Neoliberalism and Institutional Reform in East Asia: A Comparative Study

Neoliberalism and Institutional Reform in East Asia A Comparative Study

Edited by

Meredith Jung-En Woo

Neoliberalism and Institutional Reform in East Asia

Also by Meredith Jung-En Woo Capital Ungoverned: Liberalizing Finance in Interventionist States, 1996, also by Kent Calder, Sylvia Maxfield, Sylvia Perez and Michael Loriaux The Development State, 1999 (editor) Past as Prelude: History in the Making of the New World Order, 1992 (co-editor Michael Loriaux) Race to the Swift: State and Finance in Korean Industrialization, 1991 About UNRISD: UNRISD is an autonomous agency engaging in multidisciplinary research on the social dimensions of contemporary problems affecting development. Its work is guided by the conviction that, for effective development policies to be formulated, an understanding of the social and political context is crucial. The Institute attempts to provide governments, development agencies, grassroots organizations and scholars with a better understanding of how development policies and processes of economic, social and environmental change affect different social groups. Working through an extensive network of national research centres, UNRISD aims to promote original research and strengthen research capacity in developing countries. Current research programmes include: Social Policy and Development; Democracy, Governance and Well-Being; Markets, Business and Regulation; Civil Society and Social Movements; Identities, Conflict and Cohesion; and Gender and Development.

Neoliberalism and Institutional Reform in East Asia A Comparative Study Edited by

Meredith Jung-En Woo Professor of Political Science, University of Michigan, USA

©

UNRISD

2007

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2007 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978-0-230-52734-8 ISBN-10: 0-230-52734-5

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This book is printed on paper suitable for recycling and made from fully managed an sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Neoliberalism and institutional reform in East Asia / edited by Meredith Jung-En Woo. p. cm. Includes bibliographical references and index. ISBN 0-230-52734-5 (alk. paper) 1. Law reform—Asia. 2. Rule of Law—Asia. 3. Neoliberalism—Asia. I. Woo, Meredith Jung-En, 1958– KNC108.N46 2007 340⬘.3095—dc22 2007021653 10 16

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Contents List of Figures

vii

List of Tables

viii

Foreword

ix

Preface

xi

Acknowledgements

xv

Notes on the Contributors

xvi

List of Abbreviations and Acronyms

xviii

1 After the Miracle: Neoliberalism and Institutional Reform in East Asia Meredith Jung-En Woo

1

PART I: LAW 2 Ideology, Experience, and the Rule of Law in Developing Societies Frank K. Upham

35

3 Asia’s Legal Systems in the Wake of the Financial Crisis: Can the Rule of Law Carry any of the Weight? John K.M. Ohnesorge

63

PART II: BUREAUCRACY AND INDUSTRIAL POLICY 4 Re-engineering the Developmental State in an Age of Globalization: Taiwan in Defiance of Neoliberalism Yun-han Chu 5 Developmentalism as Political Culture and Liberalization in France Michael Loriaux

91

122

PART III: LABOUR 6 Asian Regimes and the Labour Contract Juhana Vartiainen v

145

vi Contents

7 Continuity and Change in Welfare State and Production Regimes in Advanced Industrial Societies Evelyne Huber and John D. Stephens

180

PART IV: GOVERNANCE OF THE PRIVATE SECTOR 8 The Korean Corporate Governance System: Before and After the Crisis Sung Wook Joh 9 Institutionalizing Creative Destruction: Predictable and Transparent Bankruptcy Law in the Wake of the East Asian Financial Crisis Bruce G. Carruthers and Terence C. Halliday Index

215

238

281

List of Figures 4.1 4.2 8.1 8.2 8.3

Taiwan’s policy apparatus for high-tech industries Industrial policy apparatus under the Ministry of Economic Affairs Debt to equity ratio of Korean firms Profitability relative to capital cost Voting Rights Premium (1st–25th biggest groups, simple average)

vii

120 121 224 225 232

List of Tables 4.1 7.1 7.2 7.3 7.4 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9

Taiwan’s top 25 manufacturing firms, 1998 and 1988 Welfare state regimes, circa 1980 Labour market regimes, circa 1980 Inequality and poverty Unemployment, female labour force participation and dependency rates Controlling shareholder ownership (per cent) In-group ownership trends of the 30 largest chaebols (percentage) Degree of influence of minority shareholder opinion in selecting directors and auditors (per cent) Debt payment guarantees of the 30 largest chaebols (trillion won) Equity investment of the 30 largest chaebols (trillion won) Number of cases and duration of bankruptcy proceedings, 1993–95 Six bankrupt conglomerates among the 30 largest chaebols Percentage of firm ownership needed to exercise the following shareholders’ rights (per cent) Intra-group ownership after the 1997 economic crisis (per cent)

viii

110 183 191 192 194 217 218 219 220 221 221 226 227 232

Foreword The idea of bringing together a group of scholars to study the 1997–98 Asian crisis arose in response to the concoction of theories and explanations of the crisis premised on a highly stylized view of western economies, on the one hand, and on the other, a sudden re-labelling of what only a few years earlier had been hailed the ‘Asian Miracle’ as ‘crony capitalism’. The initial idea was to bring to Asian debates, the previous African and Latin American experiences with the kinds of institutional reform that were now being proposed for the Asian economies. In Africa and Latin America, the ‘good governance’ discourse had been used to explain why growth had not taken place, even when countries had adopted the recommended economic policies. Specifically, it seemed then that the institutional reforms proposed to the beleaguered Asian economies were the same as those whose efficacy had aroused grave doubts in Africa, Latin America and Eastern Europe. It also seemed then that the Asian developmental states would not fully embrace the ‘Washington Consensus’ – and that, perhaps, one ought therefore to pay special attention to forms of adjustment and institutional innovation emerging in the region. In the course of a project seminar held in Bangkok in 2000, however, a different and preferable approach emerged. First, the studies would confront the argument that the crisis was the consequence of the failure of regulatory institutions or the absence of ‘rule of law’ (that is, it was due to ‘bad governance’). Secondly, they would examine the set of institutions being foisted on Asia and compare them to those of ‘really existing capitalism’ in the West, to see whether such institutions were likely to return the Asian economies to their historical development path. The recasting of the focus has meant that the time between Bangkok and the publication of the book has been long. However, one result of this lengthy gestation and shift of emphasis is a book of much general relevance to the whole debate about institutions and development. The book’s comparative approach brings fresh insights and perspectives to current debates about institutional reform that, many caveats notwithstanding, are still driven by an unflinching commitment to what Peter Evans has labelled ‘institutional monocropping’. It also suggests that even if the particular highly stylized institutional arrangements of the West were the prerequisites for growth in those economies, this does not preclude the possibility of others devising their own institutional arrangements that are functionally equivalent and provide the needed predictability and security in economic transactions. This project received financial support from the Rockefeller Foundation, to which we are most grateful. As is the case with all UNRISD projects, the ix

x Foreword

work would have not been possible without the Institute’s core funding, granted at the time by the governments of Denmark, Finland, Mexico, the Netherlands, Norway, Sweden, Switzerland and the United Kingdom. I once again take this opportunity to express our gratitude. THANDIKA MKANDAWIRE Director, UNRISD

Preface Nearly a decade separates the appearance of this book from the cataclysmic events of 1997–98 that put the punctuation mark on the developmental miracle in East Asia. While a decade may not be enough time for historical perspective, it is not too soon to begin a reflection on what that crisis was about, how it was handled, and what the legacy of this crisis might be. The premise of this book is that the Asian Crisis marked the end of an era in East Asia, forcing widespread structural revamping in the conduct of politics and management of the economy. This is not to say that the process of restructuring has been swift or comprehensive. In fact, it was anything but that, as the states and vested interests in East Asia selectively adopted, gingerly imitated, or fought off the changes that the world financial communities and international financial institutions (IFIs) sought to foster in their political economies. In the end, though, the genuine pain and fear at the time, as nations as diverse as the Republic of Korea and Indonesia faced bankruptcy, will be remembered as the end of an era of rapid development and the beginning of a new one – an era of transition, but towards what new end? On the face of it, the Asian Crisis was a fairly straightforward liquidity crisis. In the summer of 1997, a panic began in Southeast Asia as private borrowers found it difficult to pay back the short-term loans that had been made to finance their investment, mostly in real estate. Exports had been lagging for some time, since the Chinese devalued the yuan a few years back, making it harder for Southeast Asian countries to service foreign debts incurred to western and Japanese banks. Caught by surprise, international lenders to the hitherto booming Southeast Asian economies hit the panic button, recalling their loans and starting an avalanche that became known as the Asian financial crisis. This panic spread like wildfire, beginning in Thailand and reaching Korea by the end of November, and could not be put out until the International Monetary Fund (IMF) and other organizations assembled large bailout packages – in the Korean case, the largest one ever assembled. By December the winds of the crisis changed direction, and the fire moved back to where it had originally started, with the clearest possible political consequence: it destroyed the three-decade-old authoritarian regime of President Suharto. The causes of this financial crisis were many. For some it was a garden-variety financial crisis, much as Charles Kindleberger once described – a classic case of a financial crash that followed a panic, which in turned followed a mania or the ‘exuberant irrationality’ that Alan Greenspan said had infected the American stock market. But this is an aetiology of a crisis, not a causal explanation. Others thought that the culprit was the absence of institutional accountability in East and Southeast Asia, pithily described as ‘crony capitalism’ – a phrase that also xi

xii Preface

spread like wildfire, and encompassed everything from the close relationship between banks and corporations in Korea and Japan, to the outright plunder of national wealth by the family of President Suharto and his (how else to put it?) cronies. The best cure for ‘crony capitalism’ was thought to be a series of institutional reforms that were sometimes implemented in earnest and sometimes willy-nilly, but go under the rubric of transparency, accountability, and the rule of law. It is this reform package that forms the subject of our book. Regardless of the causes of this crisis, the aftermath made clear that the status quo was no longer viable. This was not just because some eternally minatory ‘global market’ was breathing down the neck of the Asian countries (it had been doing that for decades), or because the inauguration of the World Trade Organization (WTO) in 1995 had levelled the playing field for all economic actors, rich and poor, powerful and weak, rendering the idea of national development profoundly problematic. It was also the cumulative impact of the twenty-year-long incorporation of China into the world market system, which seriously eroded the competitive position of other East Asian countries, especially in Southeast Asia. For example, suddenly there was no significant East Asian country (with the possible exception of Indonesia) with labour cost as low as China’s, and the labour pool in China was seemingly bottomless. It became apparent that the old tried-and-true recipes that fuelled the ‘East Asian Miracle’ (a miracle that had happened in the absence of China), were in need of rewriting. In Northeast Asia, the miracle was predicated on state guidance of the economy, dominated by big business, and intermediated primarily by the banking system. The normative glue that held this system together was a social compact peculiar to capitalist Northeast Asia, obligating private corporations, in return for munificent financial and fiscal support from the state, to provide for societal full employment. By the late 1990s this Northeast Asian variant of a mutual aid society was in trouble. The banking system was burdened with massive non-performing loans, but getting rid of them proved difficult without triggering massive bankruptcy and unemployment, which would break the social compact that sustained the Asian Miracle. Unable to revise the system from within, and unwilling to bite the Anglo-American bullet that would ensure efficiency at the cost of inflicting social dislocation, Japan and Korea dawdled along, hoping desperately to ‘grow out’ of the old developmental paradigm, much as China was ‘growing out’ of its socialist planned economy. However, Korea had better luck than Japan in reorganizing the economy. This was in part because of the severity of the crisis, allowing for the gale of ‘creative destruction’; in part because international financial institutions were deeply implicated in the Korean reform process, and could run interference for the reformers; and in part because the political system is highly centralized, with the state still wielding an enormous regulatory clout, thus to enable swift action. Japan, for all the reverse reasons, found it harder to restructure its economy.

Preface xiii

Southeast Asia’s miracle economies were never hamstrung by the kind of social compact that prevailed in the north, and instead maintained the virtuous regime (from the standpoint of developmental orthodoxy) of liberal markets, non-interventionist states, and correct macroeconomic policies. They were fledgling economies, however, entering the world market late in world time – perhaps too late. By the time the Asian Financial Crisis was over with, the world was a substantially different place than it had been when the region started its manufacturing take-off two decades before. Ben Anderson, a prominent scholar of Southeast Asia, once argued that Southeast Asian economic growth resulted from a confluence of four factors. First, it was predicated on the political stability provided by authoritarian rulers, who were supported during the Cold War by the United States. Secondly, it was showered with a flood of Japanese capital, which grew mightily after the Plaza Accords of 1985. Third, the motor of economic growth was the overseas Chinese who were politically weak but chose to stay on because they could virtually monopolize economic activities in places like Indonesia. Finally, all of this had happened in the historically unprecedented situation of the forty-year sequestration of Communist China, which provided a vast breathing space for the Southeast Asian economies. If Anderson’s diagnosis is correct – that the ingredients for the Miracle were political stability, Japanese capital, and overseas Chinese entrepreneurs, in the context of the forty-year sequestration of China – then by 1998 the world was clearly different, with none of the four pieces that went into the making of the Southeast Asian miracle still in place. This development, which happened swiftly, showed that the portion of the ‘East Asian Miracle’ that was most highly touted by the World Bank because of its relatively liberal orientation, namely Southeast Asian countries like Thailand, Malaysia and Indonesia and Singapore, was perhaps a mirage, a happenstance based on often-harsh political rule and a fledgling manufacturing base that could not withstand competition from China. The Asian financial crisis may have been a harbinger, then, of the closing of the developmental era in Southeast Asia. The debate on economic reform in East Asia is no longer centred on the western model of correct macroeconomic policies, as it used to be in the past. Rather, after so many decades of developmental experimentation, there is at least a broad consensus now about what constitutes correct macroeconomic strategy for economic growth. Or if there were lingering differences on growth polices, say between officials in Beijing, Tokyo, Seoul, and those in Washington, at least there was a tacit agreement to disagree. The harder question – and one on which there is yet to be a consensus – is on the kind of institutions that can generate and support sustainable development after the 1997 crisis. In other words, the problem of economic growth suddenly became one of correct governance. This book brings together contributions that critically examine the policies on governance that came to prevail during and after the Asian Crisis,

xiv Preface

and the consequences of these policies on East Asian societies. These policies relate broadly to the issue of governance, including through the nature of the legal system (the ‘rule of law’, for instance), political institutions (the role of government and its industrial policy, however residual, for economic development), private institutions (corporate governance), as well as proper governance of labour markets. These policies represent the developmental Gestalt of the age, but just how new ideas about governance would translate into concrete policy is a big question that remains to be assessed. As conceptions associated with ‘good governance’ and the ‘rule of law’ were cast as the solutions for East Asian economies, these ideas suddenly acquired ‘consequences’ in the way John Maynard Keynes understood: ideas have consequences, and not always in a positive direction. In the end, the promotion of ‘good governance’ and ‘international best practices’ in the West was heeded in the way it was always heeded: selectively, filtered through the existing social, political, and economic arrangements. MEREDITH JUNG-EN WOO

Acknowledgements From its inception to the completion of the book, Thandika Mkandawire has guided and supported this project every inch of the way, and for this I am most grateful. The space in which scholars can voice their views at variance with the prevailing consensus is, for Thandika, a sacred space, and he has made sure that we never forget it. For his part, he has worked indefatigably to provide resources, putting money where his mouth is, so that intellectual disagreements can be aired in the open, and dissenting views get a full hearing. The contributors to this volume are privileged to have worked with him, and I would like to thank him in particular for his unfailing good humour, his faith in the importance of this project even when mine was in short supply, and his great patience. I also would like to thank Shahra Razavi, who is an economist by training but with erudition and broad perspective that go beyond the confines of her discipline, who read every chapter and offered valuable suggestions which were almost always on the mark. Likewise, Roger Haydon and Peter Katzenstein read this manuscript with great care and made the book a far better one than it would have been without their advice. The unsung heroes of this book are the numerous research assistants who helped with checking facts, finding obscure citations, filling in the missing footnotes, formatting and reformatting the chapters so they would flow more seamlessly: Jurgen Reichert and Tatsuhide Kanenari who were at the Asian Development Bank Institute in Tokyo where I was briefly in residence in 2001 as a visiting scholar, as well as my undergraduate students at the University of Michigan – Marty Harms, Stephanie Wang and Ilsoo David Cho.

xv

Notes on the Contributors Bruce G. Carruthers is Professor in the Department of Sociology, Northwestern University. He is the author of City of Capital: Politics and Markets in the English Financial Revolution (1996), Rescuing Business: The Making of Corporate Bankruptcy Law in England and the United States (1998, co-authored with Terence Halliday), and Economy/Society: Markets, Meanings and Social Structure (2000, co-authored with Sarah Babb). Yun-han Chu is Professor of Political Science at National Taiwan University. He is the author of Crafting Democracy in Taiwan (1992), Consolidating ThirdWave Democracies (1997), and China Under Jiang Zemin (2000). Terence C. Halliday is Senior Research Fellow at the American Bar Foundation, and Adjunct Professor of Sociology at Northwestern University. He is the author of Rescuing Business: The Making of Corporate Bankruptcy Law in England and the United States (1998, co-authored with Bruce Carruthers) and Beyond Monopoly: Lawyers, State Crises, and Professional Empowerment (1987). He is also the editor of Lawyers and the Rise of Western Political Liberalism: Legal Professions and the Constitution of Modern Politics (1998, co-edited with Lucien Karpik). Evelyne Huber is Morehead Alumni Professor of Political Science, and Director of the Institute of Latin American Studies, University of North Carolina at Chapel Hill. She is the author of Development and Crisis of the Welfare State: Parties and Policies in Global Markets (2001, with John D. Stephens) and the editor of Models of Capitalism: Lessons for Latin America (in press). Sung Wook Joh is Professor of Business Administration at Seoul National University. Michael Loriaux is Professor of Political Science at Northwestern University. He is the author of France after Hegemony: International Change and Domestic Reform (1991). John K.M. Ohnesorge is Associate Professor at University of Wisconsin Law School. John D. Stephens is Gerhard E. Lenski, Jr. Distinguished Professor of Political Science and Sociology, University of North Carolina at Chapel Hill. He is the author of Development and Crisis of the Welfare State: Parties and Policies in Global Markets (2001, with Evelyne Huber) and Capitalist xvi

Notes on the Contributors xvii

Development and Democracy (1992, with Dietrich Rueschemeyer and Evelyne Huber Stephens). Frank K. Upham is Professor of Law and Faculty Director of the Global Law School Program at New York University School of Law. He is the author of Law and Social Change in Postwar Japan (1987) and ‘Privatized Regulation: Japanese Regulatory Style in Comparative and International Perspective’ in Fordham International Law Journal (1996). Juhana Vartiainen is Head of Research Division, National Institute for Economic Research, Stockholm. Meredith Jung-En Woo is Professor of Political Science at the University of Michigan. She is the author of Race to the Swift: State and Finance in Korean Industrialization (1991) and the editor of The Developmental State (1999).

List of Abbreviations and Acronyms ADB AMA ANVAR ASEAN BNP CA CAC CBC CDC CEA CEO CETRA CFC CEPD CIDISE

Asian Development Bank Antimonopoly Act National Agency for the Promotion of Research Association of Southeast Asian Nations Banque Nationale de Paris Composition Act Computer Applications Company Central Bank of China Caisse des dépôts et consignations Commissariat à l’énergie atomique Chief executive officer China External Trade Development Council Central Finance Committee Council for Economic Planning and Development Interministerial Committee for the Development of Investment and Defence of Employment CIRI Interministerial Committee for Industrial Restructuring CMEs Coordinated market economies CNRS Centre national de la recherche scientifique CODIS Committee for the Development of Strategic Industries CPC China Productivity Centre CRA Corporate Reorganization Act CRCC Corporate Restructuring Coordination Committee CSD Corporate Synergy Development Centre DRAM Dynamic random access memory EDF Electricité de France EMU Economic and Monetary Union ENA Ecole nationale d’administration ERISA Employee Retirement Income Security Act EU European Union FDES Fonds de développement économique et social FIFO First-in-first-out FKTU Federation of Korean Trade Unions FRA Financial Sector Restructuring Agency FSAI Special Fund for Industrial Adaptation FTC Fair Trade Commission GAAP Generally Accepted Accounting Principles GDP Gross domestic product GNP Gross national product xviii

List of Abbreviations and Acronyms xix

IBM IBRA IC IDB IDCC IDF IDI IFIs III ILO IMF INRIA IRR IT ITRI JD JITF KAMCO KCTU KFTC KMT LCD LDP LG LIFO LIS M&As MITI MOEA MOF NASA NICs NII NSC NSTC NT ODM OECD OEM OPEC OTC PRC PROD PVRP

International Business Machines Corporation Indonesian Bank Restructuring Agency Integrated circuit Industrial Development Bureau Industrial Development Consultation Committee Indigenously-designed fighter Institute for Industrial Development International financial institutions Institute for Information Industry International Labour Organization International Monetary Fund Institut national de recherche en informatique et en automatique Internal rate of return Information technology Industrial Technology Research Institute Juris Doctor (degree) Jakarta Initiative Task Force Korean Asset Management Corporation Korean Confederation of Trade Unions Korean Fair Trade Commission Kuomintang Nationalist Party Liquid crystal display Liberal Democratic Party Lucky-Goldstar Last-in-first-out Luxembourg Income Survey Mergers and acquisitions Ministry of International Trade and Industry Ministry of Economic Affairs Ministry of Finance National Aeronautics and Space Administration Newly industrialized countries National Information Infrastructure National Science Council National Science and Technology Conference New Taiwan (dollar) Original design manufacture Organization for Economic Co-operation and Development Original equipment manufacture Organization of the Petroleum Exporting Countries Over-the-counter (markets) People’s Republic of China Productivity Proportional voting rights premium

xx List of Abbreviations and Acronyms

QUAL R&D ROC ROI ROS SMEs STAG UAP US USAID VLSI WAP WTO

Product quality Research and development Republic of China Return on investment Return on sales Small and medium-sized enterprises Science and Technology Advisory Group Union des Assurances de Paris United States United States Agency for International Development Very-large-scale integration Wireless application protocol World Trade Organization

1 After the Miracle: Neoliberalism and Institutional Reform in East Asia Meredith Jung-En Woo

A miracle is an extraordinary event that happens in defiance of all expectations. For decades after the developmental miracle first occurred in East Asia, scholars and pundits have debated the origins of this miracle; and for decades after the Asian financial crisis, they will debate how this wonder came to a crashing end. Just as there is no definitive scholarly consensus on the origins, there is also likely to be little consensus on the end. Bereft of comforting consensus, this volume nonetheless starts from a premise: the financial crisis that ended the miracle years in East Asia was a liquidity crisis that followed on the heels of premature and aggressive capital account liberalization (Blustein 2004; Stiglitz 2003; Jomo 2004), but that it came with a diagnosis that served the interests of international financial capital which sometimes have collided with the interests of the countries in question. In particular, this book examines a series of broad propositions regarding institutional reform of the East Asian economies, as suggested by international development institutions and financial communities. I shall term these propositions ‘neoliberal’, to signal the bias in favour of free-market and noninterventionist government (or in favour of an arm’s-length relationship between the market and government), and for which the template can be found in the practices of the United States and the United Kingdom circa the era of Ronald Reagan and Margaret Thatcher. Adam Smith can be taken as the original ideologue of this programme, modified for our time by the high priests of the ‘Washington Consensus’. If the latter characterization sounds too local, insufficiently global, it is still accurate: often the recommendations of the International Monetary Fund (IMF) in the 1990s could not be distinguished from those of the United States (US) Treasury Department. The crisis of 1997–98 is often thought to have stemmed from a failure of regulatory institutions in East Asia. Given that the same East Asian economies were also the greatest developmental success stories of the previous era, it also sent a shock wave through international financial organizations: it was in a sense their failure, as well. The end result was the ‘Second Round of Reforms’, which placed a great deal of emphasis on reforming social and economic 1

2 After the Miracle: Neoliberalism and Institutional Reform in East Asia

institutions in developing countries, something that had long dwelt in the shadow of much emphasis on economic policies per se, and, of course, growth. By the end of the 1980s, the world development community was said to have reached a consensus on the recipe for economic growth – namely, the kind of macroeconomic policies that could make markets work efficiently. This meant having clear knowledge and proper recommendations for reforming pricing structure, exchange rates, interest rates, and taxes and expenditures. East Asia was considered the best example of how this could be done in the developing world, and the benefits that would accrue from decades of following good macroeconomic advice – until 1997. Then the East Asian miracle collapsed overnight like a house of cards, and all the focus was on the absent foundations – the clay feet – that had precipitated the collapse. Predictably the new developmental emphasis went from ‘macroeconomic policy’, to ‘institutions’ that undergird sustained development. James Wolfensohn, the president of the World Bank, put it succinctly when he said that the ‘Second Round of Reforms’ dealt with ‘the structure of the right institutions, of the improvement of the administrative, legal and regulatory functions of the state, addressing the incentives and actions that are required to have private sector development and to develop the institutional capacity for reform’ (Italics mine) (Wolfensohn 1999). Whereas before the World Bank knew the right policies for growth, it now operated with the assumption that it knows what the right institutions are, in legal, administrative, and regulatory spheres. The economists at the World Bank do not believe – perhaps do not know – that there can be many right institutions that respond to complicated local realities, and that serve as substitute for, to use the phrase of the development economist whose name is rarely invoked these days, ‘the missing pre-requisites for development’. Forty years ago Alexander Gerschenkron (1962) argued that originality and creativity in development came not from copying, followership, or ‘one-size-fits-all’ dictums based on western experience, but from inventive and iconoclastic deviations – sudden industrial leaps forward, skipping over Rustovian ‘stages’, carving out new sequences, reinventing the role of states and markets, or transforming apparent developmental disadvantages into ‘advantages of backwardness’. But these insights are all but forgotten, and the massive market that today connects the globe is assumed to bring about the convergence of major economic institutions. The primary causal argument about the Asian financial crisis held that it stemmed from a lack of institutional accountability in East Asia, widely understood to mean the absence of transparency, moral hazards, and an inadequate rule of law. It then followed that the thrust of the reforms demanded by international financial institutions involved dismantling the institutions of ‘crony capitalism’, and replacing them with regulatory agencies that one might find in the Anglo-American world. Yet the IMF had no road map to guide the formulation and implementation of such reforms – except for the

Meredith Jung-En Woo 3

general policies of the Washington Consensus. Predictably, IMF conditionality packages often contained inappropriate reform targets, inconsistent reform measures and ill-advised reform sequences, leading to sharp downturns in the affected economies. If much has been written about the banking and finance aspect of the reforms in East Asia, for all the talk about ‘crony capitalism’ and inadequate social institutions, there has as yet been little analysis of the larger social implications of the suggested institutional reform measures for East Asia. If international financial institutions have been focusing on institutions, they still lack the expertise to analyse them. How, for instance, should we understand the logic and evolution of the institutions that are now under assault – the same institutions which were deemed the engine of growth just yesterday – and understand the social and economic functions they have fulfilled? Some of the target institutions have been enduring and effective in their own ways, having developed in response to idiosyncratic local conditions. They may prove not only resilient in the face of crisis, but quite possibly irreplaceable. This book is also an attempt to fill this analytic lacuna in the existing literature. Some of the recommended reforms may themselves be based on a misreading of actual practices in the West, practices which can be enormously diverse and complex in real life, but which tend to be understood as ideal types when recommended to Asian economies. This often results in demands for ‘one-size-fits-all’ institutional reform, and leads policy makers to see their options either in terms of maintaining the discredited status quo or embracing neoliberalism in its entirety. One of the purposes in this book is to understand the reform ideas on their own terms, cast against the actual practices that gave rise to the ideas, and see if the ideas really do hold on their own terrain, let alone on the different social realities of East Asia. The virtue of this exercise is that a recognition of the gap between neoliberal nostrums and the real practices in the West might enable the public and the policy community to think more creatively about the range of possibilities for institutional reform. The approach in this volume is comparative. The crisis in East Asia followed in the wake of previous experiences of economic crisis and reform in Latin America, Africa as well as Europe in the 1980s, suggesting lessons to be learned. But the relevance of the earlier reforms has yet to be explored, in part because of the mistaken assumption that the East Asian ‘miracle’ (and the crisis, as well) was sui generis, thus to defy useful cross-regional comparisons. We make many such comparisons in this volume. Sometimes the comparisons are implicit. Other times they are explicit, as in the comparing the capacity of the ‘developmental state’ in France with those in East Asia, or by examining the possibility of convergence in labor market institutions in Nordic countries and small East Asian countries. In what follows I lay out the arguments about institutional reform in East Asia in order to provide a context for the chapters included in this volume.

