was 28 (out of 208 countries we measure).  Surely there are challenges ahead in Chile, but these enormous accomplishments are real. Yet describing them as a “miracle” is misleading; they are after all not acts of God, but of the people and their leaders.

And on a somber note, the tragic earthquake in Chile over this weekend brings these issues to the forefront. The catastrophic mega-earthquake, of a magnitude of 8.8 on the Richter scale (or hundreds of times more powerful than other major earthquakes over the past 20 years, and the fifth most powerful since records have been kept) may have taken the lives of about a 1,000 people. Every single death is painful; yet, if this figure roughly stands it would constitute a very tiny fraction of the numbers that perished in recent and less powerful earthquakes elsewhere. This is not a “miracle” either.  Chile’s good governance has made a difference.

While imperfect, this institutional environment is homegrown resulting from hard work. And Chile will not require a massive international aid rescue effort. Greece will.

Note: this entry is an abridged version of the opening keynote presentation that I gave at the “Policy Forum Armenia’s Conference on Armenia-Diaspora relations”, held at the Cosmos Club in Washington, D.C., last night, Sunday February 28th, 2010.

Further, we know now that there will be a plethora of upcoming Congressional hearings on this.  But key members of the Congressional Committees for these hearings have important interests vested with the car maker, yet so far they have not indicated that they intend to recuse themselves from the hearings…

In today’s longer opinion piece at Brookings on this Toyota SUA issue (here), I argue that the complex politics in the relationship between the industry and the government regulator, and between the industry and Congress, require a much deeper look and merits particular monitoring by public interest groups and the media.  Further transparency measures and timely disclosure of data and financial interests are also needed.

Just like it was wrong to address the fundamentals of the banking crisis by only looking at technical mistakes by bankers and policy-makers (and undue focus on narrow technocratic solutions), it would also be a mistake here to focus merely on a quick ‘mechanical pedal fix’ by Toyota.

Strengthening regulatory agencies, which ought to be better protected from political influence and capture from industry, is an important objective if serious future mishaps are to be avoided.  And the broader dilemma of of the nefarious effect of money in politics and how legislators can be unduly influenced by the powerful few cannot be ignored either, however thorny the challenge of making progress in this area may be.

Elsewhere, some writings also looked at the less-than-fully successful results of the lobbying by the largest US car makers in bailing them out last year, contrasting the government’s largesse towards the banks — the Main vs. Wall St. divide in bailout treatment.

But there is a paucity of writings about whether there may be a parallel between the financial and auto industry regarding regulatory capture.  For instance, the soft capture of the Securities and Exchange Commission (SEC) by the investment banks years ago has been discussed here repeatedly, and elsewhere.

But now the Toyota safety debacle should raise questions well beyond the conventional writings about Toyota’s ills due to their unbridled growth, sacrificing safety and transparency in the process.  Let us keep in mind that other car makers are recalling cars, even their scope is less.

More importantly, where was the relevant regulator in all this, the National Highway Traffic Safety Administration (NHTSA)?

I am no expert on the auto industry and its regulators, but having looked at the abdication by the SEC of its financial regulatory role years ago, a review of evidence that is currently emerging in the media in the context of the Toyota debacle ought to raise some questions about the NHTSA:

Was the NHTSA simply asleep at the wheel?   Was it too star-struck by the ‘Toyota #1 quality’ halo effect?

Or perhaps worse, the politics of influence and soft (or even harder) capture by the car makers compromised the agency’s independence to conduct serious investigations and reach conclusions with consumer safety as its key objective?

It may be premature to reach a definitive conclusion at this early stage of the car safety saga.  But let us consider excerpts from two media articles for now, starting with the story that Toyota’s current recall of millions of cars excluded many that might have a faulty electronic throttle system that may result in unintended acceleration, according to a class-action lawsuit filed in federal court in Charleston already a couple of months ago.

Specifically, the Charleston Gazette reports that the lawsuit from last year already explicitly stated:

“Complaints and incident reports from Toyota customers who had experienced sudden, unintended accelerations continued to come in to NHTSA and Toyota in substantial numbers after the NHTSA investigation was closed… Both the agency and the manufacturer issued statements blaming the driver’s-side floor mat, despite evidence that floor mats were almost never the cause.”

The article goes on to say: ‘During George W. Bush’s presidency, the agency and the auto industry had close ties, safety expert Bloch said.  Andrew Card, Bush’s chief of staff, was a former lobbyist for the auto industry who worked for General Motors. ”While NHTSA staff tries to do a good job, they are headed up by political appointees in the administrative and legal counsel offices. During the 2001-2008 era, those appointees included lawyers from GM and Chrysler,” he said. “So it may be that some investigations were terminated for political reasons.”

‘In a sworn deposition in December, Christopher Santucci, who worked for the NHTSA’s Office of Defects Investigation before going to work for Toyota in 2003, said he “discussed” the agency’s investigation with his former colleagues before the agency decided to limit the scope…’

“Did NHTSA ask Toyota the questions I just asked you, about what is different about these models that you’re recalling and from the earlier models that also had the [problem]?” a lawyer asked during the deposition.  ”I don’t recall them asking,” Santucci said.’

Further, today’s first page article in The Washington Post states:

‘The National Highway Traffic Safety Administration, which is charged with protecting the nation’s drivers, has long relied on automakers to help identify perils posed by the cars they make.  The reliance on automakers’ cooperation, however, might have diminished drivers’ say in the safety review process.  During agency reviews, officials have at times minimized or simply rejected consumer accounts of what happened in favor of the manufacturers’ assessments, records show. The questions about safety have highlighted long-standing criticism of the agency.”

“Unfortunately, if the manufacturer says it’s OK, then it’s OK with them,” said Jeffery A. Pepski, 54, a Minnesota driver who unsuccessfully petitioned the NHTSA with a complaint that his Lexus ES 350 accelerated unexpectedly on his way home from work last year. “The agency follows that logic all the way through their investigations. They’re not really investigating with an open mind.”

“The agency and the manufacturers know each other well. Two top officials in Toyota’s Washington office, which deals with the NHTSA, are former agency employees… Clarence Ditlow, director of the Center for Auto Safety, says the agency appears to have been too willing to accept Toyota’s version of events.”

The Washington Post article then provides further detail on NHTSA having typically sided with Toyota when confronted with consumer safety complaints.

These are meant to provide food for thought at this stage.

But at the very least it is safe to suggest that focusing the wrath on Toyota alone, while failing to ask tough questions about regulatory failures may be misguided for policy-making purposes, and dangerous for drivers in the future.  NHTSA’s own performance appears to have been well short of their own logo showing a full 5 stars.

And just like in high finance, one cannot be blind to the role of politics and the revolving door for those that traverse from a regulatory agency to a lucrative job with the (regulated) industry, or with lobbyists.

It is easy to point to managerial or technical lapses, and then rush to patchwork pedal fixes.  It is much harder to delve into the role of the money and politics in regulation and policy-making.

………

[Postcript:  As further evidence came to light, I wrote this longer opinion article at Brookings a few days later (here).]