4 After the Miracle: Neoliberalism and Institutional Reform in East Asia

The first section of the book deals with the question of the reform of legal institutions in East Asia, aimed at creating the ‘rule of law’. As broad and vague as this notion is, ‘rule of law’ emerged as the solution to the deformity of the East Asian political economy, now dubbed as ‘crony capitalism’. ‘Crony capitalism’ came to refer to all relational (and not arm’s-length) economic practices in East Asia, from relational banking in Japan and Korea to the plunder of banks by the people related to the former President Suharto of Indonesia. In short, the ‘rule of law’ became the all-encompassing counterpoint to ‘crony capitalism’, regardless of the fact that law has been an important part of political and economic life in Japan, and Korea, as well. The privileging of law in the development process has gone hand in hand with the emergence – and increasing acceptance by the World Bank – of the idea that there is an empirically verifiable relationship between economic development and legal traditions. Advanced by a number of energetic economists at Harvard and Chicago law schools, the argument is that the AngloAmerican common law tradition is more conducive than the civil law tradition (of continental Europe, most of East Asia and Latin America) towards economic development. These are complex arguments, scattered in a large body of scholarly articles and not always consistent, dealing the law’s relationship not only with growth, but with corporate governance and financial markets (La Porta et al. 1998, 1999) But the message is clear: where law is concerned, there may also a felicitous single size that fits all. The problem with this kind of argument is that it tends to be made in the absence of familiarity with how legal systems have been constructed over centuries in advanced western countries, let alone in developing societies, and what everyday legal and quasi-legal practices are like. More importantly, it cannot account for the informal and relational practices that may not be in the books, but which nonetheless fulfil the function of law. We might think of such practices as substituting for the missing legal prerequisites, which for decades undergirded the development of East Asia, providing the needed predictability in economic transactions (Woo-Cumings 2001). The next part of the book examines the reform of the administrative and regulatory functions of the state in East Asia. Two broad themes stand out. One is the nature of the ‘developmental state’, through the deployment of industrial policy, like the protection of infant industries and/or strategic industries. This is a time–honoured argument with regards to East Asia, and was reaffirmed in The East Asian Miracle (World Bank 1993) and re-reaffirmed in Rethinking the East Asian Miracle (Stiglitz and Yusuf 2001). Although the economists tend to understand the ‘developmental state’ in terms of infant industry protection, the moniker also denotes something deeper in the context of East Asia. It suggests a structural tie between the state, banking sector and big private enterprises, that developed over time in the course of channelling domestic savings to targeted industries, and which ended up making the ‘exit’ solution for the banking or corporate sector highly problematic, threatening

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to bring down the whole structure on which the developmental state rested. Instead of the ‘developmental state’, then, international financial institutions suggested something vastly different, a state that keeps an arm’s-length relationship to the market while establishing and enforcing the rules of the game: we might term this the ‘regulatory state’. If it had taken the Great Depression for the United States to make a decisive break from its own version of the ‘developmental state’, might not the Great Asian Depression serve the same function? Another theme in the reform of the East Asian state concerns administrative efficiency rather than the state’s relationship with the economy (for example, ‘developmental’ versus ‘regulatory’), and comes from the 1997 World Bank Development Report, called The State in the Changing World. In that book, which the World Bank designed as a guide for ‘what the state should do, and how it should do it’, good governance was a matter of following good organizational rules: Have effective rules and restraints for political power; increase citizenship ‘voice’ and ‘partnership’; ‘subject state institutions to greater competition, to increase their efficiency’, and so on (World Bank 1997: x). In other words, the state was really no different from a business organization. In this publication, the World Bank did not think that there was a problem with the ‘state’ per se in East Asia. In fact, the states in East Asia were doing their job better than most in the developing world, and remained unscathed by the kind of crises that beset weak states – such as illegitimacy, weak capability, or questionable viability. The Bank’s eyes were instead cocked on other areas of the world and other problems – like developing the most basic state capabilities in the former Soviet republics; keeping the Latin American states on an even keel as they moved toward streamlining government and holding deficit spending in check; and, in the case of Africa, keeping the states from disintegrating in the first place. For East Asia, the main reform agenda was a deeper administrative decentralization, to better serve local needs in the era of globalization. Whether the direction of reform, as urged by the World Bank, is doing away with industrial policies or implementing further administrative decentralization, the evidence in East Asia may well go in the opposite direction. One successful case in which the state was successful in reinventing itself might be Taiwan in the 1980s and 1990s, when the government assumed the role of manager, financier, venture capitalist, and information provider in nurturing a whole constellation of high-tech entrepreneurs, thus to push the economy up the technological product cycle. Taiwan, whose reliance on industrial policy was always more restrained that those in Korea or Japan, was suddenly reinventing the developmental state, just as the notion was being given up for dead. Another example is the change in post-Asian crisis Korea. After a decade of liberalization leading up to the crisis, during which time the government was hamstrung from regulating the behaviour of big corporations and financial intermediaries, suddenly the state was back in the economy in a very

6 After the Miracle: Neoliberalism and Institutional Reform in East Asia

big way, nationalizing banks, reorganizing industrial sectors, and intervening in the management of individual firms. In the old days one called this ‘industrial reorganization’, the tried-and-true method of industrial policy. These days one would be incautious to call it that, but it is indubitably true that the Korean state has relied on industrial policy in order to lift the domestic economy out of financial insolvency. In the third segment of the book, we look at the question of labour. The neoliberal formula for reforming the labour market is fairly straightforward, in favour of ‘labour market flexibility’, again drawing inspiration from AngloAmerican practices, even though most developing countries lack social safety nets to help the population thrown out of work. The upshot is renewed concern over social safety nets, especially on the part of the World Bank, which has been extending loans to places like Indonesia earmarked for that express purpose. But does it make sense? Dismantling existing barriers to laying off workers is far easier than erecting new social safety nets. In Indonesia, existing social safety nets have been chipped away, through the erosion in employment guarantees and also through the attenuation of the protection network provided by extended families and communities – with very little to replace them. The public policy of creating new social security and insurance schemes requires not only the financial wherewithal, but, more importantly, capable state administrative structures. Many developing countries, Indonesia included, do not meet these twin requirements. Meanwhile the World Bank’s own efforts – its loans for social safety nets – remain at best temporary measures to deal with the explosive growth of people being pushed below the poverty line. Often, the money tends to disappear before it reaches the people. The situation is far more complicated in Korea, with its vibrant civil society, and having a strong labour movement at its democratic core. Korea’s labour unions are essentially enterprise unions, with strong ties with either of the two national labour federations. The structure of enterprise unions speaks to the peculiar nature of Korea’s – and also Japan’s – social compact: social welfare and safety nets are provided privately, through large corporations, and even in small and medium-sized firms, so that laying off workers is not easy. This places undue burdens on corporations in times of distress, but the state is cognizant of this and will try to come to aid of the struggling firms. The fourth arena we look at is the governance of the private sector – or corporate governance. Because the Asian crisis embroiled the private sector, rather than being a debt crisis caused by profligate states, international financial institutions were immediately focused on improving corporate governance. But what does good corporate governance mean? Prior to the crisis, the debate on good corporate governance was mostly academic, comparing the merits of the Anglo-American stockholder system with those of the Nippon-Rhenish stakeholder system; and pondering whether the two different systems might perhaps converge over time as globalization proceeds (Kester 1996). After the

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crisis, it was as if the debate was automatically resolved in favour of the AngloAmerican stockholder system, along with the recommendation that the developing countries try harder to develop the equity market. The Anglo-American system is a modern system of corporate enterprise, in the sense that Max Weber used the term ‘modern’, meaning that it is predicated on the separation of ownership from management, with a corporate civil bureaucracy acting disinterestedly under the rule of law (or good bureaucratic practice) for the benefit of the whole – or of the stockholders. In much of East Asia, though, the corporations are not ‘modern’. The majority of the firms in Southeast Asia are family owned and controlled, and this is so even in the very cosmopolitan Hong Kong. Some, like Francis Fukuyama in his book on comparative capitalism, Trust, have attributed this to the enduring traits of the family-oriented Chinese business world, which dominate economic life in Southeast Asia. But the same insistence on family enterprises also obtain in Korea. The large enterprises, which go by the name chaebol, will go to extremes to maintain family control of the firms. (For more about this, see the chapter on Korea by Sung Wook Joh.) In Japan, where modernity knocked earliest, the separation between ownership and management was not achieved until after the Second World War, in the context of foreign occupation. If after 1945 the majority of the non-Japanese East Asian firms were family firms, one cannot help but wonder whether ‘good corporate governance’, in the sense understood in the West, provides effective remedies to the problem of falling corporate profit in East Asia. In reality, there may be no relationship at all between corporate profitability and good corporate governance. All throughout the 1990s, corporate profits grew by leaps and bounds in Southeast Asia, if not in Northeast Asia. One careful study of corporate governance in Thailand shows that there was no substantial difference in corporate profits between family-controlled and non-family-controlled firms. These findings do not gainsay the need to reform the way corporations are governed. But they do point to the problem of the right remedy being imposed on the wrong ill. The problems of the Asian firms cannot be solved by insisting on adopting the American method of monitoring management, or by insisting that an objective, third party be hired to monitor the accounting, as a quid pro quo for bailing out the countries in crisis (especially when the favourites recommended were the big American accounting firms, including the discredited Arthur Andersen). It is possible that all the talk about good corporate governance is more relevant for Korea, where the activities of controlling shareholders have become a big political issue and are therefore better documented than might be the case in Southeast Asia. Still, the concerns of Anglo-American corporate governance are centred on the principal–agent problem, of ensuring that the managers behave in accordance with stockholders’ wishes. This means an emphasis on monitoring of management, through transparent accounting, outside directors on the company board, independent audits, and the protection of

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minority shareholders. These concerns are, however, a far cry from the concerns of the Korean stakeholder system, with its relatively greater emphasis on a variety of stakeholders, including employees, banks and other creditors, suppliers, subcontractors, and so on. If the collapse of Enron proves just how difficult it is, even in the United States with its most sophisticated regulatory regime, to monitor the behaviour of management and ensure transparent bookkeeping (along with big independent auditors standing by), one can very well imagine how much more difficult it would be to implement a neoliberal reform in corporate governance in the Korean context. But, more importantly, something else about the Enron case must give pause to those who are exhorted to mimic the United States: in the Enron bankruptcy, it was really only the secured interest that got bailed out, and ordinary stockholders, employees and stakeholders were left out in the cold, unprotected. By contrast, in Japan, Korea, and China, it is the employees who have the first claim on company assets, and only after their interests are taken care of, can the secured and unsecured interests stake their claims. Bruce Carruthers and Terence Halliday, in their chapter on bankruptcy, have much more to say about this aspect of governing corporations.

Reforming the legal institutions: the rule of Law and economic development The argument about the rule of law and economic development has a complex pedigree that derives from historical interpretations of the rise of capitalism in the West. It was Max Weber, of course, who argued famously that the fount of western capitalism was a rational-legal structure. This structure was a result of an organic development over a long period of time, out of a particular mix of social and cultural conditions that prevailed in Western Europe. In providing the much-needed predictability it bequeathed the most critical element in capitalist transactions. It is not clear, however, that Weber went from there to argue that a rational-legal structure was a functional prerequisite for capitalism, or that it would evolve as a necessary outcome of capitalism. Nor is it clear that he saw rational law as the only means to ensure predictability in capitalist transactions. What Weber did do was to show the simultaneity and the good fit between western capitalism and its rational-legal structure, whereas in his study of China, he endeavoured to show how alternative institutions could help or hinder capitalist development. In a reinterpretation of economic history, however, the Nobel Laureate Douglass North put a more causal spin on the relationship between law and economic development in the West. His argument was that laws establishing property rights constituted the ‘Big Bang’ that promoted economic growth. The most successful regimes of property rights arose from the capacity of property owners to resist the state and to exclude it from involvement with their separate sphere of activity – the (theoretically) free arena of impersonal

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economic exchange, otherwise known as the market. The key to economic development was to get states, which, throughout history have more often been inimical to economic growth than conducive of it, to behave more as ‘impartial third parties’, or to adopt a role sometimes called that of a ‘nightwatchman state’ (North 1981, 1990). In his view, the comparative advantage of the state is its capacity for violence, with a typically predatory goal of enhancing state revenue through the power of taxation. The best state is one that can monitor property rights and enforce contracts, but knows how to step aside or into the background as an impartial enforcer of and advocate for the rights of property holders. ‘Effective third-party enforcement’, he writes, ‘is best realized by creating a set of rules that then [or in turn] make a variety of informal constraints effective.’ A good system of impersonal exchange, combined with third-party enforcement of the rules of the game, has been ‘the critical underpinning of successful modern economies involved in the complex contracting necessary for modern economic growth’ (North 1991: 35). In the wake of the Asian Crisis in 1997, an influential body of opinion arose which essentially endorsed North’s view of the legal structure (centred on property rights) and the corresponding dim view of the role of the state. The argument was that a primary cause of the crisis in affected countries was a lack of institutional transparency and accountability, and, more generally, an absence of the rule of law, and that the best remedy for the situation was the adoption of practices associated with the Anglo-American common law tradition, which, because it developed as a way to check the arbitrary power of the state, was argued to be the best source of and predictor for the ‘rule of law’. This argument, generated by a team of economists at the Harvard Business School as well as the University of Chicago Law School (La Porta et al. 1998, 1999, 2000), was widely circulated and treated as an accepted wisdom in some of the papers produced by the research division of the World Bank (Claessens et al. 1999). The chapters herein by Frank Upham and John Ohnesorge, both of whom are professors of law and specialists on Asian law, are sceptical of the above claims made by economists. It is an irony, Professor Upham observes, that it should fall on the United States, and not France, to advocate the rule of law in the rest of the world. Most scholars of comparative law would agree that it is the civil law tradition that presents the world with the most sophisticated, evolved, well-thought-out set of laws (Merryman et al. 1994). Judges in the civil law tradition – the tradition that dominates the legal systems of most of East Asia, Africa, and South America – are more faithful to law as a set of rules, whereas judges in the common law countries adhere more to precedent. Upham also reminds us that in the United States, most state judges are elected and serve for a term of years, whereas federal judges are appointed, to serve for life, and are often politically committed – in other words, the potential for rule by politicized judges, and not the abstract rule of law.

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The American legal system may be characterized as ‘structured irrationality’, where federalism celebrates national inconsistencies in legal rules and results, and where the jury system deviates substantially and intentionally from the rule of law. In fact, Upham argues that ‘whether one defines the rule of law as the rational application of rules to facts or more abstractly as the rule of law, not men, juries simply do not fit’. Furthermore, the system of civil procedures, and specifically the adversary system, makes the practitioners of law give their primary loyalty to their client and not to truth or law. Add to that the reluctance on the part of federal or state government to make the law available to people with little or no means, and one has a system that is highly idiosyncratic and difficult to emulate even if so disposed. The larger point that Frank Upham drives home is not about the merit of different legal systems, based on fidelity to law. Rather, it is that in the United States, its ‘structured irrationality’ in the legal realm relates to political theory – that is, to the kind of goals and ideals to which the society as a whole aspires – rather than to the rule of law meaning an accurate mechanism for the uniform application of rules to facts. ‘The point here’, Upham writes, ‘is that it is perfectly understandable to create a system of checks and balances that includes direct and indirect control of the judiciary or to sacrifice predictability for the participatory virtues of the jury or the democratic value of lawyers who can effectively and freely defend their clients against the power of the state.’ So, the American legal system is an extreme example of one where the rule of law (in the sense of fidelity to rules), has been intentionally subordinated to other institutional goals or political values – and the system is no less great for that. For policy makers thinking about legal reform, other more fundamental issues regarding social goals, such as social justice and stability, may be attained through legal or through other means, such as political regulation or even fiat, yet those means may achieve the substantive goal of welfare or stability or justice. Furthermore, the introduction of new legal structures does not simply mean an addition of a new or different way of organizing society; it may also mean the destruction of old, often informal ways. Foreigners dedicated to changing other people’s laws must understand what is already in place and practised (even if it may be ill understood by outsiders), but this is precisely the kind of knowledge that is in particularly short supply among the international practitioners of the ‘rule of law’. Legal scholars Kevin Davis and Michael Trebilcock (1999), in their exhaustive bibliographical survey of the relationship between law and economic development, have concluded that in spite of the hoo-hah about the importance of legal reform for sustained economic growth, surprisingly little is known about this allegedly critical relationship between law and economics; furthermore, the ideological bias against the state as well as the preoccupation with the court system inappropriately discounted the importance of public agencies, just when their integrity and effectiveness was most sorely needed in growing

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economies. In fact, they argue that the relationship between law and development was likely to elide with the relationship between public sector institutions and development more generally, rather than in the opposite direction. I have also argued elsewhere (Woo-Cumings 2001) that the exclusive concern with law and governance would seem inappropriate in the context of East Asia where, with the exception of the former British colonies, law has often meant public or administrative law, and where the absence of the common law system (or the presence of the civil law system) did not sum up to public institutions of poor quality. The causal arrow, I have argued, does not run from the legal tradition and system to the political arrangement that favours growth, but the reverse: it runs from the political arrangement that favours economic growth, to legal development. Others have advanced similar arguments, using different historical evidence (Rajan and Zingales 2000). To the extent that law reform is required, the first requirement would seem to be the broader one of creating reliable and efficient public institutions and making them effective and accountable, rather than importing from elsewhere a legal tradition which may not take root. Or as Frank Upham argues in this volume, in the absence of a carefully elaborated model of law and development based on empirical evidence . . . advocates of legal formalism extrapolate from Weberian sociology and the historical experience of European capitalism to the rest of the world. Universal theories of the interdependence of legal form and economic activity lurk behind the rhetoric of the rule of law without a great deal of intellectual agonizing over exactly what this form of law entails. What does the World Bank really mean when it advocates the rule of law? In his chapter Upham attributes the broadest possible meaning to the term, as denoting ‘good order’, or good governance, or ‘a system based on abstract rules which are actually applied and on functioning institutions which ensure the appropriate application of such rules’. Good governance, defined as such, might well be a universal ‘good’, but also one that is indistinguishable from politics per se, which the World Bank is supposedly prevented from considering in making lending decisions. ‘Good governance’ separated from politics is synonymous with the rule of law, as a condition for the award of loans. A functioning and enforceable legal system does provide stability and predictability in the rules of the game, and it is undeniably true that it holds the promise of restraining the arbitrary exercise of power, political and otherwise. But what are the criteria for this function and enforceable legal system? Upham cites the minimal criteria that Ibrahim Shihata, the former General Counsel for the World Bank, suggested: (i) transparency; (ii) uniform application; and (iii) neutral, arm’s-length conflict resolution. The trouble is that the legal system in Japan would not meet the criteria that the former General Counsel set forth, yet it is not as if law does not matter

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in Japan. To the contrary, law has played an exceedingly important role in the social and economic development of Japan. But it was an imported hodgepodge of law from various continental countries which provided the moorings for the rise of the modern state, and for the administrative oversight of the industrializing economy. It was only with the advent of postwar democracy, and at the time of rapid economic expansion, that relative shrinkage of the legal sector of society happened. What does this say about the relationship between law and economic development? Frank Upham argues that Japanese economic growth took place against the backdrop of legal dualism, with formal legal institutions playing at best a back-up role to informal mechanisms. Economic policy was discussed, formed, and implemented largely through informal mechanisms that were consciously shielded from the interference of the formal legal system – or intervention by the courts in the implementation of economic policy on behalf of private parties. This process of formulating industrial and financial policies in the relatively prophylactic realm of bureaucratic prerogative, and implementing them through ‘administrative guidance’, is really the essence of what Chalmers Johnson (1982) once called the capitalist developmental state. The Japanese system worked for the reasons that are by now well known. Economic policy formulation and implementation were conducted by dedicated and competent civil servants, and in spite of the recent spate of corruption scandals, the public sector remains relatively free of corruption. It is also important to note the existence of pervasive consultation and communication among the interested parties and between the public and private institutions. This system was not so much corrupt in the sense of direct bribery, but it was corrupt in the structural sense of being exclusionary, collusive, and arrogant. What then provided constraints on this arrogant behaviour of the insiders? Upham argues that it was the formal legal system that in the end placed an outside limit to the flexibility and arrogance of the insiders. (See Upham and so on, also some citations from my law working paper.) This kind of dual legal system works, but is opaque to foreign actors and enterprises – the outsiders. Outsiders always complain about inefficiency and opacity in a system in which they cannot participate. It is not surprising, then, that the ‘rule of law’ is the maximal argument advanced by those interested actors who want to change indigenous legal and economic practices, in ways that are likely to benefit OECD competitors in these markets. Predictability in a particular legal regime is clearly desirable, but the question is cui bono: predictability is eventually separable from the choice of any particular legal code, and may be ensured through the existence of alternative conflict resolution mechanism, or informal adjustment process. For instance, the practice of administrative guidance in Japan and Korea is not arbitrary but quite predictable and even transparent to the players who know the game, but it is strongly prejudiced against outsiders.

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The vested interest of outsiders in forcing legal change is an issue that John Ohnesorge takes up, by returning to some useful US legal and political history. He shows that a focus on legal formalism in the United States was used as a way to thwart progressive political movements, and the reappearance, basically from the international financial institutions, of high abstraction as the criterion on which commentators call for the reform of Asian legal systems is likely to be masking similar opposition to basic differences in legal and economic structure. The core vision of the rule of law sees the protection of private property and freedom of contracts as the bases for a market economy, and is profoundly Hayekian. ‘Stripped of all its technicalities’, for Hayek the rule of law means that ‘government in all its actions is bound by rules fixed and announced beforehand – rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge’ (Hayek 1944, 1960). Ohnesorge traces this idea to an essentially utopian vision of the nineteenthcentury common law of England and the United States, with some distinctly German Rechtsstaat overtones. But there are, he notes, other more progressive traditions that directly addressed the relationship between law and economic behaviour, and which had to battle absolutisms in the form of transcendental principles like private property, freedom of contract or separation of powers to justify conservative actions. He discusses in particular the tradition of legal realism in jurisprudence, as well as American institutional economics, which are invariably associated with the rise of the administrative state through the Progressive movement and the New Deal, and which represented a rejection of formalist, deductive reasoning in favour of philosophical pragmatism. In other words, even in the United States there are many springs that the proponents of legal reforms can draw from, but it is the Hayekian spring that provides the reigning inspirations in an age where liberal markets have so thoroughly triumphed. None of this is to gainsay the real need for change in the legal system in East Asia. In fact, Ohnesorge goes on to detail the areas where the needs are most acute. The point, though, is that the rule of law argument, presented as universal principle, is blithely ignorant of local realities, and has little to say about existing problems that require change – let alone how to bring about the changes. Instead it is a rubric under which various interests make selfinterested demands for change.

Reforming the state institutions: reinventing industrial policy The idea that the days of industrial policy are over is hardly new. Scores of books on the Japanese and Korean political economies have been published in the last decade to argue precisely this point. Gone are the days of indicative

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planning, state intervention in the allocation of bank credit, financial repressions (in Korea) and overdraft ( Japan) which made demands for industrial credit insatiable, as well as the state-sanctioned industrial rationalization and reorganization which were designed to create markets that are both competitive and orderly, oxymoronic as it may be. This eclipse of yesterday’s developmental institutions is at the heart of so many arguments about the postdevelopmental regime in East Asia. But what was the developmental state in the first place? Did it mean a specific set of policies and institutions – or did it mean something bigger than that? I have argued elsewhere that the developmentalism in East Asia was not really about a specific set of institutions, but a ‘shorthand for the seamless web of political, bureaucratic, and moneyed influences that structures economic life in capitalist Northeast Asia’ (WooCumings 1999: 1), and which has a longer life span than a particular policy mix which are designed to meet the challenges of the day. Michael Loriaux, a scholar of the French political economy, which is arguably the archetypal developmental regime in Europe, concurs that developmentalism is more than a set of policies and institutions. It is, in his view, a kind of culture, composed of language games and norms, which institutions can house in a variety of ways. He argues in Chapter 4 that ‘developmentalism, understood as a kind of culture, informs and constrains the way the French think about investment strategy, both inside and outside the formal institutions of the state’. France once had a set of institutions and policies that were evocative of the heyday of developmentalism in Japan and Korea. Prior to the 1980s, France had pursued a developmental industrial policy supported by subsidies, credit controls, indicative planning, and direct intervention in state-owned enterprises. But the reforms of 1983–85 under the socialist leadership all but eliminated what had served as the principal tool of state intervention for almost three decades, most importantly state control over the allocation of credit by banks and other financial institutions. By the early 1980s, structural adjustment of the French economy was becoming increasingly problematic, given the high level of business indebtedness and low business profitability. Between 1981 and 1986, the French developmental state switched gears, and resorted to direct ‘stock-holder’ intervention by the state, made possible by nationalization of banks and large industrial firms. Nearly all large banks and industrial firms became state property. Between 1981 and 1985, the state invested 5 billion francs in nationalized firms, a level of investment that Vivienne Schmidt (1996) estimates at roughly 20 times the level of private investment between 1965 and 1980. Loriaux shows that the state used the leverage of its ownership to restructure industrial firms. The state reduced firm debt and funded industrial restructuring programmes that lowered production and operating costs. In fact the French redesigned institutional support for state-led developmentalist policy several times in the postwar years, from one of budget-funded subsidies, to credit controls, to nationalization of the most important banks and industrial firms.

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The similarity of French firms in the early 1980s, indebted and unprofitable, with those of the East Asian developmentalist political economies is patent, but the most striking similarities may be found with Korea after the crisis. If the nationalization of banks and large industrial firms in France was owing to the electoral platform of the socialist–communist alliance, in Korea the nationalization of banks happened as the result of the crisis and the ensuing lack of viability on the part of the banks encumbered with massive non-performing loans. The Korean government adopted a dual strategy of forcing large industrial firms to sell their unprofitable subsidiaries, and/or merge with other firms – as well as the effective nationalization of banks, through purchase of their shares. The first strategy was called the ‘Big Deal’, which was really a new moniker for an old phenomenon that used to be known as industrial rationalization, consisting of forced swaps and mergers of firms through state diktat and cajoling (Woo-Cumings 2001). The second strategy of bank nationalization was far more direct but less coercive; it was also far more successful. Within four years of nationalizing most of the large banks, the banking sector was once again profitable, and the firms were once again growing out of their debt crunch. And as in France, the government strategy to make the banks and firms competitive was to induce foreign investment. In France this meant a strategy of merger and acquisition in radical innovation markets, by acquiring non-French, and especially American, firms – as well as a major presence of institutional investors (again, largely American) for a large share of equity in major French firms. In Korea, the state also clearly favoured American firms to acquire some of the Korean firms and banks, as a way to force greater internationalization and enhance competition. Loriaux argues that the common thread that ties the various manifestation of developmentalism in France – budget-based, bank-based, state-ownershipbased – is the presence of the bureaucratic state elite. Developmentalism in France is rooted in organizational structures, true. But it is also in the ‘pervasive presence of an elite that shares a common education, language, socialization, and self-confidence. French thinking about industrial strategy is informed by the cultural fact of this elite’s existence, of its socialization into a system of values that thinks in terms of national interest, of France’s place in the world and in the world economy.’ Now compare the following remarks by Michael Loriaux and Chalmers Johnson about who governs the developmental states in France and Japan. In France: One set of institutions that did not change in this period, however, was that of the Grands Corps de l’État, the corporations of high civil servants. France’s administrative elite is powerful and pervasive . . . It is recruited from France’s grandes écoles, specialised professional school that function independently of the French university system. Highly selective competitive

16 After the Miracle: Neoliberalism and Institutional Reform in East Asia

examinations guard access to the grandes écoles. The Grands Corps co-opt the top students of the grandes écoles, especially the Ecole Nationale d’Administration. Co-optation means a job with tenure and the possibility of extended leave from the administration without loss of tenure. The high civil servant is free to move about, from administration to politics to business, without professional risk. Thus one finds the administrative elite not only in the state but also throughout the world of business and politics. They dominate ministerial cabinets and abound on the boards of large firms, both public and private, and in the inner circles of France’s principal political parties. The pervasiveness and power of France’s civil service elite creates a political economy in which the boundary between public and private is extraordinarily porous. For Japan, Chalmers Johnson puts it like this: Who governs is Japan’s elite state bureaucracy. It is recruited from the top ranks of the best law schools in the country; appointment is made on the basis of legally binding national examinations – the prime minister can appoint only about twenty ministers and agency chiefs – and is unaffected by elections results. The bureaucracy drafts virtually all laws, ordinances, orders, regulations, and licenses that govern society. It also has extensive extra-legal powers of ‘administrative guidance’ and is comparatively unrestrained in any way, both in theory and in practice, by the judicial system. To find a comparable official elite in the United States, one would have to turn to those who staffed the E-Ring of the Pentagon or the Central Intelligence Agency at the height of the Cold War. ( Johnson 1995: 13) This comparison with East Asian developmentalism is not simply intriguing, but suggests that western countries with a civil law and civil service tradition might be the best source of new ideas for reform in East Asia. In Chapter 5, Yunhan Chu also provides food for thought about the various manifestations of industrial policy and developmentalism – in his case, for Taiwan. As in France and Korea, the Taiwan state was most purposeful in transforming the economic landscape, and the state officials played a big role in devising a programme of technological upgrading, identifying the trajectories of innovation and diffusion, and serving as catalysts in motivating and enabling local firms to upgrade. But Taiwan has been never the pure kind of East Asian state – a hands-on, interventionist state, relying heavily on bankmediated credit to influence domestic firms. Taiwan has always been somewhat different than Japan or Korea, in that the presence of the state was in the form of the very sizeable state sector controlled by the Kuomintang. Its banks were not instruments of industrial policy – rather, they resembled pawnshops, with heavy emphasis on collateral. Consequently, its firms were far less indebted than those in Korea or Japan, and in fact the debt to equity

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ratio in Taiwanese firms is lower than any country in East Asia, and lower all through the 1990s than in countries with thriving equity markets, including the United States. The main means for technologically upgrading Taiwan’s economy rested instead in upgrading and transforming the state’s policy apparatus. Chu shows a number of ways in which the state improved its policy planning capability, and much of it was focused on creating new institutions and policies designed to recruit the best talents from a vast pool of overseas Chinese (and not necessarily Taiwanese) scientists and engineers. It is pretty amazing when you think about it: a small island tapping into the pool of the best and the brightest among the world’s biggest diaspora of some 500 million people. The human resources potential is so great that it would seem quite natural for Taiwan to have attempted this – except that India, with its similarly vast and talented pool of diasporic scientists, is not so successful in organizing itself to lure back its expatriate scientists. The state in Taiwan also created enabling environments through infrastructures like the famous Hsin-Chu Science Park, as Taiwan’s answer to the Silicon Valley, and supported them through a specially-earmarked Executive Yuan Development Fund. To upgrade research and development (R&D), the state also established a number of research institutes and semi-public institutions that disseminated the latest technology, and helped entrepreneurs to start up their new technology-based businesses. It also created institutions that focus on the latest managerial know-how, the best practices in the information technology and industrial design, and sharing them with private firms. The government also helped to internationalize the firms, channelling foreign investment into strategic sectors and abetting the development of strategic alliances with multinational corporations. The overall picture of the Taiwan state that emerges from Chu’s discussion is that of a state that was doubling as incubator of high-tech firms, performing the kind of role that entrepreneurs and venture capitalists performed in Silicon Valley, and once the firms were off the ground, to coordinate R&D and other information-related activities on behalf of these firms. This new developmental state incubates, facilitates, and coordinates the activities of the firms, but is not as high-handed as the state in Korea, which had to monitor the financial activities and conditions of the large firms, which were often huge albatrosses around the neck of the banking sector.

Reforming labour and social policy Labour market flexibility would not have emerged as one of the central issues in reforming the crisis economies of East Asia, except for the peculiar turn of events in Korea. The situation that so riveted the attention of international lending agencies, international investors, not to mention the Korean government and business, stemmed from Korean laws which were pro-labour

18 After the Miracle: Neoliberalism and Institutional Reform in East Asia

in issues of worker redundancy and layoffs. Although Korea did not have Japan’s lifetime employment system, state regulations, owner customs and strong unions made it hard to dismiss workers. Unless these older structures could be dismantled to give domestic and especially foreign enterprises wider latitude to lay off workers, corporate restructuring of any large magnitude was deemed all but infeasible. Hence, the IMF structural adjustment programme became an occasion for overhauling the labour market regime in Korea, to make it more ‘flexible’, all the while, it was hoped, without causing social instability. In the years before the Asian crisis, Korea’s labour market had been characterized widely as ‘inflexible’. This inflexibility referenced one aspect of Korean labour law – its leniency with regard to job security and certain aspects of worker welfare – but it ignores the other and perhaps more important aspects, like the extremely repressive anti-union laws which were aimed at labour control and exclusion. The Korean labour laws amalgamated exceedingly strident anti-labour legislation with regard to union membership and political association, but pro-labour regulations with regard to employment, with the laws denying the employers’ right to lay off workers in times of business difficulties. Essentially, the Korean government traded labour peace and the absence of real unions for stability of employment. This latter aspect was singled out throughout the 1990s, by employers and foreign investors alike, as needing revision in order to make Korea competitive and more appealing to investors. Even so, this job-security-related inflexibility really applied to large enterprises, and the enterprise unions that belonged to them. Labour market inflexibility in Korea is something of a misnomer. But the perception in Korea of a militant and powerful labour lingers, and this is not entirely without reason. Coinciding with the 1987 democratization in Korea, the number of labour disputes in the three summer months in 1987 exceeded the total for the previous two decades; the total number of unionized workers went from one million to 1.7 million; and the total number of unions jumped more than twofold (Koo 2001: 66). In that summer, industrial production was often paralysed, and not just in the textile sector. Workers in the heavy and chemical industries showed that rank-and-file militancy was possible even within the structural confines of enterprise unions. This was in marked contrast with the enterprise unions in Japan which had long settled into a niche carved out in the business-dominated hegemonic order. The unions in Korea are enterprise unions in form, but militant and independent in spirit. The oxymoronic nature of Korea’s militant enterprise unions can be gleaned from the front pages of major international newspapers; workers with their fists raised high in defiance, their message silently splashed across their headbands, and all of this with a great deal of militaristic precision and orderliness, in hundreds of neat files. If one of the indelible impressions of North Korea in the minds of the world is its soldiers goose-stepping to the tune of another era, as they did when Madeleine Albright visited Pyongyang

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in the fall of 2000, surely South Korea must present the world with another anomaly in the form of its militant enterprise unions, also marching to the tune of another era: labour militancy appears all but dead in the rest of the world, a relic of another era, but it is apparently alive and well in Korea. The stridency of Korean labour is an all-too-predictable result of the threedecade-long labour control by the state, which had not hesitated to inflict violence on workers, even in conflicts at the shopfloor level, and ignoring the violation of labour practice laws on the part of the enterprises. The upshot of this was the profound politicization of labour, leading to political alliances with dissident and democratic forces at large. This explains in part how labour and the middle class could join forces in 1987 to bring an end to the authoritarian government of Chun Doo Hwan (1980–87). The succeeding government of Roh Tae Woo (1987–92) sought to reduce the role of the state in the day-to-day management of labour relations, leaving the enterprises to their own resources. Panicked, Korean business made large concessions to labour demands, including an increase over 20 per cent in wage and improvements in working conditions and various welfare provisions (Koo 2001: 66). This was made possible by the great prosperity that the Korean economy enjoyed in the late 1980s when the growth rate soared to double-digit levels unheard of since the 1970s. However, labour militancy was on an upward trajectory just as corporate profits were headed south in the 1990s, as discussed in Chapter 9 by Sung Wook Joh. The conservative regime of Kim Young Sam (1993–97) and Korea’s big businesses pinned the blame on labour as the chief obstacle in restoring corporate profitability and instituting structural adjustment of the economy. So long as corporations were not free to streamline their workforce, the argument went, it was not possible to for them to compete in the world market, nor have market discipline imposed on them by others. Labour militancy was also seen as the major reason multinational firms were shying away from investing in Korea. Thus, ‘labour market flexibility’ became a major component of the reforms envisioned by the Kim Young Sam government. The first time the government tried to make a go at the ‘flexibility’ idea, in December 1996 it rammed the legislation through the half-empty National Assembly in the middle of the night; labour responded in January by nearly shutting down the entire economy. What President Kim Young Sam had not quite realized was that, unbeknownst to the conservative leadership whose ideology still harkened back to the Cold War era, and which was prone to understand politics in terms of a simple left–right spectrum, labour in Korea had become politically consanguineous with the democratic forces in Korea, including students and a very large segment of the middle class. The attempt to slam-dunk legislation providing for worker redundancy and layoffs only provoked massive protests and a near general strike, involving blue-collar workers in heavy and chemical industries and white-collar workers from banking, insurance, hospitals and the news

20 After the Miracle: Neoliberalism and Institutional Reform in East Asia

media. And it was not just union workers, but middle-class citizens, deeply concerned about their job security, that spilled out onto the streets and paralysed the economy. President Kim Young Sam was forced to withdraw the controversial labour law, and was a lame duck the rest of the year (1997). The Asian Crisis came along and changed all that. One of the first conditions for structural reform demanded by the IMF was the reform of the labour laws, thus to do the hatchet job for the government and the ruling party. How the IMF came to demand ‘labour flexibility’ in Korea, given the short political fuse it has, is something of a mystery. Most likely it was the Korean government who insisted on labour market flexibility and used the IMF as a political cover. In any event, this is how labour came into the equation of neoliberal reform in East Asia, in the aftermath of the Crisis. The 1998 inauguration of the Kim Dae Jung government, with its relatively wider base in labour, occasioned a fresh debate about the new paradigm for labour and production regimes in Korea. Kim very genuinely wanted many of the basic reforms that were in line with the desires of the international economic community, and believed that the only way those reforms could be brought about was through the nationalization of the ailing financial sector, and infusion of both the capital, management know-how, and the entrepreneurial sprit of multinational, especially American multinational, enterprises. There is a great similarity here, as we noted earlier in this chapter, between the way in which the French Socialist government restructured its economy in the early 1980s and the Korean restructuring in the period 1998–2002. Unlike France, however, where nationalization included large enterprises and the restructuring came at the expense of employment, Korea chose to force large firms into ‘voluntary’ acquisitions and mergers, and to facilitate this process the government brokered a series of tripartite meetings involving the state, big business and labour. The historically-unprecedented tripartite meetings seemed to herald a new era for labour in Korea, and raised the possibility that Korean labour, rather than capitulating to a neoliberal labour and production regime, might go the way of the Northern European welfare system and corporatist labour regime. Instead of having the hobbled corporatist regime – or what T.J. Pempel once called ‘Corporatism without Labor’, for Japan – the hope was that perhaps Korea could have a fully-fledged corporatist regime, and labour activists began looking harder at the model adopted in Germany and other continental European countries. The fact that labour was able to obtain the right to engage in politics and field its own candidates in elections has also reinforced the view that Korean labour may be able to push for a European-style welfare regime, which, as Huber and Stephens remind us in their chapter, is a political construct that reflects the commitments and power bases of incumbents. Thus, in the midst of the crisis that involved massive layoffs, labour was looking to Holland and Germany to learn more about the politics of the corporatist welfare state.

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So it is in the context of labour being at a crossroads and looking beyond the Japanese solution (where labour is essentially subjected to corporate hegemony, however benevolent) or the neoliberal solution (where labour is subjected to market) that the chapters by Evelyne Huber and John Stephens, and Juhana Vartiainen should be read. The main argument advanced by Evelyne Huber and John Stephens is that classic social democratic welfare states (defined as ones that offers comprehensive, universal, and generous protection for the entire population and have active labour market policies) do best among western governments in reducing poverty and increasing social comity. They have also performed at least as well as the liberal welfare states (defined as a residual welfare state providing partial coverage for only those who cannot protect themselves through the market and is passive in labour market policy) even under the very difficult conditions that prevailed since the 1970s. In other words, the gloomy prognoses of the lack of viability on the part of the European welfare state in the globalized world do not hold up; generous welfare states are compatible with open trading regimes. Globalization need not lead to conformity of labour and production regime around the world. Data that Huber and Stephens present show that you can have your cake and eat it, too. There has been a significant retrenchment in welfare states in recent years, it is true. But Huber and Stephens observe that this retrenchment was generally moderate and driven by budget pressures in response to rising levels of unemployment as well as demographic factors, like the growth of the elderly population – and not because globalization has made the generous welfare state, with its excessive wage and non-wage costs, uncompetitive. To the extent that globalization had a decisive impact, it was in shifting the political balance of power within the social democratic welfare state, with the business sector gaining power vis-à-vis labour and government through the credible threat of exit and relocation. Even so, the support constituencies for social democratic welfare state remain overwhelmingly large, and in the absence of a profound economic crisis and some kind of consensus on required change, these constituencies are not likely to curtail their entitlement expectations. (The exceptions are Britain under Margaret Thatcher and New Zealand under the conservative National government, where ideologically-driven regime shift did take place, for idiosyncratic reasons.) What lessons do the experience of social democratic welfare regimes hold for the East Asian countries? The first lesson, Huber and Stephens would argue, is not to lose sight of the main goal of social policy: to provide social protection through periods of illness, unemployment and old age. Social democracies in Europe have performed this role well, and reduced poverty and inequality far more effectively than elsewhere. And the experience shows that there is no necessary zero sum relationship between generous welfare and economic growth.

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The second lesson is of the great resilience of the postwar classic welfare regime. The European states have had to change in the face of demographic and other pressures, in order to make their social policy more viable economically. But this has not led to the kind of regime shift under Margaret Thatcher or Ronald Reagan; instead, there can be and has been a great deal of learning, copying, and experimenting between different variants of democratic welfare states. Some of the reform experimentations include the Nordic model which combines support for women’s employment and active labour market measures to promote higher labour market participation, and the Danish model of lower employer payroll taxes, especially for small and medium-sized employers, and labour market flexibility with strong safety nets in order to promote employment in the private sector. In other words, the neoliberal model is not the only realistic option open to East Asian economies. The last, and perhaps the most important, lesson for East Asia is that the welfare state in Europe is a political construct – and not a market-driven economic construct. Stable support coalition for generous welfare regime include strong political parties and strong labour movements – and it is here that some real changes are taking place in East Asia. In Korea there has never been a major political party that was allied with labour, and even Kim Dae Jung, the most pro-labour president since the founding of the republic, was roundly denounced by labour for his neoliberal reforms. But the ascendancy within Kim Dae Jung’s party of the labour-oriented group, as well as the founding of a political party that is backed by one of the national labour federations (the Korean Confederation of Trade Unions), may augur well for the emergence of political coalitions that can sustain a corporatist welfare regime. The labour movement in Korea is also being streamlined, moving away from the enterprise structure to a more centralized, industry-wide, structure. The two national labor organizations are merging numerous smaller federations they oversee into occupational or industrial unions. This is because the current enterprise union structure is ill-equipped to develop a social compact between labour and capital; only when the unions are more centralized, much as the capitalist organizations are centralized, can they engage in corporatist policy concertation. It is when labour is backed by strong political parties and strong movements that it can better reach accommodation with the employers. Such accommodation must be based on the common goal of a productive and competitive economy, which can be obtained through an emphasis on the cultivation of strong human capital. Labour is more inclined to make concessions on such issues such as wage setting and employment creation if they can rely on the party in power to promote adequate taxation and expenditures for comprehensive welfare state programmes. Like Huber and Stephens, Juhana Vartiainen argues that there is ample room, even in today’s globalized capitalism, for viable but differentiated labour market institutions. Reflecting on the historical development of labour markets

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in Japan and Korea, Vartiainen argues that a more European-style corporatism is not an impossibility for East Asia; in fact, he thinks it is quite possible that it could succeed, mutatis mutandis, the authoritarian developmental state. The reason behind such thinking is not unlike those of Huber and Stephens – it has to do with politics. The affinity between the East Asian model of labour markets and the European social democratic model may be found, according to Vartiainen, in the political culture – or the shared belief according to which the oikos should always be subordinated to the polis, or the reluctance to let the market dictate the political. The ‘thick fabric between the state and society’ in East Asia could, in principle, support European-style corporatist labour markets and corporatism in the sense of cooperation between a strong state and organized economic agents; it can also, in principle, severely limit the scope of decentralized market relationships in the labour market. If Vartiainen is surprisingly forthcoming in discussing the corporatist possibility for East Asia, it is but a logical extension of his earlier work that compared the ‘etatist late-development strategies’ of two European countries (Finland and Austria) and two East Asian countries (Taiwan and Korea). His argument was that the two European and two East Asian late-developers were remarkable similar in terms of their positions in the world system, and in their economic policies that derived in part from their positions in the world economy, as well as in the corporatist structure that undergirded the state–business relationship. Yet Finland and Austria could maintain very strong regimes of labour market corporatism, thus disproving the often-heard argument that the developmental state goes hand in hand with weak labour. Pushing his earlier argument to its logical conclusion, Vartiainen sees little reason to foreclose the possibility that East Asian developmental regimes could develop some kind of labour corporatism a la Finland and Austria.

Governance of the private sector The governance of the private sector, more than anything else that we focus on in this book, was at the heart of the comprehensive reform package put together during the Asian Crisis by the IMF. Generally speaking, the public sector in East Asia has been in sounder financial condition than in other parts of the developing world: it is not bloated, nor is it excessively indebted. Unlike the debt crisis of the past decades, the Asian crisis did not involve sovereign debt. By contrast, the private sector in East Asia – especially in Korea and Japan – was excessively leveraged, over-extended into a broad range of markets, specializing in everything (and often nothing). So the reform package put together by the IMF was designed to alter, once and for all, the way that the big business conducted themselves in affected countries like Korea. The IMF, in full cooperation of the newly elected government of Kim Dae Jung, demanded that Korea’s big business reduce their reliance on debt financing by half, from over 400 per cent to 200 per cent by the end

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of 1999, and suggested specific ways it could be done. The IMF also asked of Korea’s big businesses to sell off ‘non-core’ subsidiaries, and to stop diversifying into unrelated fields. It also demanded that Korea institute a governance system whereby the power of minority shareholders and outside directors would be vastly enhanced. More generally it demanded transparency and accountability, and to ensure that such was forthcoming, had the Korean firms hire big international accounting firms – and, most notably, Arthur Andersen. Even as the IMF and the World Bank helped set concrete, near-term goals for the Koreans on how big business should be restructured, however, they failed to address the deeper issue of what constitutes, in the context of developing countries, good corporate governance. In fact, the very notion of corporate governance was relatively alien to East Asians, including the Japanese. In the context of societies that may lack legal norms and traditions that undergirded the rise of the rational modern corporation, corporate governance is a problematic concept. The traditional discourse of corporate governance is predicated on the longstanding practice in the United States of separating corporate ownership from control. In the context of ‘modern’ enterprise, good governance is really about holding corporate management accountable to the interests of shareholders, or reducing agency costs (meaning the costs to shareholders of managerial behaviour not consistent with their interests). The methods for achieving this accountability are often formal and legalistic and, according to some, idiosyncratic to Anglo-American traditions. In this sense, corporate governance can be thought of as a separate taxonomic entity from, say, ‘contractual governance’, which is said to characterize the ‘Nippo-Rhenish’ model of business organization. In the latter, good governance is a matter of reducing transactions costs by building and investing in stable and long-term commercial relationships among transacting companies (Gourevitch 1996). To avoid equating corporate governance with the ideal-type of AngloAmerican business practice (which would have limited utility as a template for countries with substantially different legal norms and traditions), some have sought a broader conceptualization that transcends the regional-specificity of governance models. Carl Kester (1966) argues that corporate governance should be understood simply as ‘the entire set of incentives, safeguards, and dispute-resolution processes used to order the activities of various corporate stakeholders, each seeking to improve its welfare through coordinated economic activity with others’. In this rendering, both the Anglo-American and NippoRhenish systems of governance are economically rational attempts to resolve problems of coordination and control among corporate stakeholders, and no a priori judgement is made about the ultimate superiority of either national configuration. Even so, this catholic definition of corporate governance is predicated on the highly evolved structure of the modern corporation, with a whole panoply of legal or otherwise regularized sets of norms that dictate the behaviour of transacting parties.

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The debate on corporate governance in the context of global competition has been particularly fickle and prone to revaluations. In the 1980s and well into the 1990s, for instance, it was fashionable to argue that the Anglo-American style of corporate governance (and various corporate-restructuring movements in particular) reduced investment incentives and forced American managers to think ‘short-term’. In contrast, Japanese corporate managers were thought to enjoy certain freedoms in retaining excess capital (rather than returning it to shareholders) and in determining long-term investment strategies (without oversight of shareholders). Once upon a time, this was viewed as the core of Japan’s competitive edge. Today, this historical verdict has been completely reversed. Michael Jensen argues that in periods of industrial transformation, in the late nineteenth century and in the last two decades, rapid technological and organizational change encourages reduced production costs and increased the average productivity of labour. Rapid change results in widespread excess capacity and reduced rates of growth in labour income, causing corporate downsizing and exit. The best example would be the mergers-and-acquisitions wave of the 1980s that ended up sharply reducing capacity (by consolidating some 1,800 US firms into roughly 150); that, combined with leveraged takeovers and buyouts, represented ‘healthy adjustments’ to over-capacity that burdened many sectors of the US economy. Corporate raiders turned out to be the ‘ephors’, or the overseers, of modern capitalism. Likewise, the decline in the Japanese economy was viewed as the result of a ‘structural’ over-capacity, fuelled by lax investment criteria employed by Japanese companies and the failure to pay out excess capital in the form of higher dividends or share repurchases. Such periodic revaluation reflects profound (or at least shifting) uncertainty about what constitutes a good system of corporate governance. We all agree that good corporate governance is important, as are motherhood, the flag, peace, and goodwill to humanity. But what exactly constitutes truly good governance, and how is it obtained? The contemporary discourse on corporate governance, influenced as it is by western practice and experience, offers little hope of achieving a consensual understanding of the meaning of good governance. This makes institutional emulation on the part of ‘late’ developers that much more difficult – particularly for the economies of East Asia, where the norm is not the ‘modern’ corporation, with a long-standing separation between management and ownership, but the family-owned and controlled firm, which can take the form of the modal Korean conglomerate, the chaebol, or the Chinese family enterprise in Southeast Asia. A reform project of corporate governance must first determine which measures will work. And the essence of making dramatic reform work is to ask, ‘Cui bono?’ Societies differ in their collective goals and priorities, and in the moral valence they assign them, so it is conceivable that the improved welfare of stakeholders may not always have priority, for better or worse, over other collective goals. The rise of particular business systems bears some relationship

26 After the Miracle: Neoliberalism and Institutional Reform in East Asia

to the collective goals of the society, whether they are popularly mandated or unilaterally imposed from above. The chaebol in Korea, like the prewar Japanese zaibatsu, is unthinkable apart from a massive project of nationalist economic mobilization that prevailed over three decades, the aim being to create, through all variety of state subsidies and supports, world-class competitive enterprises. Likewise, the behaviour and organization of Chinese enterprises in Southeast Asia are influenced by the highly charged political terrain where they operate, leading to ‘catch-as-catch-can’ outcomes – that is, ethnic divisions of labour and ethnically demarcated redistributive policies, both perhaps most visible in Malaysia. Bruce Carruthers and Terence Halliday, in their chapter on bankruptcy law, address how political concerns over social and collective welfare profoundly influences the emergence of legal systems in developing and transitional economies, and not necessarily for the worse. In Chapter 8, Sung Wook Joh examines corporate governance in Korea. While most social scientists have lauded the modal Korean enterprise, the chaebol, for its organizational efficiency and aptitude in absorbing manufacturing know-how, Joh takes them to task, and shows how controlling shareholders have acted without impunity, illegally transferring resources from the firms, thus contributing to steep declines in corporate profitability.1 There is nothing in the Korean controlling shareholders that remotely resembles the Schumpeterian entrepreneurs, Joh argues: slippage in corporate monitoring seems to have happened in tandem with greater financial liberalization, and the increasing diminution of the government’s supervisory functions. And greater reliance on equity capital does not seem to have empowered the shareholders into exercising control. Korea was severely affected by the Asian Crisis, forcing the Korean government to concentrate its mind on overhauling the banks and the chaebols. This reform from above was coupled with demands for reform from below, from the activists in Korea’s thriving civil society, demanding economic justice and the empowerment of shareholders. The upshot is the sweeping legal changes that Joh describes. Although reform should not be taken at face value, and rule change does not always mean behaviour change, there are reasons for optimism in the Korean case: legal changes have reflected both a deep commitment on the part of the reform leadership of Kim Dae Jung’s, and grassroots demands for economic democracy. They also reflect the demands of multinational institutions and corporations, leading to derivative injunctions, lawsuits, and inspections. Legal change, we argue in the first section of this book, is most likely a reflection of a deeper political change that is taking place, rather than the other way around. But law, once in place, can also present opportunities for governments to shape national markets. Bankruptcy laws are a case in point. The Asian financial systems, from Japan to Thailand to Indonesia, are unduly burdened with non-performing loans. In times of economic downturn, the banks continue to keep the firms in trouble afloat, rather than forcing bankruptcy.

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This is not so surprising. The typical East Asian firm relies on bank loans for its business operations, and in periods of economic downturn (often caused by external shocks) it has trouble meeting its huge interest payment requirements. One of the virtues of the relational banking practices is that the banks would refrain from turning short-term cash flow problems into foreclosure, unleashing unemployment and social disturbances; instead they would wait until the economic upturn lifts up all boats. During the Asian crisis, however, the crisis of the financial sector – and the problem of massive non-performing loans – was interpreted as a legal problem, in part: the absence of the legal mechanism in East Asia to enforce the ‘exit’ option for the firms that are in trouble. To borrow Albert Hirschman’s famous words, the East Asian system was all ‘loyalty’, very little ‘voice’, and no ‘exit’. In Chapter 9, Bruce Carruthers and Terence Halliday show that the reform of bankruptcy laws is not simply about creating the ‘exit’ option, winnowing out the inefficient, and making sure only the fittest would survive. Rather, at the heart of bankruptcy laws are the larger distributional consequences. For instance, the laws that favour liquidation allow creditors to be repaid some portion, but it also means loss of jobs for the employees, and for a supplier, the loss of a customer. In the short run, the liquidation option leads to higher unemployment and lower levels of economic activity, but it does provide for better payoffs for highly ranked creditors. Secured creditors do best since their collateralized loans give them high priority and first crack at the debtor’s assets. This is considered ‘creditor friendly law’, or ‘hardest’ law. On the other hand, in situations of reorganization, rather than liquidation, lenders, suppliers and workers all have reduced claims. But reorganization is more advantageous for workers, managers, suppliers, shareholders, and the communities in which firms are based, than for secured creditors. If a debtor recovers, then creditors get their money back, shareholders retain their wealth, employees keep their jobs. If it fails again, the burden of the additional loss falls on the secured creditors. This is considered the ‘debtor-friendly law’, or ‘softest’ or liberal law. If a substantial proportion of the investment comes from overseas lenders, ‘soft’ bankruptcy law will bring domestic political benefits but may provoke the fury of foreigners. But both the hard and soft bankruptcy laws can stay firmly within a neoliberal policy regime, since in the case of the latter, legally-governed reorganization can help the state avoid additional public spending or direct public responsibility for corporate affairs. Carruthers and Halliday show that the East Asian countries vary widely in their bankruptcy regime, but, in all cases, creditors end up getting the short end of the stick. Whether for softening hard budget constraint or for reasons for ‘cronyism’, the Thai government and its senate (full of powerful businessmen/debtors) make it difficult for creditors to enforce their claims over an insolvent firm. The new bankruptcy law, updated in the aftermath of the Asian crisis, is therefore not used much. Indonesia has also updated its old bankruptcy law that dated back to 1906, deriving from Dutch law of

28 After the Miracle: Neoliberalism and Institutional Reform in East Asia

even more ancient vintage, in a mimicry of the so-called ‘London Rules’. But it is not much in use, either. Creditor rights are extremely weak in Indonesia; debtors simply cannot be forced through the courts to pay their debts. Korea has more complicated bankruptcy procedures, but they were not vigorously used until 1997. This non-use of bankruptcy law, so widespread throughout East Asia, finds echo elsewhere. Bankruptcy laws were not much in use in Eastern Europe, either. In Russia it was because it would lead to too many bankruptcies (as in Russia law in 1993). In Hungary it led to the liquidation of so many firms (Hungary bankruptcy law of 1991) that it had to be changed to make liquidation more unlikely and reorganization more common. The authors also show that the non-use of bankruptcy law in Thailand and Indonesia (and less so in Korea, for reasons I will explain later) may be about plain cronyism, as much as it is about moral economy or economic redress. In Thailand, the culprits blocking effective legislation of bankruptcy laws are a ‘Senate filled with powerful debtors’, weak governments, and politicallyconnected finance companies, and their calculations would have little to do with sagacious public policies of ‘softening the hard budget constraint’. In the case of countries with a relatively short history of industrialization and a relatively small population in manufacturing (as in Indonesia and Thailand), bankruptcy would not affect too many workers. Even if it did, the unemployed can easily float back to the countryside (or float in the boat market outside of Bangkok, and sell mangoes to the tourists) since they are not yet permanently urbanized. (Besides, the bankrupt firms in the aftermath of the bubbleburst in Thailand and Indonesia were not engaged in productive activities but in real estate speculation.) Korea is a different story, and here one sees a conception of moral economy at work. Korea’s bankruptcy legislation is an artefact of long-standing industrial policy geared to protect various stakeholders, rather than creditors. The concerns of the employees typically came first, as well as the impact of a possible bankruptcy on the economy as a whole. For instance, Daewoo, which recently went bankrupt, had supported more than two and a half million people, including dependents and suppliers; it also owed more than $70 billion to domestic banks and foreign creditors, meaning that its bankruptcy could sink the entire banking industry. Thus, the decision to allow the liquidation of Daewoo had to be a profoundly political decision, taken to send a strong signal to the world that Korea was fully committed to the task of corporate reform.

Conclusion The Asian crisis may have been the first ‘post-Cold War’ financial crisis, but it could be explained in terms that Charles Kindleberger (2005) used – of investors’ mania about the booming and undefaultable economy, then their

Meredith Jung-En Woo 29

panic, followed by a financial crash. In other words, there was nothing unusual about the aetiology of this financial crisis. Even in terms of the causes of the crisis, there is little that is surprising. The Asian crisis looked a lot like the 1980s financial crisis in the Nordic countries, and in both cases, the controlled capital markets (for instance, in Norway, Austria and Sweden) allowed, as part and parcel of globalization, capital account liberalization. This led to a big lending boom, soon to be followed by a bust and bank insolvency. But rather than blame a series of policy mistakes leading to precipitous capital account liberalization sans institutional preparedness, the charges were made that it was the type of political economy – in this case, the European welfare state – that was responsible for the crisis. Likewise, in the Asian crisis, the blame fell squarely on the ‘developmental state’, and the institutions that fuelled economic growth for the decades preceding the 1997 fiasco. In the end, however, the economies of East Asia have recentred themselves, in ways that are predictable and true to their character. Of the four countries most severely afflicted by the financial crisis, South Korea and Malaysia recovered most fully, guided by the strong hand of the state, and taking advantage of the electronics boom that had taken off before the financial crash. In Thailand and Indonesia, financial crisis immediately metamorphosed into a political crisis that hobbled the old status quo but without giving birth to a new order. In Thailand, a new government came into being, led by a Sino-Thai prime minister with populist platform – the ‘Thais love Thais’ – but before long, it would return to the old groove of relying on foreign direct investment for development (Phongpaichit and Baker 2004). In Indonesia the financial crisis smashed the edifice of Suharto’s New Order, only to replace it with one that is no less corrupt, if with a democratic veneer, and the financial and political oligarchs today jostle for power and influence in the new and fluid structure where private power continue to expropriate public authority (Robison and Hadiz 2004). None of this is to gainsay the fact that meaningful structural changes have occurred in some of these societies, with Korea being the best example. But this only underscores one of the themes in this volume, namely that in times of crisis, it is the efficacious state (developmental or no) and the policy tools at its disposal that are best able to bring about sweeping social and economic changes.

Notes 1 For overview of this literature, see Meredith Woo-Cumings (1999).

References Blustein, Paul (2003) The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the IMF (Washington, DC: Public Affairs).

30 After the Miracle: Neoliberalism and Institutional Reform in East Asia Camdessus, Michel (1994) Second Generation Reforms: Reflections and New Challenges. Opening Remarks to IMF Conference on Second Generation Reforms, 8 November. Claessens, Stijn, Simeon Djankov, and Leora Klapper (1999) Resolution of Corporate Distress: Evidence from East Asia’s Financial Crisis, Working Paper No. 2133 (Washington, DC: The World Bank). Davis, Kevin and Michael J. Trebilcock (1999) What Role Do Legal Institutions Play in Development?, paper prepared for the International Monetary Fund’s Conference on Second Generation Reforms, Washington, DC, 8–9 November. Dore, R.P. (1986) Flexible Rigidities: Industrial Policy and Structural Adjustment in the Japanese Economy, 1970–1980 (Stanford, CA: Stanford University Press). Gerschenkron, A. (1962) Economic Backwardness in Historical Perspective (Cambridge, MA: Harvard University Press). Gourevitch, Peter (1996) ‘The Macropolitics of Microinstitutional Differences in the Analysis of Comparative Capitalism’. In Suzanne Berger and Ronald Dore (eds), National Diversity and Global Capitalism (Ithaca, NY: Cornell University Press). Hayek, Friedrich A. Von (1960) The Constitution of Liberty (Chicago: University of Chicago Press). Hayek, Friedrich A. Von (1944) The Road to Serfdom (Chicago: University of Chicago Press). Johnson, Chalmers (1995) Japan: Who Governs? – The Rise of the Developmental State (New York: W.W. Norton). Johnson, Chalmers (1982) MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925–1975 (Stanford, CA: Stanford University Press). Jomo, K.S. (2004) After the Storm: Crisis, Recovery and Sustaining Development in Four Asian Economies (Singapore: Singapore University Press). Kester, W. Carl (1996) ‘American and Japanese Corporate Governance: Convergence to Best Practice?’. In Suzanne Berger and Ronald Dore (eds), National Diversity and Global Capitalism (Ithaca, NY: Cornell University Press. Kindleberger, Charles (2005) Manias, Panics, and Crashes: A History of Financial Crises (Hoboken, NJ: John Wiley and Sons, Inc.). Koo, Hagen (2001) Korean Workers: The Culture and Politics of Class Formation (Ithaca, NY: Cornell University Press). La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny (2000) ‘Investor Protection and Corporate Governance’, Journal of Financial Economics, 58, 3–27. La Porta, Rafael, Florencio Lopez de Silanes, Andrei Shleifer and Robert W. Vishny (1999) ‘The Quality of Government,’ Journal of Law, Economics, and Organization, 15(1), 222–79. Loriaux, Michael (1991) France after Hegemony: International Change and Financial Reform (Ithaca, NY: Cornell University Press). Merryman, John H., David S. Clark, and John Haley (eds) (1994) The Civil Law Tradition: Europe, Latin America, and East Asia (Charlottesville, VA: Michie Company). North, Douglass C. (1990) Institutions, Institutional Change and Economic Performance (New York: Cambridge University Press). North, Douglass C. (1981) Structure and Change in Economic History (New York: Norton). Pistor, Katharina and Philip A. Wellons (1999) The Role of Law and Legal Institutions in Asian Economic Development: 1960–1995 (Hong Kong: Oxford University Press and the Asian Development Bank). Phongpaichit, Pasuk and Chris Baker (2004) Thaksin: The Business of Politics in Thailand (Charg Mai: Silkworm Books).

Meredith Jung-En Woo 31 Rajan, Raghuram G. and Luigi Zingales (2000) The Great Reversals: The Politics of Financial Development in the 20th Century, Working Paper. Robison, Richard and Vedi R. Hadiz (2004) Reorganizing Power in Indonesia: The Politics of Oligarchy in an Age of Markets (London: Routledge Curzon). Stiglitz, Joseph (2003) Globalization and Its Discontents (New York: W.W. Norton). Stiglitz, Joseph E. and Shahid Yusuf (eds) (2001) Rethinking the East Asian Miracle (New York: Oxford University Press). Suehiro, Akira (2001) Ajia Seiji keiziron: Ajia no naka no Nihon o Mezashite (Tokyo: NTT Shuppan). Wolfensohn, James (1999) Keynote Address at the IMF Conference on Second Generation Reforms, Washington, DC, 8 November. Woo-Cumings, Meredith (Meredith Jung-En Woo) (2001) Diverse Paths to the Right Institutions: Law, the State, and Economic Reform in East Asia, Working Paper no. 18 Asian Development Bank Institute). Woo-Cumings, Meredith (Meredith Jung-En Woo) (ed.) (1999) The Developmental State (Ithaca: Cornell University Press). Woo, Jung-en (Meredith Jung-En Woo) (1991) Race to the Swift: State and Finance in Korean Industrialization (New York: Columbia University Press, 1991). World Bank (1997) World Development Report 1997: The State in a Changing World (New York: Oxford University Press). World Bank (1993) The East Asian Miracle: Economic Growth and Public Policy (New York: Oxford University Press).

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Part I Law

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2 Ideology, Experience, and the Rule of Law in Developing Societies Frank K. Upham

Prologue In 1868, Mrs Eliza Sanderson purchased a tract of land on the banks of the Meadow Brook in the city of Scranton, Pennsylvania. In 1870 she finished the construction of a house on the property and in conjunction therewith dams and pipes to bring water from the brook to a fish and ice pond, a cistern, and a fountain. In choosing this location, Mrs Sanderson was attracted by the flow and purity of the water in the Meadow Brook both for her domestic uses and the commercial purposes of the pond. Almost simultaneously with Mrs Sanderson’s purchase, the Pennsylvania Coal Company opened a new mine three miles upstream. In the course of their operations, the company so polluted Meadow Brook that not only did Mrs Sanderson’s pond become unusable for either fish or ice but her entire system of pipes was corroded and destroyed. Much of her investment in the property was made useless. She sued. The law was clear, at least in the sense of the applicable legal rules. The water law of Pennsylvania at the time, called the natural flow doctrine, not only guaranteed her access to the water in Meadow Brook, but also the right to receive the stream in its natural state, in purity and impetus as well as in amount. The natural flow doctrine had been developed in the water-rich countryside of England to suit the needs of an agrarian society and economy, then brought to North America with the first British colonists. It suited Mrs Sanderson’s needs to a tee and she undoubtedly relied implicitly if not explicitly on it in her decision to purchase and develop her land. What was to a layperson like Mrs Sanderson an easy question, however, was not so easy for the courts. In fact it would take eight years and six trials, including three opinions by the Pennsylvania Supreme Court, for the judiciary to decide that she did not have a right to clean water under these circumstances. It took that long because Pennsylvania judges, like their counterparts all over the world, did not see the issue as the simple application of legal rules. Instead they were vitally concerned with the social, political, and economic 35

36 Law

repercussions of their decision. And in the final analysis, those repercussions were strong enough to outweigh the value of maintaining the ‘rule of law’, as defined as the application of legal rules to facts by judges operating without fear or favour. Judge Clark’s opinion for the Pennsylvania Supreme Court in its third and final ruling on the issue is painful to read. He attempts to explain why the vast increase in the amount of flow and the poisoning of the water caused by the coal mine’s pumping of water from its underground shafts was ‘natural’ and therefore unobjectionable from the perspective of the natural flow doctrine. As one would expect, the general intellectual dishonesty of the opinion is awesome, but at one point in the opinion, Judge Clark does allude to the real reason for the decision. In a tone that makes one wonder whether he was concerned that a reader might actually take their definition of nature seriously, he points out that enforcing current doctrine would end coal mining in Pennsylvania and destroy the sole source of ‘population, wealth, and improvements’ in the region. Although the Court evinced the ‘greatest reluctance’ to change the law so dramatically, they were convinced that even the majesty of the law could not protect Mrs Sanderson’s ‘mere private personal inconvenience’ if that meant destroying ‘a great public industry, which although in the hands of a private corporation, subserves a great public interest’.

Introduction In this chapter I discuss critically the current attempts by the World Bank, the IMF, and other international and national financial institutions to encourage and sometimes compel borrowing countries to create the ‘rule of law’. I begin with Mrs Sanderson’s story because it succinctly portrays aspects of the operation of legal institutions that are frequently lost in the simple imagery of the ‘rule of law’ rhetoric that dominates the current law and development movement.1 It illustrates the occasional necessity of destroying clear property rights and legitimate investment expectations in the name of economic development and does so in a manner that brings out the all too human side of the process. It makes explicit the role of economic power and political influence in legal decisions and illustrates that even in the United States (USA), the home of rule-of-law rhetoric, the courts do not always enforce the law, at least when defined narrowly as the faithful application of rules. These and others are truths that are often overlooked by rule-of-law advocates in their earnest haste to create regimes in developing countries that will supply the transparency, accountability, and stability that they are certain hold the keys to successful economic growth. The arguments of Ibrahim Shihata, former General Counsel of the World Bank, and the writings of Hernando de Soto provide examples of the ideas that drive these discussions, and I will use them as the template against which I will pose, first, what I believe to be a more complete elucidation of

Frank K. Upham 37

what the rule of law can be and, second, a series of alternative models of social order, drawn largely from the experience of Japan in the second half of the twentieth century.

A model of formal law Given the attention and money now directed to legal reform efforts – one estimate puts the amount spent from the 1980s to the early 1990s by entities such as the United States Agency for International Development (USAID) and the World Bank at over $1 billion2 – one would assume that there is a carefully elaborated model of law and development based on empirical evidence and reflective of the experience of the previous period of law and development in the 1960s. Although there are excellent studies exploring the various roles that law and other institutions might play in development (Davis and Trebilcock 1999), they do not yet reach the level of accepted guides for lending institutions. Instead, advocates of legal formalism extrapolate from Weberian sociology and the historical experience of European capitalism to the rest of the world. Universal theories of the interdependence of legal form and economic activity lurk behind the rhetoric of the rule of law without a great deal of intellectual agonizing over exactly what this form of law entails, how it relates to economic activity, how it fits in different social and institutional contexts, or whether reference to the European experience, even if correctly portrayed, is helpful to other societies. The lack of a contemporary model leaves us with the justifications of those involved in the law and development movement and the thought of Max Weber. I examine these in turn. At the end of the 1980s, in an effort to increase the effectiveness of the World Bank’s development loans, its legal staff began to address what it calls ‘governance’ issues in borrowing countries. Concerned that the way power is exercised in Third World countries may contribute to the inefficient use of World Bank funds but constrained by its Articles of Agreement from considering political criteria in its lending, the General Counsel of the Bank, Ibrahim F.I. Shihata, drafted a memorandum that distinguished governance from politics and identified the former as a legitimate consideration in the award of Bank loans. At its most general, Mr Shihata equates governance to ‘good order’; in more specific terms, he calls it the rule of law, which he defines at one point as a ‘system based on abstract rules which are actually applied and on functioning institutions which ensure the appropriate application of such rules’ (italics in original). Such a system, Shihata claims, provides a necessary legal foundation for social stability and economic growth and is a necessary prerequisite for the effective use of World Bank assistance: Concern for rules and institutions is particularly relevant to a financial institution which at present does not only finance projects but is also deeply

38 Law

involved in the process of economic reform carried out by many of its borrowing members. Reform policies cannot be effective in the absence of a system, which translates them into workable rules and makes sure they are complied with. Such a system assumes that: a) there is a set of rules which are known in advance, b) such rules are actually in force, c) mechanisms exist to ensure the proper application of the rules and to allow for departure from them as needed according to established procedures, d) conflicts in the application of the rules can be resolved through binding decisions of an independent judicial or arbitral body and e) there are known procedures for amending the rules when they no longer serve their purpose. (Shihata 1991) Shihata goes on to state that in the absence of such a system the fates of both individuals and enterprises will be left ‘to the whims of the ruling individual or clique’ and that only such a system can provide the ‘general social discipline’ that makes economic reform possible. A better-known voice of the legal formalist or legal centralist school of law and development has emerged from the writing of Hernando de Soto (1989). In The Other Path, de Soto describes the success of informal elements in Peru’s economy in achieving economic growth and social mobility despite their almost total isolation from formal legal protection. De Soto convincingly claims that Peru’s official economy had become so encrusted with legal and regulatory formalities that virtually all economic growth within the official sector had ceased. He powerfully describes the success of informal actors, usually poor immigrants to Lima from rural areas, in establishing stable systems of production and exchange without explicit rules to define entitlements or formal institutions to settle disputes. Although de Soto sees informality as ultimately limiting growth, he contrasts the vitality of the informal sector with the stultification and stagnation of Peru’s formal economy. I believe that the phenomena that de Soto describes provide powerful evidence of the possibility of sustained and complex economic activity, at least on an individually small scale, without structure or protection provided by a formal legal system. The lesson more commonly drawn from de Soto’s work, however, is that the isolation of poor Peruvians from law has seriously limited their economic opportunities and, in turn, the general economic growth of Peru. Instead of weakening their faith in the need for formal law and for its most celebrated constituent part, the judicial enforcement of property and contract rights, de Soto and those influenced by him call for the official recognition of the informal economy and its inclusion within the legal system. They argue that formalization of the informals’ rights would give them greater access to credit and legal protection for large-scale investment. De Soto envisions a formal legal system that would operate within a deregulated economy stripped of virtually all of the government intrusion that originally stifled the Peruvian economy and outside of which the informal

Frank K. Upham 39

economy emerged. It would be an economy much like that envisioned by Shihata. The market would allocate resources efficiently. Legal actors, individuals and corporations, would have clear property and contract rights that would be seamlessly interpreted and enforced by the courts. Government’s role would be limited to responding to instances of market failure. De Soto and his followers appear uninterested in the possibility that a formal legal system of the type they advocate could stifle growth or that courts would face the apparent conflict between the application of rules and economic growth of Sanderson. Nor do they consider the possibility that the formal legal system that they envision could not exist within the context of politics, whether autocratic or democratic. They seem to assume that those whose interests would suffer from the mechanical operation of the market and the rule of law would either not have legitimate avenues to oppose its operation or would choose not to do so out of an appreciation of the greater good. Also left out of the calculus is the question of cost and cost benefit analysis. Even if one assumes that a formal legal system of this type is possible, that it contributes to economic growth, and that it can continue to exist in a political world, it remains an empirical question whether it is worth the cost, including of course, the opportunity cost of the financial and human resources necessary to establish and maintain such a system. Perhaps the most surprising omission of de Soto, however, is that de Soto and others appear uninterested in investigating the practices that have provided the social stability and investment security that fostered growth in the informal sector in Peru. In seeming defiance of their own evidence, they leave untouched the assumption that productive capitalism needs formal adjudication, scrupulously enforced contracts, and inviolable property rights. They are not interested in whether the informal practices that supported growth in Lima could be replicated elsewhere or whether they might be superior, at least in a cost–benefit sense, to a formal legal system in some circumstances. They never investigate, therefore, the intriguing use of informal devices by other groups, whether they be ‘outsider capitalists’ like the Diaspora Chinese of Southeast Asia (Chirot 1997), ethnic capitalists like New York diamond merchants (Bernstein 1992), trade groups like the Japanese cement industry (Upham 1996) or grain merchants in the American Midwest (Bernstein 1996), or small businesses of Taiwan (Winn 1994). As a result, de Soto et al. never consider what one would think would be a fundamental question: whether it might be more cost effective to introduce some of the successful informal mechanisms into the stultified formal sector, instead of formalizing the informal sector. Nor do they get to the second-level question of the interaction of formal and informal norms that would seem crucial when introducing the former into a regime heretofore governed by the latter. Shihata, de Soto and their followers can ignore these questions because they accept uncritically the intellectual heritage of Max Weber and his concept of rational law. While I cannot provide more than a caricature of

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Weberian sociology here, three points need to be made. First, Weber considered European law to have developed organically out of a mix of social and cultural conditions and not in response to the economic demands of capitalism: Weber stressed his belief that the unique legal aspects of European society were not the mere result or reflex of economic phenomena. He explicitly and repeatedly denied that the special features of European legal systems were caused by capitalism itself. Rejecting the Marxian deterministic theory which held that legal phenomena were caused by underlying economic forces, he demonstrated that what was unique in the European legal systems had to be explained by . . . non-economic [social and political] factors. (Trubek 1972) It was not, therefore, economic conditions that created legal phenomena, but if causality had to be stated as unidirectional, the reverse. The West had a legal heritage, especially the Roman law tradition and aspects of medieval legal organization, and religious, economic, and political features that were not present in the Chinese and Islamic civilizations that Weber also studied. It was this historical mix that created the rational law that arguably became one of the foundations for capitalism and which holds so much apparent promise for accomplishing the same for today’s developing world. The second aspect of Weber that is crucial to our purposes is the concept of formal and structural rationality that he found unique to European law. Western legal systems differed from those of other societies not so much in substantive content, but in the forms of legal organization and the resulting formal characteristics of the legal process. Weber was concerned not with differences or similarities in specific rules but with questions such as whether legal organization is differentiated or is fused with political administration and religion, whether law is seen as a body of manmade rules or as a received corpus of unvarying tradition, whether legal decisions are determined by prior general rules or are made on an ad hoc basis, and whether rules are applied universally to all members of a polity or if specialized law exists for different groups. (Trubek 1972) Rational law provided the predictability that capitalism required. Because it was autonomous from religious and political interference, the legal process was not distorted for ethical, social, or political purposes extrinsic to the law. Rational law included a formal separation of law making and law finding and developed a corps of legal specialists who employed highly differentiated (and hence autonomous) techniques for the latter function and ensured that the application of law followed general and universal procedures rather than ad hoc determinations based on parties’ interests.

Frank K. Upham 41

Having developed the concept of legal rationality, however, Weber failed to explain why security is peculiarly necessary for capitalist development or why this security needs to take legal form. In the absence of a full explanation, David Trubek has offered possible theories of the relationship of formal law and capitalism. To begin with, uncertainty is inherent in capitalist markets because the conflict between the profit motive and interdependence in the economic market produces a clash of egoistic wills. Economic actors need a way to predict with relative certainty how other actors will behave over time, and legal coercion provides the only means to make this prediction. Tradition, religion, morality, and so on, cannot constrain egoistic behaviour because the market and industrialization destroy the religious and cultural bases of social cohesion. The third point of Weberian sociology concerns the World Bank’s concept of governance in its broader sense of ‘good order’ rather than the narrow sense of security in economic transactions (Shihata 1991). In the urbanized and industrialized world of capitalism, the fragmentation of the bonds of tradition, religion, and geographic community put the social order itself at risk. Rational law, because it draws on autonomous techniques not tied to any particular religious ethical or political tradition, offers the promise of social legitimacy as well as the predictability needed for complex market transactions. Put overly simply, rational law is what Shihata means by ‘the rule of law, not men’; it prevents ‘the whims of the ruling individual or clique’ from determining the fates of individuals or their economic enterprises; and by so doing it provides the political legitimacy that makes the creative destruction of capitalism acceptable. Finally, it is important to add to the Weberian list a fourth attribute of the rule of law that is more narrowly targeted to the economy and therefore perhaps less obvious. It is ease of market entry. If there is stability and predictability in the legal order and neither the state nor private parties can use extra-legal means effectively, then markets will be open to anyone with the resources to enter them. As soon as a market becomes too concentrated or its members too complacent, new resources will enter and relative efficiency will be restored. While elementary in an economic sense, free entry can not occur without the rule of law to prevent existing market players from forming cartels and informally, through economic coercion or physical force, protecting their interests (Upham 1996). It is difficult, although not impossible, to argue with the desirability of the characteristics and results that Shihata and de Soto ascribe to the rule of law: that contracting parties should be required to perform the substance of their promises or pay compensation, that business people should be able to predict the requirements of licensing procedures and to receive the license when they are able to meet those requirements, or that investors should not be surprised by rule changes that deprive them of a return on their investment or, worse, the value of the investment itself. So, for the moment, let us assume

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that these are uniformly attractive attributes at least for a society concerned primarily with fostering economic growth.3 But before we conclude that the rule of law is a desirable short- or mediumterm goal for developing societies, let us examine whether it is a possible goal – indeed whether it exists anywhere in the world or ever has existed. For if the rule of law as envisioned by the World Bank is impossible to achieve, it is not worth spending money on, no matter how attractive it would be in theory. To investigate the rule of law, we look at arguably the two most successful economies of the twentieth century, the United States and Japan. Through an examination of their legal systems and their relationship to the rule of law ideal, we can get a more sophisticated sense of what the rule of law is, what it entails, and what alternatives may exist. We start with the United States, the most vigorous advocate and practitioner of a rule of law diplomacy.

The myths and realities of American law and practice The rule of law ideal might be summarized by universal rules uniformly applied on the basis of legally recognizable transactions. It requires a hierarchy of courts staffed by a cadre of professionally trained personnel who are insulated from political or other non-legal influences. The decision-making process must be rational and predictable by persons trained in law, the entire system must be funded well enough to attract and retain talented people, and the political branches must respect law’s autonomy. To casual observers, the epitome of the rule of law is the United States, but when we look closely at the American legal system, we find few of these characteristics.4 Adjudication by politicized judges, not by legal rules The judiciary is a good place to begin. Under the rule of law, the judiciary would be staffed by apolitical jurists chosen solely for their independence and competence in the technical processes of the law. The reality is quite different. The American judiciary is under direct and constant political pressure, especially when compared with the judiciary in legal systems influenced by the civilian tradition of continental Europe. Most state judges are elected and serve for a term of years. They belong to political parties and are chosen for their allegiance to partisan platforms. If they are not constantly aware of the effect of their important rulings on the electorate and their party’s leaders, they will not be reelected and they will cease to be judges (Glaberson 2000; Yardley 2000). Highly emotional cases, such as that of Rose Bird, the Chief Justice of the California Supreme Court who was removed from office by the California voters for her opposition to the death penalty, are better known because of their attraction to the media, but more relevant to our purposes are the mundane stories of economic interests changing the law through the ballot box, rather than formal legislation. The recent ideological swings of the Texas

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judiciary at the hands of competing commercial interests are illustrative (Yardley 2000). In the early 1980s wealthy trial lawyers succeeded in transforming the historically pro-business Texas Supreme Court into an ‘all-Democratic, lawsuit-friendly court that began upholding enormous jury verdicts against corporate and medical defendants’. In response, corporations and doctors struck back and reversed the court’s politics, again through partisan elections, so that by the mid-1990s the winning record of defendants before the court had risen from 40 to 83 per cent. By 2000, with a governor running for president as a ‘compassionate conservative’ using his interim appointment powers to portray a picture of moderation, the pendulum had swung back once again toward the centre. But of course it is not the drama of Rose Bird or of noisy Texas judicial politics that is representative of American judges. It is the quiet, everyday consideration of political acceptability of the countless judges who have not been electorally removed that better represents the nature of state and local judiciaries in the United States. It is the judges who have remained in their positions because they have been sensitive to political shifts among their constituents that would give us a more accurate view of the reality of the direct political influence on US judges. Unfortunately, this number is literally uncountable, but it must be huge. If we move from the state to the federal judiciary, the picture is more complicated, but fundamentally similar. Federal judges are appointed, not elected. They serve for life, subject only to impeachment for egregious misbehaviour, and the story of the politically conservative judge becoming a liberal on the bench (or the reverse) is a warhorse of American platitudes about the rule of law. The inspiring stories of life tenure giving judges the security to grow in their jobs or to adhere to principle or their consciences should not blind us to the reality of the appointment process, however.5 It is overwhelmingly political, and, the occasional Earl Warren or Hugo Black notwithstanding, federal judges rarely experience substantial conversions. It would be difficult to imagine it otherwise, since they are appointed largely in their fifties after decades of professional and political activity. Of course the ultimate proof of the infrequency of judicial bench conversions is the role of judicial appointments in federal politics, both during presidential elections and in the relationship between the president, who nominates federal judges, and the Senate, which must confirm them. If judges often acted inconsistently with their prior political views, judicial appointments would not loom so large in political campaigns. More striking, if less obvious and well known, than the open political behaviour of those appointing judges, is the political behaviour of sitting judges. In a recent rather spectacular instance, Judge Richard Posner, of the Court of Appeals for the Seventh Circuit, published a book arguing for the prosecution of President Clinton for perjury in the Monica Lewinsky affair while that very issue was being considered by the Office of Independent

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Counsel. While controversial, this action was not generally criticized or seen as abnormal.6 Less flamboyant, but more common, are the common identification of sitting judges with a political philosophy and a commitment to its implementation in the legal system and through the courts. While usually done quietly and even unconsciously, one aspect of this approach to judging – the cultivation of young lawyers who share your philosophy – is well illustrated by the dialogue between Judge Alex Kozinski of the Court of Appeals for the Ninth Circuit and his clerk, Fred Bernstein. Recently published in The Green Bag, which bills itself as ‘An Entertaining Journal of Law’, the dialogue begins where Kozinski is explaining why a conservative like him would hire liberal clerks like Bernstein: Kozinski: The reality if that law schools are pumping out liberals. Not every law school, obviously, but the overwhelming number of students at the top-notch schools tend to be liberal. I can’t afford to cross liberals off my list, the way Judge Reinhardt crosses conservatives off his. Bernstein: Does he? Kozinski: Judge Reinhardt says, ‘I’m not interested in hiring conservatives. I’m not even interested in hiring people who are moderately liberal. I’m only interested in hiring committed liberals, who are going to spend their careers promoting liberal causes. I don’t train corporate lawyers.’ That’s a paraphrase, but it’s accurate. Bernstein: How do you feel about that? Kozinski: He justly sees himself as providing a unique opportunity to advance the careers of young lawyers. And I feel the same way. I think I owe an extra measure of consideration to conservative and libertarian law students. First of all, I feel an obligation to train conservative and libertarian lawyers. There are a lot of liberal judges out there, not as many conservatives and libertarians. Second, there are a lot of cases, and having a clerk who basically agrees with me makes for an easier year. In my heart of hearts, I know it’s a good thing to have dissent in chambers, but sometimes I’d just as soon have an easier year (Kozinski and Bernstein 1998, emphasis added). Nowhere in the dialogue is there any sense that either participant fears that the use of a judicial position to ‘advance the careers of young lawyers’ with certain political opinions would be considered illegitimate. Indeed, at one point Judge Kozinski remarks that although doing so may sometimes be hard, ‘following the law is good practice’. So one must presume that Kozinski considers the politicization of legal decisions either desirable or unavoidable in following the law. In either case, he would be keeping company with the vast majority of American legal scholars, who long ago rejected the possibility, if not desirability, of the formalist model of law advocated by Shihata and de Soto. The belief that one’s political beliefs affect one’s interpretation of the law,

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and hence judicial decisions, is not limited, therefore, to politicians running for office and those voting for them, the judges themselves and others within the system recognize it as well. Structured irrationality7 It is not just the nature and behaviour of the judiciary that contradict the formalist model. Four fundamental aspects of the structure of the American legal system make the extreme view of the rule of law literally impossible. First, federalism guarantees, indeed celebrates, national inconsistencies in legal rules and results. Each state enjoys its own legislative and judicial sovereignty, limited only by the supremacy clause of the federal Constitution. As a result, most laws governing commercial or financial activity are state laws and may vary from one to another of the 51 jurisdictions. While model codes like the Uniform Commercial Code reduce substantially the disparities in some areas, they do not eliminate them. It is not, for example, coincidence that the vast majority of large American corporations are incorporated under the laws of Delaware. Nor is it because most major corporations are headquartered in Delaware. It is because Delaware has triumphed in the interstate competition to attract corporate registration fees and related business. It triumphed because it created a legal regime that most corporations have found sufficiently different and more attractive to them than that found in their states of origin to justify the cost and inconvenience of incorporating in a state distant from their places of business. Far from being condemned by legal scholars or politicians, this type of interstate legislative competition is valued as creating a series of laboratories of legislation on the one hand and preventing states from stifling economic activity by creating legal regimes less favourable to corporations on the other. The second structural aspect of the US legal system that deviates substantially and intentionally from the rule of law is the jury system. As with federalism there are myriad reasons why one might want a jury system, particularly in criminal trials, but fidelity to the rule of law is not one of them. Whether one defines the rule of law as the rational application of rules to facts or more vaguely as ‘the rule of law, not men’, juries simply do not fit. Juries are, in theory, limited to deciding questions of fact and are generally prohibited from relying on their own interpretation of legal rules. Even if the distinction between law and fact were clear – and dozens of scholarly careers have been made disputing that point – it is quite unlikely that juries even understand the law that they are to apply. This misunderstanding has nothing to do with intelligence or goodwill. As lawyers, judges receive three years of postgraduate education, learning the professional techniques necessary to analysing, interpreting, and applying legal rules, usually followed by decades of practice honing these skills. To expect a jury to understand legal rules in the same way and depth just because they are patiently explained by a judge borders

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on the fantastic. A jury may well have a good common-sense understanding of the judge’s instructions, and hence a good common-sense understanding of the legal rules, but it is imperative to note at this juncture than a commonsense understanding of the law is most definitely not what is required by the rule of law. Common sense varies from person to person and context to context; it is not a sound basis for the rule of law, however defined. Indeed, the supposedly ‘common sense’ decision making of the anthropological stalwart village elder or neighbourhood boss is precisely the image against which the rule of law is most frequently contrasted. The third structural aspect of the American legal system that leads to deviations from Shihata’s rule of law ideal is its system of civil procedure and specifically the adversary system. Here there are two aspects that deviate from fidelity to rules, the lawyers’ obligations to their clients and the passive role of the judges. Ethical rules require lawyers to represent their clients zealously, to keep virtually all information received from clients confidential, including information of illegal acts, to work to discredit the opposing party’s evidence regardless of its truth, and, perhaps summing up the result of all the other duties, to give their primary loyalty to their client, not to truth or law. As with federalism and juries, there are powerful arguments for requiring attorneys to give their primary loyalty to their clients. Many of these, however, relate to political theory, rather than the rule of law as defined as an accurate mechanism for the uniform application of rules to facts. It is true in this instance that many attorneys and law professors do argue that requiring lawyers to be faithful to their clients’ interests rather than to truth or justice does paradoxically lead to accuracy because zealous advocacy by two equally talented partisans is the best path to truth. Even if one accepts this position in theory, the social reality is that opposing sides are rarely represented by equally talented lawyers with equal resources. All too often one side has vastly more talent and money than the other.8 One might expect in instances where one party has markedly greater resources or a clearly more effective attorney that the judge would have an obligation to step in to correct the imbalance. Such is not the case in common law legal systems, however, where the judge is to play a role more akin to a referee than to a seeker or guarantor of justice or fidelity to rules. She is not expected to redress inequalities of resources, talent, or dedication that threaten to lead to inaccuracy or injustice. Nor is she obligated to structure the trial so that truth will out, or prevent an advocate from misleading the jury with a legitimately zealous cross-examination. Her role is to create a space where the opposing lawyers can compete, within the rules to be sure, but still with their primary obligations to winning, not to the law. Then, at the end of the competition between frequently mismatched lawyers, she turns the result over to a group of citizens whose legal education is usually limited to television shows, which ironically may be far closer to a heroic version of the rule of law than is the understanding of legal professionals.

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A final anomaly of the US legal system as an exemplar of the rule of law ideal is the extreme reluctance on the part of federal or state governments to make the law available to people with little or no means (Johnson 1994). Perhaps the most fundamental norm of rule of law ideology is the uniform application of the law, without which the universality of norms, their rationality, indeed their substantive content, mean nothing. Society will not reflect the benefits of the rule of law if the rules are not enforced even-handedly. Despite the simplicity of this concept, American governments have never devoted even a fraction of the resources necessary to ensure that poor people have access to the courts in economic or other civil disputes. Indeed, the middle class is often effectively excluded. The United States, for example, spent approximately one-ninth as much per capita on civil legal services for lowerincome persons as England (Johnson 1994). The implication is that the uniform application of law is not important enough to spend significant resources on, a policy judgment that seems unlikely if Americans were convinced that the rule of law were indispensable to economic growth or stability. Such a great deviation from the rule of law is not a failure of execution, the inevitable falling short of an ideal. On the contrary, it is the result of the conscious choice to subordinate the rule of law, at least as seen as fidelity to rules, to other institutional goals or political values. First, for the judiciary, democratic control via elections and politically driven appointment processes and a judiciary with broad social experience are preferred to professionalism and legal expertise. Second, for the substance of legal rules, the interstate competition and the freedom to experiment afforded by federalism are preferred to universality. Third, in the realm of process and procedure, the drama of the lawyer as gunslinger and the democratic symbolism – and high tort judgements – of the jury are chosen despite the knowledge that they will substantially impair if not destroy uniformity and consistency even within a single jurisdiction. And finally, the political right is actively hostile to equal access to the courts, seeing it, accurately, as politically threatening. Even the political left puts little emphasis on effective access to courts, and it is rare to hear anyone in the political process discuss the issue as one of the vindication of the rule of law or of the market’s dependence on the fidelity to rules in the correct allocation of economic resources. My point is not that these choices are wrong by any criterion other than fidelity to the rule of law ideal as articulated by Shihata, de Soto et al. On the contrary, except in the arcane world of economic development, it is bizarre to think of creating a legal system without giving primacy to political considerations. It is perfectly understandable, therefore, for the United States or any other country to create a system of checks and balances that includes direct and indirect political control of the judiciary or to sacrifice predictability for the participatory virtues of the jury or the democratic value of lawyers who can effectively and freely defend their clients against the power of the state.

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My point is twofold: that these devices have created a legal system that departs substantially and intentionally from the rule of law ideal and that they have had a non trivial impact on the legal framework of the economy. They have intentionally introduced uncertainty and expense into commercial dispute resolution and have generally increased the immediate cost of doing business in the United States. Federalism has created the very real possibility of being sued simultaneously for the same act in dozens of different locations under several different sets of rules and procedures; the combination of the jury system and punitive damages means that a corporation must seriously consider the possibility of having to pay a customer millions of dollars for a defective paint job, as BMW was ordered to do by an Alabama court; the adversary system and the rules of civil procedure raise the cost of litigation to the point where it is often economically rational for even the deepest pockets to pay off the lawyers in groundless cases rather than to pursue them to their proper legal conclusion; and conversely many meritorious legal claims go unenforced because the victims are unable to bring them to court. These aspects of its legal system have not gone unnoticed by either domestic businesses or America’s trade partners. Although political battles like that between plaintiffs attorneys and corporate lobbyists that ideologically transformed the Texas Supreme Court three times in the course of 20 years are undoubtedly better explained by the opponents’ respective self-interests than by concern for the rule of law, the issues of economic cost and efficiency are nonetheless real. So much so, in fact, that Japanese trade negotiators have repeatedly argued that the US legal system is so impenetrable, expensive, and unpredictable that it constitutes a trade barrier in violation of the General Agreement on Tariffs and Trade, and foreign corporate defendants in state courts can argue plausibly that their home jurisdictions will refuse to enforce state judgements because of the failure of the US legal system to abide by fundamental values of procedural justice. These characteristics of the US system make it an unlikely model for rule of law advocates, despite the dominance of American rule of law rhetoric in international discourse. More appropriate as a model, if one is a believer in Shihata’s rule of law ideal, is the civilian tradition that grew out of the French Napoleonic Code and German Pandectists of the nineteenth century and that dominates the legal systems of parts of Africa and Asia and most of South America. The civilian tradition does not have juries, does not urge lawyers to subordinate their loyalty to the law to their clients’ interests, or limit the judge’s role to making sure the sides obey the rules of civil procedure. Nor does it in general have a judiciary that is chosen largely on political criteria from a pool of lawyers who have already had substantial careers as practising and politically active lawyers. The last point is worthy of elaboration. Judges in a civilian legal system are chosen from young law graduates and trained as professional judges. Instead of mature individuals with lots of ‘real life’ experience, as we find in the US

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judiciary, civilian judges are likely never to have done anything but be a judge. As such, they are less likely to have any non-legal experience to bring to bear on legal decisions. Their faithfulness to law as a set of legal rules, rather than as a set of flexible guidelines for social behaviour, is therefore more likely than with their common law counterparts. In Japan, for example, judges are carefully socialized as members of an expert and specialized bureaucracy insulated from society. They are periodically trained by the Secretariat of the Supreme Court with the goal that they will approach legal and factual issues likely to appear before them in identical fashion. Such indoctrination is successful because Japanese judges enter the judiciary in their early twenties having done nothing other than be a student and study for the bar exam. In contrast, common law judges are appointed after decades of legal practice and would be unlikely meekly to follow the dictates of senior judges. Indeed, the practical wisdom, as opposed to legal expertise, of American judges is valued, and they are expected to bring their personal experience and knowledge of the world to bear on legal issues. All of which makes it supremely ironic that it is the United States, rather than France, for example, that is leading the rule of law crusade. Unfortunately for the rule of law advocates, France is unlikely to pick up the rule of law cudgels. If anything, the trend seems to away from the civilian tradition. Several civilian systems have introduced modified juries, lay judges, a system of the appointment of judges from the bar, or aspects of the adversary system. There seems little movement in the other direction. Indeed, even in the common law systems, the trend is away from formal adjudication towards informal dispute resolution of various sorts. The rule formalism of the civilian model is seen as both impossible to achieve, needlessly complex and time consuming, and destructive of a necessary connection between law and society.

The myths and realities of Japanese law and practice Few would propose Japan as a model for the rule of law. Just as the national mythology of the United States is the rule of law, that of Japan is a society governed by harmony and consensus. The overwhelmingly dominant view is that Japanese social life is affected hardly at all by law, that law is irrelevant to most Japanese and disfavoured as a means of dispute resolution, and that the Japanese economy is ruled by powerful and wise bureaucrats unhindered by legal restrictions. Much of this conventional wisdom is either exaggerated, outdated, or simplistic, and I will try in this section briefly to correct some of these misunderstandings. I will argue that law has been more important in Japan than is normally acknowledged and that in limited ways the study of Japan can be useful to those interested in the possible contributions of law to economic and social development. As is true with the United States, however, the Japanese legal system falls far short of the rule of law as envisioned by

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Shihata or de Soto, although in remarkably different ways that provide an important counterpoint to the US experience.

Japanese culture and law By the thirteenth century, when the English were still throwing defendants in rivers to see if they would float or basing legal judgements on the oath rock, Japan had developed a legal system to adjudicate competing land claims that valued procedural regularity, the right to confront hostile witnesses, and objective third party adjudication based on evidence instead of magic or divine ritual (Mass 1979). Even during the Tokugawa Period, seen largely as the heyday of neo-Confucian authoritarianism and the flat prohibition of the legal profession, formal legal institutions were overloaded with lawsuits, legal advice was a booming industry, and legal justice was available for even the most downtrodden.9 By number of cases, commercial matters and debt collection cases dominated, but the courts were used for disputes concerning property rights and personal status as well. Law continued to play a significant role in the 80 years of Imperial Japan, and not solely as a superficial ornament intended to give the appearance of modernity and persuade the West to relinquish their extraterritorial treaty rights. Legal rules and litigation to enforce them became an important tool in defending privilege and challenging it (Haley 1982; Ramseyer 1993). Landlords exploited their rights under the Civil Code, and tenants sued landlords for overreaching. Husbands exercised their rights to quick and simple divorce, and wives countered with suits for damages and for the injuries they suffered because of their husbands’ adultery. Contracting parties sued each other for default and neighbours sued each other for irritating and harassing land use practices. Lawyers were numerous, and litigation was common. The Diet reacted by attempting to restrict litigation and protect the ‘beautiful customs’ of Japan’s imaginary past from its corrupting influence, but to little avail. It was not until the advent of postwar democracy that the government’s efforts to suppress litigation bore fruit. The number of lawyers plummeted through the simple device of a legal limitation on their number. For most of the second half of the twentieth century, the government simply set the maximum annual production of legal professionals at 500. What is remarkable about this dramatic shrinking of the legal sector of society is that it occurred at a time of rapid economic expansion and demographic dislocation. Put simply but accurately, during the very same period that the economy boomed, the number of legal professionals per capita, especially private attorneys, declined dramatically, the litigation rate fell, and the size of the formal legal system relative to the society shrank substantially. It is difficult to exaggerate the importance of the juxtaposition of these phenomena to the topic of this essay. If formal legal institutions were necessary for either social order or economic growth or even just weakly associated

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with it, one would expect the de-emphasis of formal law to have hindered growth. Instead, a shrinkage of legal institutions is positively correlated with growth. I cannot prove a causal connection, that is, that the lack of attention to formal legal institutions created growth. It is even theoretically possible that Japan would have grown even faster had it diverted more resources away from investment in human and physical capital and the production of goods and services and into the production of lawyers and litigation. To state this possibility, however, is to illustrate its implausibility. More likely is that the Japanese were able to devise a cheaper method of protecting property and contract entitlements, resolving disputes, and maintaining order than the use of the formal legal system. In the next section I attempt some explanation of how the Japanese economy could have flourished in the face of a set of formal legal institutions that were steadily shrinking in relationship to the level of economic activity and social change. Before I do so, however, it is important to stress that my argument is not that the legal system ceased to exist. The courts continued to function; litigation occurred; and courts were available to protect fundamental rights like property and freedom. Indeed, I have argued elsewhere that positive law and the courts were much more important to norm formation and social change during this period than is generally assumed (Upham 1987). My claim here is more limited; it is that Japan managed to find a way to achieve rapid growth and accommodate extensive demographic change with formal legal institutions playing at best a back-up role to informal mechanisms. Informal mechanisms of economic order For economic growth, at least in a capitalist setting, a few social characteristics are necessary. Investors must expect to capture a reasonable return on their investment, reasonable being in part defined by what is possible elsewhere. Property owners must be relatively secure that the government will not allow others to take their property by force and will not do so itself. Individuals must be relatively free to choose how to deploy their resources, including their own labour. Each of these in turn depends on two general conditions: limited harmful intrusion into the operation of the market and durable social stability. For most observers of most successful economies, particularly those of the law and economics school, the easiest and most common way to achieve these characteristics is a set of incentives that direct private behaviour towards activities with public benefit. The mechanism for establishing these incentives is most commonly law and the formal legal institutions that apply and enforce legal rules. This view of the world is at the core of rule of law ideology. For Japan, however, a legally established and maintained incentive system is not the dominant explanation. Although there are forceful exceptions (Ramseyer 1993), the conventional explanation is that the Japanese economy developed under the strong guidance of a dedicated and talented cadre of

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all-powerful central governmental bureaucrats that created what has become known as the developmental state (Johnson 1982). In this world, the bureaucrats of the Ministry of International Trade and Industry (MITI) and the Ministry of Finance (MOF) decided where Japan’s resources should be invested and who should receive them. They picked winners and then did their best to make sure their choices were correct. The market played a crucial but passive role; it was there to ratify MITI’s choices and to reward the winners, but it did not function as the pivotal allocator of resources assumed by economists. On the contrary, the market had to be bypassed and distorted both to provide emerging sectors the necessary resources and to provide a soft landing to the losers. For the proponents of the developmental state model of Japan, the law played virtually no role. A major focus of this debate on the nature of the Japanese economy is the role of the bureaucrats and whether they deserve credit for Japan’s success or whether they acted at the behest and under the control of Japanese politicians. Although potentially crucial for a general model of development and the question of the relative roles of democracy and expertise, this issue is not central to our immediate purposes. In fact, I would argue that these two viewpoints underestimate the role of private third parties in the formation and implementation of economic policy (Upham 1996). Whether Japanese bureaucrats acted on their own, as agents of elected politicians, or in cooperation with the private sector, the crucial point is that they largely acted outside of and unaffected by the formal legal system. Again, it is important to note that I do not mean that they deprived individuals or corporations of property or profits, although this did happen on occasion (Upham 1991). My point is that economic policy was discussed, formed, and implemented largely through informal mechanisms that were consciously shielded from the interference of the formal legal system. The administrative actors in this process were MITI and MOF for industrial and financial policy respectively and whatever other ministries might be involved in a particular sector. The private actors were the trade associations of the industry involved. The implementing agents were most frequently cartels, facilitated by MITI but directly enforced by the trade associations. These cartels were sometimes legal, formally approved by MITI or the Fair Trade Commission (FTC), whose mission it is to enforce the Antimonopoly Act (AMA) and the legislation exempting certain industries from its coverage. At other times, the cartels were legally informal, created through consultation between the industry and MITI, sometimes with the understanding of the FTC, sometimes without. On rare occasions the FTC would object to a cartel’s formation or attack an already existing one. The most famous example of the latter was the Oil Cartel Cases of the late 1970s, which confirmed that business activity that violated the terms of the AMA was criminal even if taken in compliance with direct instructions from MITI or other government agency. The short-run effect of the Oil Cartel Cases, however, was not

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to eliminate informal cartels but simply to improve the FTC’s bargaining power relative to MITI. What was almost completely missing during the entire postwar period into the 1990s was intervention by the courts in the implementation of economic policy on behalf of private parties. Individual banks undoubtedly chafed under some of the restrictions of MOF, and industrial firms certainly disagreed with the cartel allocations of MITI and trade associations and with the need for cartels in general. Disagreements led to fierce and bitter battles among the players in a given industrial field, but they rarely made their grievances public and even less frequently did they resort to the courts. In fact, those few times when firms went public, much less litigated, became legends and known by nicknames like ‘the Naphtha War’ or the ‘Sumitomo Metals Incident’ and are recounted in the popular media in the breathless terms usually reserved for sports or soap operas. The dominant reason for restraint was that it was not in the long-run interest of most firms to fight the system, which meant of course not merely fighting the bureaucracy but fighting the other firms in the industry, the trade association, and the leading Liberal Democratic Party (LDP) politicians. It often would have meant bad publicity as well, since they would be portrayed as renegades, destroying the economic order that had brought prosperity to postwar Japan. The economic system undoubtedly harmed individual companies from time to time, but they were not without recourse. They could go the politicians or battle within the framework of policy making and, even if they lost, could be assured that their interests would not be forever ignored. They could also cheat, which individual firms certainly did, sometimes openly, sometimes covertly. The formal legal system was not irrelevant in this system, but it was hardly what Shihata or de Soto would argue was necessary. Because the government’s own actions were often legally indefensible, the threat of litigation was another option for aggrieved or greedy firms. It was not easy, however. Litigation could proceed only if the firm satisfied the administrative law doctrines governing who can sue the government for an official decision. The first of these, the requirement that the government act constituted an official act that immediately and directly infringed on one’s legal rights, known technically as an administrative disposition, meant that all informal activities of administrative agencies, including important decisions such as cartel allocations were immune from suit. The second doctrinal requirement was standing, which focused on who could sue to challenge those relatively few government acts like requests for permits, licenses, and so on, that constituted an administrative disposition. Standing was limited to the direct applicant, which meant that the interests of competitors, consumers, and the general public were beyond judicial scrutiny. Even with standing and an administrative disposition, winning was more complicated than it might appear to a casual observer. In the first place, the

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firm had to convince the agency to accept the application officially. It was common bureaucratic practice to refuse to accept troublesome applications.10 Instead of accepting and then denying such a request, the agency would engage in a bargaining process called ‘window guidance’ denoting the ‘window’ through which the agency spoke to those under its jurisdiction. Unless the applicant agreed to amend its application to fit agency policy, the agency would not accept it and therefore would not deny it. As long as the application had not been denied, it was impossible to challenge the policy or its application in this case because legally there had been no official act. First, the firm had to sue the agency on its refusal to accept the application. Only after it had won on that level could it resubmit and get official action, presumably a denial. Then and only then could it sue on the merits of that denial, and given the breadth of discretion granted under administrative statutes and the agency’s opportunity to craft its decision to withstand judicial review, victory was not assured. With this tortuous and risky path, it is not surprising that such suits were rare, at least until the 1980s, and where they did occur they were often driven by ideological motives, rather than commercial calculus. After all with the general willingness of most bureaucracies to reward compliance and the general sympathy of most agencies for the firms under its jurisdiction, it was rare that an individual firm was better off in the long run by defying the government rather than going along.11 Even more curious from a rule of law perspective was the absence of lawsuits brought by either consumers, other Japanese excluded from the deals cut by industry and the bureaucracy, or foreign firms, who were unrepresented in policy formation and were often the real losers in industrial and financial policy. The reasons were simple and had little to do with Japanese preferences for consensus or submissiveness to authority. First, as argued by those observers who claim that the bureaucrats were mere agents of the politicians, these policies were on the whole at least implicitly approved by LDP politicians and frequently taken at their explicit direction. Although political approval could not transform an informal cartel into a legal one, it did give the activity legitimacy, both politically and to a certain extent in the minds of the public. Secondly, the formation and enforcement of informal cartels were never transparent in the sense of being part of the public record and were often totally opaque to outsiders, as is usually the case for behaviour that is at least theoretically open to criminal prosecution. Knowing exactly what was going on was hard, gathering evidence even more so. Thirdly, they had little chance of success in court. Although the AMA explicitly authorizes a cause of action for its violation, no private plaintiff ever won a case under it during this period. The courts made the requirements of proof of causation and of damages so onerous that they were literally impossible to meet. In other consumer areas, the lack of a class action provision or a practical equivalent made litigation expensive, and in regulatory actions, for example where a firm was denied or granted a license to operate, standing doctrine excluded

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consumers from the class of possible plaintiffs. Even where standing was available, the scope of discretion of administrative agencies was broad and courts understandably reluctant to take the side of an individual’s private interest over that of generally legitimate, if informal, public policy. These various factors, the long-term self-interest of the insiders, the legal invisibility of the mechanisms used, their political legitimacy, and the doctrinal difficulties of challenging them, combined to create a system that heavily discouraged opposition through the formal legal system. It did not mean, of course, that the legal system ceased operation or that it was irrelevant. In the Big Four Pollution Cases undertaken at the heart of this period, largely poor victims of industrial pollution started a process that resulted in the eventual reform of Japan’s environmental policy and law. So even for the most marginalized of outsiders, the legal system remained a guarantor of some measure of justice. For relatively weak insiders, like the FTC in the Oil Cartel Cases or a renegade firm inside a cartelized industry, the formal legal system provided a tool that could be used to increase one’s bargaining power. They may not win the litigation, but the mere threat of exposing the informal deals struck by the insiders was embarrassing enough to provide significant leverage. But the role of the legal system fell well short of that portrayed by the rule of law ideology. To paraphrase Shihata, such a system requires that rules are known in advance, properly interpreted, and vigorously enforced; that exceptions to a rule’s application occur only according to established procedures; and that conflicts in the application or interpretation of the rules are formally adjudicated by an independent judicial or similar body. In other words, transparency, uniform application, and neutral, arm’s-length conflict resolution. It is hard to argue that the regulation of the Japanese economy for the first three to four decades of the postwar period had many of these characteristics. Yet it would be equally difficult to argue that Japanese society was not successful, not only in achieving economic growth but also in preserving civil order and a high degree of social justice. Although this essay is not the place to speculate on the factors that made this possible, a few are immediately relevant. First, the actors involved in economic policy formation and implementation were stable institutions staffed by dedicated and competent private and public bureaucrats. Whether it was the corporations themselves, the trade associations that represented them, or the ministries that had responsibility for their regulation, the men (and a very few women) who worked there were well educated and trained and usually stayed at or close to the institution for their entire career. Second, there were pervasive and institutionalized means of communication between and among public and private institutions. The most famous were the trade associations and various cross-sector business associations such as the Keidanren or Douyuukai, which kept private actors in constant touch with each other, and the amakudari system of bureaucratic ‘retirement’ to private firms or trade associations, but there was also informal interaction on an almost daily

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basis between regulated and regulator. Third, there was little direct corruption in the public sector. Amakudari might be interpreted as a form of corruption, but its effect was indirect and in any case far from the massive corruption of many public bureaucracies. Fourth, the politicians and the voters behind them always had a veto power if policy failed disastrously or important interests were ignored. Finally as stated above, the legal system provided an outside limit to the flexibility and arrogance of the insiders.

Implications for developing countries Both the formal legal mechanisms of economic ordering of the United States and the informal mechanisms of Japan have served these two societies well in the period under review, despite deviating from what the rule of law ideology would assume is necessary for economic growth. We can draw from this several contrasting conclusions. One would retain the rule of law model and conclude that both countries would have developed faster and more efficiently if they had spent the necessary capital and paid the necessary political costs to create legal systems more closely approximating that ideal. But it is important to remember in this context that one cannot simply assume a formal legal system. The creation of any legal system that might have improved economic performance would have run the risk of disrupting the political stability served by the existing systems and required the diversion of significant resources from other social needs. Any consideration of the role of such a system, therefore, must include the economic and political impact of striving for the ideal at the cost of the actual. Since this hypothesis is impossible to test, however, I do not pursue it further in this concluding section. Instead, I address more modest lessons these two experiences might have for contemporary developing countries. The first and most important lesson may be that neither the Japanese nor the American legal system is likely to provide an immediate or comprehensive model for other societies. They both deviate substantially from the rule of law ideal, so they cannot be neatly encapsulated in that pre-existing model. The American system is massively expensive in terms of human capital, as well as in purely financial terms, and its primary features are at least as attributable to political goals, ideals, and compromises as they are to efforts to promote economic growth. The Japanese system was certainly created with economic growth in mind, and political scientists have portrayed it as a possible model for developing societies (Johnson 1982), but the institutional requirements of the Japanese system seem at least as historically dependent as the American. The relatively balanced interaction of political, governmental, and private institutions, each component of which was characterized by competence and stability, seems more suitable as a goal of development efforts than the means. Furthermore, each system has substantial flaws. The details of the US legal system are as likely to be cited as a politically created counterweight to economic

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efficiency as a foundation for it. The Japanese system is currently under siege, blamed for contributing to the decade-long recession that has tarnished the glitter of Japan’s economic ‘miracle’ and the institutions that contributed to it over the past 50 years. Indeed, it is arguable that the very institutions that served Japan so well while it was a fast growing economy are no longer suitable now that it is a mature one. A second lesson is that the creation of a formal rule of law system of the type advocated by Shihata may well not be worth the cost. As I have argued, even the United States, the country most insistent on the virtues of the rule of law for developing countries, has chosen to depart from the model in fundamental ways, and Japan was able to grow economically with a relatively shrinking legal sector. If these societies grew without a formalist rule of law, why should a developing country consider it a necessity? Of course, this does not mean that the protection of basic economic entitlements is not necessary. Both of these countries did precisely that in most situations and the legal system played a role in both. Nor does it mean that an effective formal legal system may not be politically desirable or that political stability may not be a prerequisite to growth. Again, both legal systems played central, although in the Japanese case often unappreciated, roles in the creation and maintenance of social and political stability. It remains true, however, that the rule of law model does not appear to have been a major immediate factor in economic growth in these two countries. One would urge caution, therefore, before recommending that a developing country divert significant resources from more directly productive activities or, equally importantly, attempt to replace effective and inexpensive means of social order with an imported version of either the American or Japanese legal systems. The last point – that legal transplants may displace indigenous institutions – deserves elaboration. The cost of importing a western-style legal system is not solely the expense of courthouses and legal education or the diversion of human talent into the legal profession. A less obvious but perhaps more important cost is the risk to existing informal means of social order, without which no legal system can succeed. Although it is highly unlikely that any transplanted system will operate as it did in its country of origin or exactly as intended by the borrowing country, it does not follow that it will have no social effect.12 A legal system provides a powerful set of resources and those who see themselves as benefited will use them to their own advantage. That is, of course, precisely what the creators of a legal system wish for, but if the social context of the legal system is not able to support the individual exercise of rights or the incentives governing the utilization of the resources are not finely calibrated, the results can be far from those intended. In other words, unless the creators of the legal system get it exactly right, unexpected consequences will occur. In a mature system, negative consequences can be dealt with by established institutions using some of the same methods used to deal with changes and anomalies in the existing system. In a new legal system,

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especially one imposed or imported from abroad, there are no established institutions and the new institutions lack experience, expertise, and political legitimacy. In addition, a later recognition of weaknesses in the new regime will almost inevitably come too late to save or restore any displaced preexisting social institutions. Informal institutions, once destroyed, are extremely difficult to recreate. The result can become the legal anarchy of a society that has a formal legal system without the social capital, institutions, and discipline to make use of it. The reason that advocates of the rule of law are willing to take this risk, in my opinion, is that they view the rule of law as a scale of social development, not as the result of incremental social development (Dowdle 2000). Such advocates hold a relatively unvarying vision of the end product of legal reform efforts. Depending on the sophistication, nationality, and political orientation of the person, the vision will resemble to a greater or lesser degree the Weberian model, but the commonality will be a deductive, teleological approach, rather than a pragmatic or inductive one. Institutions like a legal system, however, are so complex and so intertwined with their social, institutional, and cultural contexts that the chances of large-scale legal transplantation performing in substantially the way intended, especially right off the bat, are slim. Because the reformers are focusing on the expected result, the rule of law vision, rather than the new institutions’ interaction with the social context, it is difficult for them to perceive problems and react effectively to the inevitable surprises. These difficulties are exacerbated if the designers of the new legal system are ignorant of the pre-existing indigenous mechanisms that might be used to integrate the reforms into the existing patterns of social order. I do not intend to discourage legal reform or the borrowing of legal rules or institutions from other countries. Indeed, some have argued that legal transplants are the main source of legal change, not only in the developing world but everywhere. There are undoubtedly components of both the American and Japanese legal systems that could be usefully adapted to certain other societies, and to argue against doing so would mean arguing against transnational legal learning. Nor do I intend to champion the romantic view that indigenous institutions are intrinsically superior to imported ones. The mystical call to allegiance to an invented ‘traditional way’ can be as viciously destructive of human dignity and progress as any imposed western device. My point is a much more moderate one and one which may seem self-evident to students of the role of law in society. A legal system is too complicated to be planned from the top down. Any group of competent legal scholars with the necessary audacity could devise a formal legal system that would work well on paper, making the various assumptions about human behaviour, institutional capacity, incentive structures, and so on, necessary to implement their worldview and normative universe. Unfortunately, this exercise is precisely what the planners of the former Soviet Union did with their economy. I doubt that we can expect any greater

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success from the proponents of western rule of law ideology. The problem with centralized economic planning, after all, was not that the planners were stupid, ignorant, or corrupt; it was that an economy is too complicated to be effectively directed over the long term by a central authority. Designing a legal system faces the same issues. Even if the assumptions about human behaviour are correct, the knowledge of social context is insufficient to calibrate perfect rules and the legal institutions too weak to implement them on their own. As Robert Putnam has eloquently demonstrated about Italy, legal rules do not operate in a social vacuum. Identical rules can exist in dramatically divergent societies. The secret to legal borrowing and to legal reform in general, therefore, is not merely attention to the foreign model or the institutional goal; it must include close attention to and genuine respect for the conditions of the receiving society and its pre-existing mechanisms of social order. Acquiring this detailed knowledge is time-consuming and difficult for outsiders, whether they be World Bank economists or the western-trained lawyers or law professors often called upon to implement legal reform. It may be almost as difficult for domestic officials, especially if they are members of a centralized elite far removed from, for example, land tenure practices in minority regions. And these difficulties exist even if we assume that all interested parties are immune from all selfish or political temptations. When the fact that both international and domestic actors in the development game will almost inevitably be politically engaged and have exogenous reasons for choosing one course of action over another, the chance that fine-tuned, ‘one size fits all’ plans for institutional change will materialize as anticipated dwindle further. The implications for legal institution building in developing societies need not be paralysingly pessimistic. Legal borrowing will proceed with or without western encouragement, and the building of mutual knowledge and respect can in the long run only improve the chances of success, whatever the various normative visions of development that a society may choose. What must be remembered, however, is that building an effective legal system requires humility and patience; to paraphrase Oliver Wendell Holmes, law is the product of experience, not ideology.

Notes 1 I could have selected any number of cases from the dozens with similar import discussed in the standard histories of nineteenth-century American law. The most frequently cited such case is probably Charles River Bridge, where the plaintiff claimed unsuccessfully that its monopoly franchise for a bridge over the Charles River in Massachusetts constituted constitutionally protected property that could not be destroyed without compensation. The court’s decision to allow the government to license other bridges freely is generally considered a judicial imprimatur of the transition from one form of property, in franchises and monopolies, to another that allowed free entry into previously protected enterprises.

60 Law 2 Conversation with David Trubek of Wisconsin Law School. Trubek further notes that most of this amount has been in the form of grants, rather than loans, because recipient countries are not eager to borrow for legal reform. It is my impression that legal reform is usually undertaken by Third World countries not primarily because they consider it necessary to their internal economic development, but because they are told that it will be necessary in order for them to receive and attract foreign loans and investment. These two levels are interrelated, however, and there are instances where legal advice for primarily domestic purposes such as land registration has been requested. 3 In this chapter, I am limiting my discussion to the narrow sense of development defined by economic growth. I do not consider the role of law and legal institutions under broader definitions of development. For the latter see Davis and Trebilcock (1999). 4 In this section, I highlight American departures from the rule of law model. A different but equally appropriate approach to this topic could be to highlight that informal practices dominant economic activities, including dispute resolution, even in the United States, arguably the most litigious nation at present. 5 Actually, it might be fairer to honour the judge who continues to honour the political deal that got him or her the job than to celebrate the ones who betray those who nominated and confirmed them. But to do so would be to acknowledge the politicization of the federal judiciary and disavow the myth of the rule of law. 6 It was criticized by law professors, most notably liberal Ronald Dworkin. The ensuing vituperative exchange between Posner and Dworkin is itself a remarkable example of the open partisanship of sitting federal judges. 7 I am using rationality here in the Weberian sense of legal rationality arrive at through formal processes rather than irrational law arrived at through magic, morality, or common sense. 8 The persistence of the theory over the reality in this instance probably has a great deal to do with the self-interest of lawyers and clients in being able to discuss questionable acts and plans candidly, but it may also be influenced on a cultural level by Americans’ attachment to game and marketplace metaphors. The image of trial lawyers battling it out resonates with other metaphors like the ‘marketplace of ideas’, ‘a level playing field’, and so on. 9 Litigation was not cheap or fast and using the courts was extremely difficult for those at the bottom of the social hierarchy, but this has been true for virtually all legal systems at all times. I should also note that I am not claiming that the law was ‘efficient’ or amounted to the rule of law as Shihata (1991), would define it. For an account of the use of litigation by burakumin to defend their economic rights against incursion by status superiors in the eighteenth century, see Upham (1998). For another account of one woman’s use of law to attain justice, see Ooms (1996). 10 It was illegal for an agency to refuse to accept an application that was on its face complete. The courts established this in at least one case in the affirmative action context, but the practice continued up to the 1990s, so much so that the Diet had to restate the law in the Administrative Procedure Act of 1993. 11 The practice was somewhat different on the local level. In one celebrated case, communist sympathizers pursued litigation in the affirmative action context against a socialist government in Osaka, at least in part to embarrass the government. In another a building contractor sued a leftist government for its restrictive land use policies. In both of these cases and most other examples of legal opposition to a bargained consensus, the plaintiff was a political outsider with nothing to lose, even in the long run, in irritating the incumbent government.

Frank K. Upham 61 12 The experience of Japan with its Civil Code of 1889 is illustrative. The Meiji leaders may well have intended their new legal system as primarily a demonstration to foreign powers of their modernity, but the Code was taken seriously by the Japanese people. They used its provisions in the courts to pursue their own interests in ways that political leaders of Japan had not anticipated and did not welcome. The result was a flurry of legislation in the 1920s to ‘correct’ the excessive individualism of the Japanese by limited the peoples’ rights under the Code and requiring prospective plaintiffs to use ‘traditional’ means of dispute resolution in place of litigation.

References Bernstein, Lisa (1992) ‘Opting out of the Legal System: Extralegal Contractual Relations in the Diamond Industry’, Journal of Legal Studies, 115. Bernstein, Lisa (1996) ‘Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms’, University of Pennsylvania Law Review, 1765. Chirot, Daniel (1997) ‘Conflicting Identities and the Dangers of Communalism’. In Daniel Chirot and Anthony Reid (eds), Essential Outsiders: Chinese and Jews in the Modern Transformation of Southeast Asia and Central Europe (Seattle and London: University of Washington Press). Davis, Kevin and Michael J. Trebilcock (1999) What Role Do Legal Institutions Play in Development?, paper prepared for the International Monetary Fund’s Conference on Second Generation Reforms, Washington, DC, 8–9 November. de Soto, Hernando (1989) The Other Path, J. Abbott (trans.) (New York: Harper & Row). Dowdle, Michael W. (2000) Rule of Law and Civil Society: Implications of a Pragmatic Development, paper presented at the Woodrow Wilson International Centre Scholar Seminar on Developing Civil Society in China: From the Rule by Law toward the Rule of Law, Washington, DC, 9 February. Glaberson, William (2000) ‘Fierce Campaigns Signal a New Era for State Courts’, New York Times, 5 June, A1. Haley, John O. (1982) ‘The Politics of Informal Justice: The Japanese Experience, 1922–1942’. In Richard Abel (ed.), The Politics of Informal Justice (New York: Academic Press). Johnson, Chalmers (1982) MITI and the Japanese Miracle (Stanford, CA: Stanford University Press). Johnson, Jr., Earl (1994) ‘Toward Equal Justice: Where the United States Stands Two Decades Later’, The Maryland Journal of Contemporary Legal Issues 5(2), 199. Kozinski, Alex and Fred Bernstein (1998) ‘Clerkship Politics’, The Green Bag 2(1), 57–64. Mass, Jeffrey (1979) The Development of Kamakura Rule, 1180–1250 (Stanford, CA: Stanford University Press). Ooms, Herman (1996) Tokugawa Village Practice: Class, Status, Power, Law (Berkeley, CA: University of California Press). Ramseyer, J. Mark and Frances McCall Rosenbluth (1993) Japan’s Political Marketplace (Cambridge, MA: Harvard University Press). Shihata, Ibrahim F.I. (1991) ‘The World Bank and “Governance” Issues in Its Borrowing Members’. In Franziska Tschofen and Antonio R. Parra (eds), The World Bank in a Changing World (Dordrecht: Martinus Nijhoff). Trubek, Donald M. (1972) ‘Max Weber on Law and the Rise of Capitalism’, Wisconsin Law Review, 720–53. Upham, Frank K. (1998) ‘Weak Legal Consciousness as Invented Tradition’. In Stephen Vlastos (ed.), Mirror of Modernity: Invented Traditions of Modern Japan (Berkeley, CA: University of California Press, 1998).

62 Law Upham, Frank R. (1996) ‘The Man Who Would Import: A Cautionary Tale about Bucking the System in Japan’, Journal of Japanese Studies 17(2), 323–4. Upham, Frank K. (1987) Law and Social Change in Postwar Japan (Cambridge, MA and London: Harvard University Press). Winn, Jane Kaufman (1994) ‘Relational Practices and the Marginalization of Law: Informal Financial Practices of Small Businesses in Taiwan’, Law & Society Review 28(2), 193–232. Yardley, Jim (2000) ‘Bush’s Choices for Court Seen as Moderates’, New York Times, 9 July, A1.

3 Asia’s Legal Systems in the Wake of the Financial Crisis: Can the Rule of Law Carry any of the Weight? John K.M. Ohnesorge

Admitting that there are some sciences where a few elementary truths being given, the whole mass of subordinate principles may be readily evolved from them – a proposition which may require further investigation before it is admitted – yet this cannot be the case with jurisprudence which does not deal with abstract propositions simply but with a state of facts where the question is perpetually recurring – what does human experience prove to be the wisest rule which can be adopted? or what does it prove to be the wisest construction of a rule already in existence? (Grimke 1968: 450–1)1

Introduction People have long been interested in the relationships between legal systems and economic performance, and have approached these issues in many different ways. The original American institutional economics produced such works as Ely’s Property and Contract in Their Relations to the Distribution of Wealth (Ely 1914) and Commons’ The Legal Foundations of Capitalism (Commons 1924). That law should have occupied a central place in their thinking about economics should come as no surprise, since the study of legal institutions was key to the German historical approach to political economy (Cohn 1894), which strongly influenced many American institutionalists (Kloppenberg 1997; Hovenkamp 1991). For Weber, of course, legal, political and economic organization were intimately related, and the rise of a specific style of legality (‘formally rational’ in his terms) was closely tied to the rise of modern, industrial capitalism (Weber 1968; Trubek 1972). And although he seems not to have elaborated on the theme, law, or rather the lack of a functioning legal system, also played a role in the theorizing of the economic historian Alexander Gerschenkron. In explaining why the modernizing Russian state of the 1890s had to assume capital accumulation and allocation functions 63

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that had been successfully performed by private universal banks in Germany, Gerschenkron speculated that ‘no bank could have successfully engaged in long-term credit policies in an economy where fraudulent bankruptcy had been almost elevated to the rank of a general business practice’ (Gerschenkron 1965). In the United States (USA), the original institutional economics was associated with the rise of the administrative state through the Progressive movement of the late nineteenth century and later the New Deal, and with Sociological Jurisprudence and later Legal Realism2 in jurisprudence (Purcell 1973; White 1952; Commager 1950). All of these to some extent represented, or depended upon, a rejection of formalist, deductive reasoning in favour of philosophical pragmatism, empiricism and institutional innovation. The institutional innovations proposed by the Progressives in pursuit of greater public regulation of the economy had to overcome formalist legal arguments based upon abstract principles such as liberty or freedom of contract, due process, or the separation of powers that were invoked to rule them out a priori, thus allowing the courts to avoid rational discussion of the social implications of either the status quo or the proposed rule change.3 The fact that the courts often invoked such arguments in justifying decisions that preserved the status quo explains the central role that the normally esoteric field of judicial reasoning assumed in the adversarial relationship between conservative courts and those seeking change. Taking the historian Commager to represent the Progressive–New Deal critique, For half a century the courts . . . abandoned themselves to delusions of mechanical jurisprudence, interpreting the Constitution as a prohibition rather than an instrument, reading into it limitations on the scope of governmental authority which existed only as abstract conclusions of natural law syllogisms. Insisting that they were without discretion and that their functions were purely mechanical and phonographic, judges struck down literally hundreds of state police laws on the theory that they deprived somebody of property or of liberty of contract without due process of law. (Commager 1950) Wage and hour legislation had to overcome formalist interpretations of liberty, property and freedom of contract, labour unions had to overcome formalist interpretations of antitrust doctrines prohibiting ‘combinations’ in restraint of trade, workers’ compensation schemes had to overcome formalist reasoning from the fault principle in tort, and regulatory bodies such as the Interstate Commerce Commission and the Federal Trade Commission had to overcome formalist interpretations of the separation of powers scheme of our Constitution that would have precluded the delegation to them of effective legislative or adjudicatory powers. The original institutional economics thus combined with Sociological Jurisprudence and later Legal Realism to address

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very directly the relationship between law and economic activity, and to their broadly shared political agenda as Progressives the anti-abstractionist, anti-formalist aspects of the new jurisprudential currents contributed an important tool. The recent law reform initiatives of the international financial institutions (IFIs) – the Asian Development Bank, World Bank and International Monetary Fund (IMF) – as well as many bilateral legal assistance initiatives, also focus on the relationship between legality and economic performance. Indeed, in the case of the IFIs such initiatives must be cast to some degree in the technocratic language of economic performance in order to avoid criticism as unauthorized political interference (Upham 1994). These economicallyoriented law reform initiatives (the ‘Law & Development movement’4) are also informed by institutionalist thinking, this time ‘new’ or rational choice institutionalism, which finds its jurisprudential counterpart not in Legal Realism but in the Law & Economics movement. Although rational choice institutionalism and Law & Economics are by no means monolithic, their basically pragmatic goal orientation, which they share with early institutionalism and Legal Realism, often succumbs to formalist reasoning and assumptions that make them fundamentally antithetical to the pragmatic approach of the Legal Realists and the early institutionalists. Modern Law & Economics is, like Legal Realism, sceptical of formalist legal reasoning and calls for judges to look to social science to find pragmatic solutions to legal problems (Posner 1990; Arnold 1934). But whereas Legal Realism looked to the old, pragmatic institutional economics, modern Law & Economics, like new institutionalist political science, has relied predominantly on neoclassical economics, with its distinctly un-pragmatic reliance upon reductionist assumptions about human behaviour and its tendency towards formal modelling and deductive reasoning.5 Law & Economics shares with rational choice institutionalism not only a distinct bias towards formalist assumptions about human behaviour and institutional frameworks, but also a bias towards model building and refinement at the expense of empirical research (Hovenkamp 1990; Green and Shapiro 1994).6 These tendencies in the theoretical underpinnings of today’s Law and Development movement are reflected in its reliance on highly abstract notions, from which, it is implied, can be derived particular changes to particular regimes of national law. Like the original Legal Realists, these writers are explicitly instrumental and policy-oriented in their approach to law, but unlike the Realists they tend to ignore the uncertainty and discretion involved in judicial decision making, and tend to exaggerate the determinacy of the rule structure, the public’s knowledge of the rule structure, and the extent to which private actors orient their behaviour toward the rules even if they are determinable and actually known. They also show no hesitation in assigning functions to, and building theories around, abstractions such as ‘secure property rights’, ‘independent judiciary’, ‘market economy’, or ‘civil society’.

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One such abstraction is the Rule of Law, which has become a very powerful term in the new Law & Development literature, a kind of meta-abstraction under which the other abstractions are grouped. This chapter addresses whether the Rule of Law as a concept can provide useful guidance for, or insight into, change to the legal systems of East Asia in the wake of the financial crisis. The next section discusses the Rule of Law concept, contrasting the ways in which it is used in the Law & Development literature and in more mainstream legal discourse. Then we discuss particular aspects of law and legality that have been seen as hallmarks of Northeast Asian societies, how these fit into the Rule of Law as presented in the Law & Development literature, and whether the Rule of Law has anything say with regard to how, or whether, these institutions and practices would change in a transition to more liberal economic regimes.

The Rule of Law The Rule of Law as a term is highly contested among legal theorists and intellectually inclined judges, but otherwise is not a very central term for rankand-file American lawyers. It is entirely possible to receive a JD degree from a top-tier US law school and never participate in a sustained, in-depth exploration of the term, its history, or the various definitions that have been offered for it. In other words, the Rule of Law is not a term of art, at least for American lawyers, in the way that other fields of knowledge have terms of art. This point, whether surprising or obvious, is important for understanding how economists, political scientists and others are able to appropriate the term for their own purposes with little notice from the legal profession. Debates among elite legal and political theorists over the meaning of the Rule of Law and the possibility of its attainment have little impact on the rank-and-file lawyers who work on Law & Development projects, and seem to be totally unknown to many of the non-lawyers involved in this work. Since the concept itself has no highly determinate meaning, and is peripheral to the work of most lawyers, people of all political persuasions quite naturally seek to infuse it with their particular substantive agendas, many of which are entirely admirable, but all of which are fundamentally political. These include interests in human rights protections, in controlling judicial discretion, in controlling bureaucratic discretion, in insulating private property from public regulation, and in ensuring democratic participation in the lawmaking process. All of these could probably be put under a general umbrella of attempts to shift power from one locus to another, either among branches of government or between public and private spheres, and this is in fact a consistent aspect of Rule of Law writings. For example, calling for a Rule of Law based upon detailed positive rules as opposed to discretionary standards or general principles could be seen as advocating a shift of power from judges or bureaucratic adjudicators to private actors in particular matters,

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and a general systemic shift of authority from the judicial to the legislative branch. By the same token, a Rule of Law agenda seeking to place fundamental substantive rights or principles of justice beyond legislative control, and to anchor them somewhere beyond positive legislative enactments, will tend to place courts at the centre of the vision, and place great emphasis on the quality of the judiciary. For courts to play such a role requires enormous institutional legitimacy, a point we will return to later. There are purely formal definitions of the Rule of Law which emphasize the form of the rule structure, there are definitions that emphasize process over either form or substance, and there are many that include elements of all three (Raz 1977; Bodenheimer 1962). Perhaps the proper metaphor for the Rule of Law concept is not an empty vessel waiting to be filled, but a balloon waiting to be inflated. One who does not want to put much in it can blow the balloon up a little way, while one who wants to put a lot in it can blow it up more. At some point it will pop, but there is great room for variation in the size of the balloon. I have attempted elsewhere (Ohnesorge 2003) to present a picture of how Rule of Law rhetoric is being used by the IFIs and others in the Law & Development movement, and to contrast that with more traditionally jurisprudential uses of the term. For the purposes of this chapter I will accept the usage of the term, as I see it, by the Law & Development movement. This approach, which I describe as a ‘functioning legal infrastructure’ approach, but which might also be thought of as the legal theory of the Washington Consensus, can be summarized as follows. The Rule of Law in this vision describes a situation in which a complete system of rules defines and delimits the rights and duties of both private actors, and the state. The approach to the materials of the law is basically positivist in that what counts as law is rules, so that other factors that affect the implementation of rules do not count as law, but as politics, morality, or something else. The approach is also formalist in the sense that the system of rules is imagined to be largely complete, and in general subject to one correct interpretation for every case brought before it. This results in a basically mechanical vision of the role of courts, which are presented as applying single correct rules to the facts presented, and as enforcing rights enshrined in law or in contracts bargained for between market actors. There is neither room for a positivist vision of rules and gaps, with judges being able to fill the gaps according to ‘politics’ (Hart 1958), nor the more sceptical indeterminacy thesis, championed by the Legal Realists, and later the Critical Legal Studies writers, that in many cases two rules may be equally applicable to particular case, allowing politics, ideology, or bias, to affect the judge’s choice of the applicable rule itself (Kennedy 1976). There would also seem to be little room for the ‘law as integrity’ approach of Ronald Dworkin, relying as it does upon the individual judge accepting the ‘Herculean’ challenge of filling the gaps, indeterminacies and contradictions existing in the rule structure of any actual legal system by ‘trying to find, in some coherent set of principles about people’s rights and duties, the best

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constructive interpretation of the political structure and legal doctrine of their community’ (Dworkin 1986: 225). The Law & Development vision of the Rule of Law is decidedly not formal, however, in the sense of being neutral with regard to the content of the rules. The core of the entire vision is the protection of private property and freedom of contract, seen as the bases for a market economy, and this substantive agenda informs Law & Development initiatives for private and public law reforms. In comparative historical terms this vision probably corresponds most closely to the ‘formal’ or Liberal Rechtsstaat concept as it developed in late-nineteenth-century Germany (Böckenförde 1991a). The Liberal Rechtsstaat provided the basis for the image of law which Weber connected with the rise of modern capitalism, so it is hardly surprising that this image informs much of the Law & Development literature, which remains deeply indebted to Weber, consciously or not. When the Rule of Law is invoked in the Law & Development literature a standard set of prescriptions thus tends to follow. Private property must be protected first through criminal law, then through private law – the law of property and contract – that will allow ‘competent’ courts to enforce the rights bargained for between market actors and enshrined in contracts.7 ‘Competency’ is sometimes given a substantive gloss by reminders that these are judges administering the rules of a market economy, suggesting both a recognition of the limits of rule formalism, and a hope that inevitable judicial discretion and judicial rule making can be constrained by invoking the concept of a ‘market economy’, as if that will supply the determinacy that the materials of the law itself cannot provide. Other statutory regimes such as those creating and protecting intellectual property rights are explained and legitimated in basically the same manner: as creating the property rights incentive structure that will maximize the activities of rational economic actors. The International Country Risk Guide, a privately compiled investment risk ranking used as the ‘empirical’ foundation for oft-cited economic studies of institutional quality, now uses ‘Rule of Law’ to describe the variable it used to label ‘Law and Order Tradition’ (Knack and Keefer 1995: 225). That sums up the vision nicely. The power of the Law & Development movement’s property rights/Rule of Law rhetoric lies in the fact that it sounds both obvious and reasonable: of course, a market economy cannot operate unless people have rights they can exchange, and of course people should be secure in the ownership of their property. This effect is maintained when writers claim ‘broad consensus among economists on secure property and contract rights’, while admitting that there is actually great diversity and disagreement on the details of such institutions (Clague 1997: 368–9). The claim of a broad consensus may be entirely right as far as it goes, but the subsequent admission is crucial because legal reform efforts by definition do not leave off at the level of generality of the broad consensus, because legal systems themselves do not and cannot. By examining the rhetoric a bit more closely, moreover, one comes to see that

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‘secure property rights’ often becomes code for property rights that are regulated by the state in certain ways, but not in others. The law that creates property rights in the first place, and regulates them by setting the boundaries between conflicting rights claims, will be said to ‘violate’ such rights if it regulates them in ways incompatible with the neoliberal economic orthodoxy. For example, in laying out the methodological framework for the Asian Development Bank’s study of legal and economic change in six Asian countries, the study’s primary authors write, [C]learly defined property rights were on the books in 1960 in all countries, except for China. However, they were superseded to a greater or lesser extend (sic) by government regulations limiting the use of land for specific purposes (agriculture), restricting access to land (e.g. by foreigners), or trying to counteract excessive concentration of land or speculative real estate trading. As these rules changed considerably and resulted in far reaching state interference in private property rights, it is not possible to assert that clearly defined private property rights over real estate played a key role in Asian economic development. (emphasis added)8 There is no suggestion that rights over real property were not clearly defined in these countries in 1960, in fact they had to be clearly defined to be so tightly controlled. Similarly, the IMF’s Vito Tanzi, one of that organization’s major voices on anti-corruption and ‘governance’, uses rent control as an example of government acting as a ‘major violator of property rights’.9 In a mode of thinking highly reminiscent of the formalist judicial opinions attacked by the Progressives and Legal Realists, these writers believe, or at least want us to believe, that there exists a set of property rights that, while obviously created and defined by law, can also be ‘violated’ by more law if it is of the wrong type (‘regulation’). And how is one to tell the good law (that creating and protecting property rights) from the bad law (that regulating and violating property rights)? Reasoning syllogistically from concepts like ‘property’ or ‘freedom of contract’ no longer convinces, but neither can the IFIs admit the fundamentally political nature of any attempt to delimit spheres of legitimate versus illegitimate legal regulation of property. Instead the answer seems to come from the right wing of academic economics, so that ‘security of property rights’, designed to invoke images of sturdy farmers and hard-working shopkeepers, becomes code for the kind of unregulated capitalism that generally does not exist in the real world, least of all in the democratic, developed West. The focus on protecting private property extends into public law as well, and in administrative law the approach is distinctly Hayekian. Hayek’s influential formulation was that the Rule of Law, ‘stripped of all its technicalities’, means that ‘government in all its actions is bound by rules fixed and announced beforehand – rules which make it possible to foresee with fair

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certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge’ (Hayek 1944). This vision of the Rule of Law, elaborated in The Constitution of Liberty (Hayek 1960), has proven attractive to neoliberal economists and other reformers because it would rule out as illegitimate many intrusions by the state into market activities, thus leaving the maximum free play to the ‘invisible hand’ (Raz 1977), while also promising to limit opportunities for corruption and rent-seeking on the part of state actors (Ohnesorge 1999). It is worth noting that Hayek himself did not claim to be describing the actual operation of law in the West (we were on the ‘road to serfdom’, after all), but in fact seemed to be presenting a utopian vision of the nineteenth century common law of England and the United States, with some distinctly Rechtsstaat overtones. And though he made economic performance claims in terms of a contrast between the Rule of Law and ‘planning’, his main agenda seems to have been the pursuit of his vision of political liberty. What appears to have happened, however, is that those in the Law & Development movement who now draw on Hayek for ideas about the relationship between law and economic performance seem to believe that legality in the West, or in ‘successful market economies’, substantially conforms to Hayek’s normative vision of the Rule of Law (Dhonte and Kapur 1996). In constitutional law the focus is on how to create a legal order that will allow the government to ‘credibly commit’ to rigid protection of private property from public limitation, whether enacted legislatively or undertaken by the executive branch, thus maximizing economic activity by rational private actors (Olson 1993; Weingast 1993). This is presented as the solution to the ‘fundamental political dilemma’ of having a state that is effective enough to enforce property rights, collect taxes, and generally keep order, but that will not use that strength to go beyond these ‘nightwatchman state’ functions. Distrust of both the executive and the legislative arms of government, democratic or otherwise,10 pervades this literature, with the result being a naivesounding faith in the ability to lock-in expansive private property protections through favourable constitutional language and independent courts. Even outstanding scholars of American law who would count as progressive in the US political spectrum will participate in constitutional ‘reform’ advocacy, trumpeting the Rule of Law that appears simultaneously anti-democratic, obsessed with property rights, and simplistic when viewed through the lens of America’s own historical experience (Elkin et al. 1993). The fact that an international Law & Development movement could define the Rule of Law in a warm, fuzzy and culturally sensitive way11 may or may not be an answer to Trubek and Galanter’s famous 1974 critique (Trubek and Galanter 1974), but it provides no answer to what is happening today. The Rule of Law as presented in this literature is most certainly a cartoon, then, but it is not a funny one. The idea that it is being forced on countries that find themselves prostrate before the IFIs is far too simplistic, in part

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because there is likely to be a domestic constituency backing, or at least coalescing around, any particular change being advocated, and in part because social change via law reform is notoriously unstable and unpredictable. Nonetheless, attempts to implement the agenda will have enormous social consequences, and the fact that the agenda is both utopian and internally conflicted makes it more disturbing rather than less.

What can the Rule of Law say about legal reform in the wake of the financial crisis? Even if one adopts the Law & Development movement’s limited ‘functioning legal infrastructure’ ideal of the Rule of Law, outlined above, one has to confront the fact that legal systems in many parts of Asia have failed to conform in important respects to even that limited vision (Ohnesorge 2003; Jayasuriya 1999; Tomasic and Little 1997; Winn 1994; Upham 1994, 1987), let alone more substantive definitions. These ‘failures’ have not prevented countries in the region from achieving dramatic economic development however, and if one expands the definition of economic development to include national political and strategic concerns, not simply raw gross domestic product (GDP) growth, many of these failures seem less inexplicable or perverse, even admitting that they may have been economically inefficient. Discretion-laced bureaucratic screening systems governing cross-border capital and technology flows, anaemic protection of intellectual property rights, indifference on the part of competition authorities to anti-competitive practices, a tendency towards informality rather than strict enforcement of rights in insolvency administration, weak protections for minority shareholders, constrained or even highly constrained judicial independence, all become more understandable if seen in the context of late economic development under Northeast Asia’s post-Second World War circumstances. The remarkable performance of these economies over most of the postwar era suggests that to the ‘England problem’ that haunted Weber’s theorizing – the fact that industrial capitalism had actually arisen in a society that diverged in substantial respects from his model – should be added the ‘Asia problem’.12 It is nonetheless true that law and economic governance are changing rapidly in the region, most obviously under the pressure of the financial crisis, but perhaps more importantly as a result of longer-term trends, including democratization and economic liberalization, that have been underway since the 1980s. Many of these changes will have important implications for economic performance and for governance more generally, particularly those structural changes that will affect the operation of entire legal systems, and the temptation for those advocating particular changes will be to seek to cast them as steps towards the Rule of Law. In some cases this may be plausible, but in other cases such a claim would simply obscure important social or political consequences that should be openly acknowledged and debated by those who will

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be affected. The following sections focus on legal changes that are taking place, or are likely to take place, in Northeast Asia, and address whether the Rule of Law concept provides useful criteria for directing or evaluating change. Receptivity of legal systems to private litigation13 The attractiveness of a legal system to private litigants will greatly affect the rate of private litigation in a society. Although using litigation rates as a variable for comparing legal systems is fraught with complicating factors (Blankenburg 1997), it seems intuitively obvious that amounts and types of litigation matter for economic performance. The Law & Development literature is often cast at too high a level of generality to address receptivity issues directly, but the claim is often made that the Rule of Law corresponding to a market economy demands courts that are readily accessible to private litigants, especially to enforce contractual and property rights (World Bank 1996). Legal regimes in Northeast Asia have not been seen as friendly for private litigation, however, either overall or with regard to particular sorts of litigation. Neoliberal reformers may well seek to make these legal systems more receptive to litigation, but the Rule of Law as such will not provide much guidance in such efforts, either in terms of how litigation-friendly a system should be overall, or with regard to what particular changes should be made to accomplish whatever effect is desired. The following sections discuss systemic factors that have been identified as discouraging litigation in the region, factors that affect both the way that litigation has been financed, and that affect the way litigation has been conducted. The nature of the bar will affect the extent to which a legal system is able to approximate traditional Rule of Law ideals such as equal access to justice, and will also effect the extent to which the Law & Development movement’s ‘functioning legal infrastructure’ vision can be attained. One of the main factors affecting the financing of litigation in countries of the region is the very low passage rates for their bar examinations, which keep bars small, competition restrained, and fees high. Interestingly, little attention is paid in the Law & Development literature to domestic legal professions,14 yet at the same time this is one of the hottest areas of debate and development throughout Northeast Asia. South Korea, Japan, and Taiwan are all considering a range of options for reforming legal education, and all have moved to increase the number of practicing attorneys. These movements began well before the financial crisis, and have potentially wide-ranging social, political and economic consequences, yet these consequences are at the same time quite hard to predict. One could imagine more lawyers resulting in lower legal fees and thus lower transaction costs for business, but one could also imagine more lawyers leading to more litigation, more formalized business relationships, and thus higher transaction costs. Another common perception is that litigation in the region has also been discouraged by professional rules limiting contingency fee arrangements,

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which allow lawyers in the United States to charge no fixed fee, but instead take a percentage of any eventual award in the client’s favour. Contingency fee arrangements allow plaintiffs’ attorneys to finance certain cases, with plaintiffs required to pay nothing unless they prevail. A third phenomenon common to the legal systems of the region is the institution of the ‘stamp duty’, a kind of tax that must be paid in full at the time litigation is initiated, and which also works to discourage litigation. The ‘stamp duty’ has normally been calculated as a percentage of the claimed amount, rather than being related to the actual costs of administering litigation, and this discourages not only inflated damage claims, but also certain types of litigation. That this works as a negative incentive against shareholder derivative litigation, for example, has been well-documented, and in Japan the law has been amended to make shareholder derivative litigation more attractive to plaintiffs.15 Rules and practices governing the process of litigation in the region have also been seen to discourage litigation. One such practice is that of spreading out rather than concentrating hearings in a particular case. Rather than the court blocking off a period of time for an individual trial and consolidating hearings within that period, South Korean and Japanese courts have instead conducted trials through a series of brief hearings, spread out over many months, even in simple cases. Another factor some cite as discouraging litigation in the region is that judges, as representatives of the Civil Law tradition, generally lack the broad contempt of court powers that common law judges use to discipline litigants. In the author’s experience in South Korea, for example, the fact that a witness simply did not show up to testify at the appointed time did not create a serious problem for the witness, the court, or the lawyers involved. The hearing would simply be rescheduled for the following month. A third factor often cited is the relative weakness of civil ‘discovery’ provisions in the civil procedure rules of the region, which allow defendants to withhold substantially more evidence from the plaintiff’s side than would be possible under US procedural rules. Finally, class action mechanisms, which are very important for making certain kinds of litigation practical, have also been absent. Several aspects of the foregoing discussion are noteworthy. First, the discussion makes little sense unless the implied standard of comparison can be identified. Unfriendly court system – compared to what? Small number of lawyers – compared to what? The Rule of Law concept will not help much in that exercise, with the proviso that if private litigation were so unattractive that no one resorted to the courts, most would probably agree that law had receded to the point of irrelevance. So long as that extreme condition is not approached, the Rule of Law does not provide much guidance, either with regard to overall attractiveness to litigation, or to which particular procedural rules should be adjusted, and in which directions. Yet these mundane structural/procedural changes are exactly the kinds of changes that must be made in any serious effort to affect how a legal system operates, which is why real

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law reform work is intensely political while at the same time remaining ‘below the radar’ of even most informed observers. Although the Rule of Law is not of much use in making such decisions, other choices for evaluation are also limited. Law reformers often look to another country, in practice often the United States in spite of the widespread horror in which many hold our legal culture, or to ‘international best practices’, which may well mean comparison to the United States or to the unconscious model of a ‘normal’ legal system held in the head of the person making the comparison. But similar procedural provisions do not necessarily yield similar levels of litigation, even between societies that share similar substantive law and many other attributes in common. ‘Substantive law, and even procedural codes, might be alike from one country to the next, but they are bad predictors as to how the law is handled’ (Blankenburg 1997: 64). Another strategy would be to attempt to ground a judgement about receptivity to litigation in some other objective criteria, such as economic efficiency. This sounds more scientific than either Rule of Law rhetoric or comparison between existing legal systems, but unless one believes that all the variables that influence the performance of a particular legal rule or practice can really be held constant, there must be great doubt that a particular legal rule or practice, even if highly efficient in its home environment, will be the optimal choice for a different environment. Setting aside the effects of social and other non-legal norms on the functioning of legal norms, differences in the surrounding formal legal norms alone will inevitably cast doubt on the optimality of a proposed rule change unless larger parts of the regime are changed as well. A second important point is that the new Law & Development literature stresses the need for lawyers, courts and other institutions of a legal system to enforce contract and property rights, but substituting the word ‘challenge’ for the word ‘enforce’ opens up whole new lines of enquiry that should at least be considered by those proposing to tinker with legal systems in ways that will affect their receptivity to litigation. What lawyers actually do in a given society will not be limited to the functions assigned to them in a model, even if the model is constructed empirically, based on what lawyers do and have done in other actual societies. But if the model is not constructed in this way, and lawyers are given a limited role of simply facilitating the enforcement of property and contract rights, history suggests that they will not conform to the model. A common position in the legal education and bar membership debates is that legal education in Northeast Asia is too formalistic, too focused on exegesis of the rule structure, and needs to become more ‘pragmatic’ and policyoriented, like American legal education. Licensing more lawyers, especially those trained in this more ‘realistic’ way, will help meet the demands of business for more sophisticated legal advice, while also making it easier for people generally to pursue their legal rights. The fact is, however, that American legal education is in major respects radically un-pragmatic, with instruction

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in how to actually practice law generally relegated to low-prestige ‘clinical’ courses, and in any case it involves a great leap of faith to think that the US system of teaching law, which reflects our quite unique intellectual history, can be transformed from a reflection of one society into an instrument for bringing about predictable change in another. It is likewise unclear what having more licensed lawyers will do for Northeast Asia. Business interests might find transaction costs, including legal fees, rising instead of falling with additional licensed lawyers, and human rights advocates may find that having more lawyers does not translate directly into better representation for the poor. Finally, many of these rules and practices are in fact contested, controversial and subject to change in their countries of origin, with well developed arguments for and against many of them. For example, after much controversy England is now experimenting with certain forms of contingency or ‘conditional’ fee arrangements (Mears 2000; Levin 1998), thus appearing to move toward the US practice, but retains the ‘loser pays’ principle under which the unsuccessful litigant must generally pay the victor’s attorney fees as well as litigation costs. US anti-litigation ‘law reform’ groups, and some noted academics, advocate the ‘loser pays’ principle for this country, where the basic practice is that each side pays its own attorney fees, except where attorney fees are ‘shifted’ in favour of successful plaintiffs for public policy reasons, and only some litigation costs are likely to be recoverable by a successful defendant.16 A conservative Japanese Supreme Court justice likewise advocated a ‘loser pays’ system for that country in the 1950s, to dampen a tendency to litigate that was growing, but that in comparative perspective appears somewhat quaint (Tanaka 1959). Discovery provisions are also contested ground in the United States, with the relevant procedural rules being amended periodically. Recent amendments to the Federal Rules of Civil Procedure tinker with the statutory language in an attempt to narrow the scope of discovery that will be available to a plaintiff as a matter of right, but then add an element of judicial discretion by allowing the court to reimpose the current, broader standard ‘for good cause’. As one commentator candidly notes, ‘it seems inevitable that we will have hundreds of new federal court discovery decisions to review in the coming years’ (Herr 2000). Independent judiciaries and the development of legal doctrine One of the mantras of the Law & Development literature is that target countries need independent judiciaries, with independence being basically a proxy for how freely and effectively the courts can act to protect private rights, especially property rights, against expropriation or inefficient regulatory initiatives by the executive or legislative branches. This fits well with the literature’s mechanistic assumptions about what judges do in deciding cases, since in the vision private rights are created and protected by rules, so being an effective independent court can be assumed to be simply a matter of non-political,

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non-arbitrary, rule enforcement. Given that the IFIs and other international proponents of legal change will exercise influence primarily over the written rules themselves, and will often need to worry about political backlash against their policy prescriptions, it is understandable why they advocate judicial independence largely in terms of enforcing written rules, and as a check on populist politics. Actual judiciaries with a high degree of institutional independence do much more than this, however, so it is hard to see how an instrumentalist law reformer could give a highly independent judiciary more than a lukewarm endorsement. Judges in common law jurisdictions, particularly the United States, are noted for their ability to send legal doctrine spinning off in new and creative directions, but judges in European Civil Law jurisdictions have also developed, in spite of theories of legislative supremacy and judicial restraint, private law causes of action in areas such as tort liability for defective products. The doctrines developed by judges through adjudication can have extremely important economic effects, as witnessed by the controversies in the United States over litigation explosions, excessive damages awards against manufacturers, and the political clout of the Trial Lawyers Association, so if a core element of the Rule of Law is an independent judiciary with at least some ability to independently develop private law, as courts have done both in the United States and in Europe, then Rule of Law advocates must be prepared for the possibility that courts in Northeast Asia will show an increased willingness to expand the tort liability of manufacturers and other businesses. If that occurs, a more robust Rule of Law will impinge directly on the conditions that long made East Asia the envy of US manufacturers, who felt that expansive tort liability in the United States put them at a competitive disadvantage vis-à-vis their East Asian competitors, who in turn complained that US tort law constituted a protectionist barrier against imports. Another doctrinal area ripe for expansion by increasingly independent and assertive courts would be professional malpractice. In Korea, for example, malpractice litigation against lawyers has been basically non-existent, which has meant that Korean lawyers, and thus their clients, have not had to bear the added costs of malpractice insurance, but it has also meant that Korean lawyers have not been disciplined in the manner of their US counterparts. They are less disciplined by the market for legal services, since there are relatively few of them, and they are little disciplined by the threat of malpractice litigation. This absence of professional malpractice litigation is changing now, but neither the Rule of Law nor the lesser included abstractions relied upon in the Law & Development literature are particularly useful in a discussion of whether legal or other professional malpractice should be expanded in Korea, or what the economic and social consequences of that would be. Insolvency As will be discussed by Carruthers and Halliday in Chapter 9, insolvency law has become a great focus of attention in the wake of the financial crisis.

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Foreign creditors who lent to Asian parties without proper legal security, assuming sovereign guarantees that had little or no legal basis, now want protection. In addition, foreign investors now want to buy cheap debt in Asia, then be able to foreclose, if necessary. The IMF appears to be leading attempts to change local insolvency regimes, in general by tightening up rules to make regimes more creditor-friendly. In Korea, at least, one of the aims has been to constrain judges who have been seen as being too soft on debtors, but it is hard to constrain judges without limiting their independence, thus infringing the Rule of Law ideal. The insolvency law regime, on paper and in practice, will greatly influence the degree of ‘creative destruction’ that will occur in an economy, but the Rule of Law says little about what level of ‘creative destruction’ a society should aim for, and even a more focused concept such as ‘secure property rights’ really does not get to the details of how an insolvency regime actually functions. East Asian economies have not been known for high levels of creative destruction, being noted instead for ‘convoy systems’, managed competition and reliance on informal alternatives to formal, legal insolvency procedures (Tomasic and Little 1997). Neoliberal bankruptcy reforms will certainly occur in those countries that are subject to IMF discipline as a result of the financial crisis, but most of the institutional changes will involve particular rule changes not derivable from the Rule of Law or any other general concept. In addition, the desire to use insolvency law in an instrumental way to achieve a higher degree of ‘creative destruction’, to the extent it relies upon disciplining judges to enforce statutes in desired ways, may run up against the Rule of Law goal of judicial independence.

The historical development of administrative law in Northeast Asia In order to provide context for a discussion of neoliberal reforms to public law and regulatory practices in Northeast Asia it may be useful to put administrative law and regulation in comparative perspective by looking at the sequence in which liberal legality, industrialization, and regulatory government have occurred in different societies. This clearly requires some broad generalizations, but may nonetheless yield useful insights. In the United States liberal legality was well established prior to industrialization, and industrialization was well underway prior to the rise of administrative government at the end of the nineteenth century (Skowronek 1982). In this sequence, one could say that the establishment of liberal legality and a relative separation of the state from private interests meant that industrialization was generally carried out by private entrepreneurs, who in a democratic polity amassed great power to resist regulatory government, and to ensure that administrative law, as the law governing the regulatory relationship between the state and private interests, was highly protective of the latter.

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The fact that judicial independence and the private legal profession were well-instituted in the United States meant that the courts and the private bar were positioned to resist those aspects of administrative governance that would limit their roles, and opponents of regulatory government could rely on deeply held societal commitments to liberal legality and private property when crafting their arguments for the courts, or for the public arena. Germany provides an example of a somewhat different sequence, though not so different as some would argue. In important German polities, such as Prussia, bureaucratically organized governments with relatively ambitious regulatory agendas arose prior to the rise of liberal legality, and both of these arose prior to industrialization. The Liberal Rechtsstaat that became the goal of many German liberals during the nineteenth century was based on ideas of individual rights and formal legality, but in general was not as hostile to the rising tide of regulatory government as liberal legality in the US context, and important German liberal administrative law theorists became supporters of an interventionist state in response to the social problems associated with industrialization (Böckenförde 1991b; Hahn 1971). At least by comparison to the United States, administrative law as it developed in Germany focused more on controlling how the state carried out its governance tasks, on insuring that governance was in accordance with law, and less on trying to handicap the state’s substantive regulatory agenda. In Northeast Asia, one could say that a third sequence has been followed, according to which the interventionist state arose prior to, but really in conjunction with, industrialization. With these two established first, and established in a manner that left the state and private industry in a complex and mutually dependent relationship, liberal legality and liberal administrative law have been struggling to establish themselves ever since. Judicial independence has been problematic, even in Japan, which meant that judiciaries were not going to be able to do much in the way of creating and enforcing systems of liberal administrative law on their own, even if they saw that as an appropriate task. The states did not regulate all areas of the economy, but what they did regulate, such as the interface between their domestic economies and the international economy, or the structure of important national industries, they regulated with comparatively little interference from the courts. Two points are important here, however. First, this is not an argument for the autonomy of the Northeast Asian state from private interests, but rather an argument that the relationship between the state and private interests was relatively unconstrained by legality. The fact that the relationship was so little governed by law has laid the groundwork for years of debate about state autonomy, because so much must be inferred. In the cases of South Korea and Taiwan it is easy to understand why private interests did not effectively push for a more legalized relationship with the state, but in the case of Japan, where democracy and political corruption scandals have been the norm since the end of the Second World War, one must assume that they did not

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do so because they did not feel that it would benefit them economically. The second point is that governance was not necessarily arbitrary, or even un-law like, despite the fact that the courts were kept at a distance. Administration may be highly rule-bound, and discretion highly constrained, by internal bureaucratic norms, processes and procedures, with little or no supervision by the courts. The liberalization of economic controls that has been going on in Northeast Asia is well known, but this has also been accompanied by steps to introduce more liberal administrative law regimes, specifically by adopting statutes governing the internal decision-making processes of administrative agencies, so-called administrative procedure laws. The United States adopted its Administrative Procedure Act in 1946, West Germany adopted a version of such a statute in 1976, and there had been calls for such statutes within Asia for decades. Those calls are now being met, with administrative procedure laws being adopted in all three jurisdictions. In South Korea and Taiwan political democratization has been accompanied by enhanced judicial independence, so that the administrative law reforms that have been enacted will play out in the context of judiciaries that are more independent from the executive, and that perhaps wish to take on a more active role in mediating state–private interactions. In Japan, the judiciary itself has not changed, so changes in administrative law there will be implemented by a judiciary that still faces the same structural challenges to its independence. The timing of these initiatives, once they finally achieved some success, may be useful for evaluating some of the claims of the Law and Development literature. One such claim, which smacks of the sort of formalist reasoning discussed earlier, is that ‘civil society’, in particular private owners of capital, can be assigned the function of providing demand for the Rule of Law and liberal legality, in much the same was as an increasingly wealthy middle class is assigned the function of demanding democracy in modernization models. Although one might simply look at the economic oligarchy in Russia for yet another example of how extensive private property cannot be assumed to result in a demand for the Rule of Law, one could also look at the problematic history of private capital in Japan in relation to liberal administrative law. It may be that private capital interests now feel that they want to extricate themselves from existing relationships with governments and ruling parties, but that does not mean they want the Rule of Law in society generally, only a more law-governed relationship with the state. But even such potentially important administrative law reforms as are going on in Northeast Asia will remain highly dependent upon particular circumstances, and there will be many important issues that cannot be resolved by invoking Rule of Law rhetoric, or the rhetoric of liberal legality. As Frank Upham has demonstrated so well in the case of Japan (Upham 1987), one key issue will involve the doctrine of standing to challenge administrative decisions. Generous standing doctrine will tend to slow down administrative

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action by facilitating legal challenges, while narrow standing doctrine could keep judicial review far in the background in spite of reforms to the statutory law. The Rule of Law concept is not very useful in the debate over scope of standing, though if the Rule of Law is achieved in terms of the courts becoming more firmly independent it will likely be they who determine the scope of standing, within broad limits. Likewise the issue of justiciability – whether the government agency has undertaken the requisite ‘administrative act’ that will allow a citizen to obtain judicial review. This is a notoriously malleable doctrine, and Rule of Law ideals arguably provide only a bottom limit on how restrictively the ‘administrative act’ requirement might be interpreted. This is a key doctrine in administrative law, with important economic governance implications, the detailed interpretation of which would typically lie within the authority of an independent judiciary. Yet despite the fact that there would seem to be clear economic governance effects from enhanced judicial independence, as part of the Rule of Law, the raw economic effects would not be subject to easy generalization, as the impact of broad or narrow standing or justiciability doctrines would vary depending upon what sort of regulatory initiative was involved. Similar problems arise if we look at other basic areas of administrative law, such as the intensity of judicial review of agency factual determinations, of agency compliance with procedural requirements, or of agency interpretations of law. These and other doctrinal areas are subject to continuing debate and development in the United States, and with certain exceptions the Rule of Law is not at the core of contemporary debates. To the extent that administrative law in Northeast Asia comes to resemble administrative law in the United States, and to the extent that judiciaries in Northeast Asia are given autonomy to develop administrative law doctrines, what can be expected is not tight convergence to the United States or any other model, but rather that legal debates and doctrinal shifts will occur within broadly similar parameters, and will be conducted on broadly similar rhetorical grounds. After a century of debate we in the United States have not settled fundamental issues concerning the respective roles of the President and Congress in supervising administrative agency activities, the extent to which Congress may delegate its legislative authority to administrative agencies, and the extent to which Federal government agencies may regulate matters not obviously within Federal authority. Leaving aside such legal issues, we have yet to reach settlement on even the most basic questions of political theory raised by the coexistence of democracy and bureaucracy – the desired balance between bureaucratic expertise and public participation in administrative agency decision making, and how to best achieve that balance. From the outside US administrative law may appear to comprise a model that might be imported, but from the inside the system appears dynamic along several different dimensions, and intimately connected with broader political concerns and debates.

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Administrative guidance and the legality of South Korea’s Big Deal One notorious facet of regulatory practice in Northeast Asia, administrative guidance, could be quite dramatically affected by a shift towards a stronger Rule of Law in administrative law, but this will likely depend upon the courts. Administrative guidance has probably been over-conceptualized in some senses, but in one important sense it has not. Although not all administrative guidance would fall into this category, it is quite clear that in many instances informal requests or suggestions emanating from the government were in fact backed up by threats of retaliation, and thus were voluntary only in the most formal sense. These threats of retaliation were facilitated by the fact that many areas of regulatory control fell within the jurisdiction of mainline, hierarchically organized ministries, as opposed to the US model of independent regulatory commissions and single function agencies, so that cross-jurisdiction retaliation was facilitated. A company that did not heed an informal government request or suggestion could suffer unfavourable treatment in a later, formally unrelated matter coming before the same ministry. Nearly any conception of the Rule of Law would seem to render this illegitimate, as an abuse of the authority given to the retaliating authority. For example, for tax authorities to audit a company because that company ignored a government campaign against imports of luxury goods, or for a company to be denied an import license, a license to enter a line of business, or permission to access international capital markets because it ignored guidance in a legally unrelated matter, would mean that such later decision was based on factors inappropriate to the agency’s decision making process. Courts in many jurisdictions have developed administrative law doctrines to combat this sort of practice as an abuse of otherwise lawful discretion (Singh 1985; Hamson 1954), but the development and enforcement of such doctrines require aggressive courts willing to explore the actual, subjective motives of government actors, since the later retaliatory action might very well fall within the scope of the legitimate regulatory authority of that government body. In other words, effective administrative law in this context requires courts that will go beyond a review for formal compliance with the rules, but there is no guarantee that more independent courts will actually heighten their scrutiny of government actions in this way. To the extent that neoliberal economic reforms do away with capital controls and other controls over domestic industrial structures such reforms would seem to complement and support a stronger Rule of Law in administrative law, though governments might try to maintain extra-legally the legal control measures they have lost. Reforms that involve creating quasi-independent regulatory bodies should tend to reduce the abuse of discretion problems that have been discussed here, though efforts to export this US innovation have not fared well in the past.

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The story of administrative guidance and the Rule of Law can be complicated, however, as exemplified by the South Korean government’s desire to push through chaebol reforms known as the ‘Big Deal’. The Law & Development literature’s core Rule of Law concern is with the protection of private property rights against government interference, yet constitutional protection of private property could be interpreted in such as way as to call into question the legality of the means by which the Kim Dae Jung government is pushing the Big Deal. South Korea’s Constitutional Court ruled that government restrictions on bank lending to the Kukje chaebol in the 1980s, and the resulting forced sale of Kukje assets by the owner, was an unconstitutional infringement upon private property rights (Hong 2000; West 1998). To the extent that the Big Deal relies on similar government leverage over bank lending policies, a legacy of Korea’s developmental state that has been hard to relinquish, the outcome of the Big Deal could be subject to future legal challenges (Kim 2000). Yet the overwhelming power of the chaebol in the South Korean economic and political environment may also hinder the long-run development of the Rule of Law in South Korea, in addition to being economically questionable. If that is the case, perhaps achieving the Rule of Law in the long run will require a violation of the property rights – Rule of Law in the short run, just as a rationalized economic structure may require some substantial pressure on private property to push through the Big Deal. This is hardly ideal, but neither is it ideal to see property rights and Rule of Law rhetoric stand in the way of initiatives such as chaebol reform, or land reform in some developing countries, which can improve societies in very fundamental ways, both economically and politically. In any case, while the South Korean judiciary may now enjoy the stature in that society that is required when constitutional norms are invoked to limit popular political initiatives, courts in many developing countries simply cannot be assumed to possess such authority.

Conclusion Legal systems, from their broadest structural arrangements down to their most detailed procedural rules, certainly affect economic performance, yet the realworld economic effects of legal system change are not easy to study. The dominant theoretical approach of the Law & Development movement, based on rational choice institutionalism and Law & Economics, has advantages in terms of theoretical rigour and is backed by the work of several Nobel laureates, but it may involve costs of its own in terms of an overreliance on abstract modelling and deductive reasoning invoking concepts like the Rule of Law. The financial crisis has demonstrated to many the dangers of financial deregulation without re-regulation, confirming the insight that freer markets may indeed require more rules (Vogel 1996). Yet comparative studies of regulatory styles and administrative law suggest that ‘rules’ are really not the answer – that

John K.M. Ohnesorge 83

successful regulatory systems mix rule, discretion and judicial review to varying degrees, and that discretion is both inevitable and desirable (Kagan and Axelrad 2000; Rubin 1997; Kagan 1991). Rule of Law advocates that forget this fact in the effort to provide the tightly rule-based environment that will maximize predictability and certainty for the private sector are not only out of touch with the realities of regulation and administrative law in actual existing market democracies, but are selling a one-sided and potentially unsustainable vision. There are many ways to think about law and economic activity, and perhaps especially when trying to transplant new legal institutions into existing legal and social systems, it might be useful to resurrect some of the pragmatic, anti-abstractionist sentiments of the old institutionalist economics and Legal Realism. In a wonderful essay entitled The Supreme Court and American Capitalism Max Lerner captured this sensibility when he wrote: It is generally accepted that one of the essential elements of law is certainty, and that it is especially essential for the development of capitalism. It encourages accumulation and investment by certifying the stability of the contractual relations. But it is to be conjectured that a speculative period in capitalist development thrives equally or better on uncertainty in the law. And in periods of economic collapse the crystallized certainty of capitalist law acts as an element of inflexibility in delaying adjustments to new conditions. (Lerner 1933) The one thing we can probably be sure of when gearing up to tinker with a legal system is that nothing is going to work out exactly as planned, so why not begin with a less parsimonious but more pragmatic and empirical approach? Whether concerning the relative attractiveness of the legal system to private litigation, the ability of independent courts to develop new substantive law, the degree of ‘creative destruction’ produced by the insolvency law regime, or the development of administrative law that interjects law and courts more deeply into government–private sector relations, the Rule of Law, for all its virtues, does not provide ready answers to many of the important legal reform questions now facing Northeast Asia. Unfortunately, however, neither does any competing approach. Although this chapter has focused on the errors of those selling the Rule of Law as one of the ‘good things’ (property rights, democracy, the Rule of Law, economic growth) that ‘all go together’, one could make the same category of error in the opposite direction, and with equal certainty claim that the results of the new Law and Development initiatives will be inevitably perverse, and that market liberalism will never contribute to political liberty. This would be equally unwarranted, but as has been noted, ‘[a] tendency to resort to dogmatism is particularly noticeable in situations where the supply of evidence is scarcest, which in itself should be evidence enough against such claims’ (Pepper 1961). This is one of those situations.

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Notes 1 Frederick Grimke was a state court judge in Ohio from shortly before 1830 until 1842, and served his last six years on the bench as a member of the Supreme Court of Ohio (Grimke 1848: 5–6). 2 Important Legal Realist works are excerpted and discussed in Fisher et al. (1993). For a brief but thorough example of Legal Realism’s critique of traditional jurisprudence, see Cook (1928). 3 A highlight of this genre is the decision of Supreme Court of Illinois striking down a state statute mandating washing facilities at coalmines so that miners could wash and change into dry clothes before leaving the mines. The court found that the statute, democratically enacted and indisputably intended to protect the health of miners during cold weather, was an example of unconstitutional ‘class’ legislation because ‘[t]he evil at which this statute is aimed is one that is not visited alone upon persons employed in coal mines. The legislature cannot ameliorate the coal miners’ condition under the guise of an exercise of the police power and leave others unaided who suffer from like causes’, Starne v People, 222 Ill.189, 195 (1906). 4 On the rise and fall of the Law and Development movement of the 1960s, see Trubek and Galanter (1974). 5 The idea that federal judge and Law & Economics scholar Richard Posner is a pragmatist (Ryerson 2000) therefore requires one to ask, pragmatic about what? For example, Posner concludes an otherwise sensible excursion into the Law & Development themes with a thoughtless and totally unsupported claim that in countries ‘such as Russia’ . . . ‘a strict criminal law and a corresponding de-emphasis on the protection of civil liberties may be an important part of legal reform and an important tool for the protection of property and contract rights’ (Posner 1998: 8–9). 6 It is now typical for Law & Economics scholars to readily admit the reductionism and formalism of early Law & Economics, and that empirical verification has been far outstripped by model building and refinement (see, for example, Korobkin and Ulen 2000: 1053–4), while simultaneously touting the great contributions Law & Economics has made to ‘understanding the interaction between legal rules and society’ (ibid.: 1055). One might be tempted to ask why we should believe that the early contributions were so important scientifically, as opposed to socially or politically, if the foundations upon which they were based were fundamentally flawed. 7 In some writings contract law seems to become a mere subset of criminal law, as if courts deciding contract disputes are analogous to state authorities prosecuting property crimes. See, for example, Clague (1997: 373). (‘The victim of theft or contract nonfulfillment is usually willing to provide information to government authorities in their efforts to enforce the laws.’) 8 Unpublished memorandum dated 13 May 1997, on file with author. 9 Tanzi (1997: 18, n. 32). Mr Tanzi’s paper is well worth reading for the window it provides on the politics behind the technocratic rhetoric. Tanzi suggests, absent any evidence or even reasoned argument, that ‘in many countries’ crime rose because governments had taken on too wide a regulatory agenda (ibid.: 15–16), and later indicts regulations having ‘purely social, and somewhat debatable, objectives, such as those that control working hours, minimum wages, and length of work week’ (ibid.: 20). 10 As in the broader rational choice tradition, this literature seems able to address and to justify democracy only as a means to an end, not as an end in itself.

John K.M. Ohnesorge 85 11 See, for example, Tamanaha (1995: 476). ‘A minimalist account of the rule of law would require only that the government abide by the rules promulgated by the political authority and treat its citizens with basic human dignity, and that there be access to a fair and neutral (to the extent achievable) decision maker or judiciary to hear claims or resolve disputes. These basic elements are compatible with many social-cultural arrangements and, notwithstanding the potential conflicts, they have much to offer to developing countries . . . After many decades of work by people in developing countries, the end result [of Law & Development work informed by Tamanaha’s vision] may be the achievement around the world of successful, indigenous permutations of the rule of law, maintaining its core elements yet altering it to fit local circumstances.’ 12 For purposes of sensible debate it is unfortunate that some sought to transform this ‘Northeast Asian problem’ into a single model, an alternative Asian End of History to challenge triumphal Western neoliberalism. That tendency, which thrives on images of economic models struggling for global supremacy, meant that when the financial crisis hit the political-economic systems of the entire region would be written off as complete failures, incapable of providing insights that might challenge a victorious neoliberalism. 13 This section is indebted to the pioneering work of John Haley on Japanese law (Haley 1978), which regrettably has been too little pursued in writings on law in Korea or Taiwan. 14 One sometimes sees hints of long-standing populist sentiments that lawyers as such are really part of the problem, and would play a greatly reduced role of the Rule of Law were properly implemented (Clague et al. 1997: 82–3, n. 15). 15 Japan’s Liberal Democratic Party and Ministry of Justice now support legislation to rein back in shareholder litigation. ‘LDP planning review of Commercial Code,’ Daily Yomiuri On-Line, http://www.yomiuri.co.jp/newse/0924po03.htm. 16 The interplay of fee arrangements between lawyers and their clients, fee and cost allocations between litigants, and such other institutions as the English practice of ‘payment into court’, render it notoriously difficult to make sensible comparative assessments even between the English and US systems (Napier and Armstrong 1993). For a useful comparative survey see Davis (1999).

References Arnold, Thurmon W. (1935) The Symbols of Government (New Haven: Yale University Press). Blankenburg, Erhard (1997) ‘Civil Litigation Rates as Indicators for Legal Cultures’. In David Nelken (ed.), Comparing Legal Cultures (Harts, UK: Dartmouth Publishers). Böckenförde, Ernst-Wolfgang (1991a) ‘The Origin and Development of the Concept of the Rechtsstaat’. In State, Society and Liberty: Studies in Political Theory and Constitutional Law (J.A. Underwood, trans.) (New York: Berg, 1991a, pp. 47–70). Böckenförde, Ernt-Wolfgang ‘Lorenz von Stein as Theorist of the Movement of State and Society towards the Welfare State’. In State, Society and Liberty: Studies in Political Theory and Constitutional Law ( J.A. Underwood, trans.) (New York: Berg), pp. 115–45. Bodenheimer, Edgar (1962) ‘Reflections on the Rule of Law’, Utah Law Review 8(1). Clague, Christopher (1997) ‘The New Institutional Economics and Institutional Reform’, Institutions and Economic Development, 368. Cohn, Gustav (1894) A History of Political Economy (Joseph Adna Hill, trans.). Supplement to the Annals of the American Academy of Political and Social Science, Chapter 8: ‘The New German Political Economy’.

86 Law Commager, Henry Steele (1950) The American Mind (New Haven: Yale University Press). Commons, John R. (1924) Legal Foundations of Capitalism (New York: Macmillan). Cook, Walter Wheeler (1928) ‘Book Review’, Review of Carleton Kemp Allen, Law in the Making, American Political Science Review 22, 989–92. Davis, W. Kent (1999) ‘The International View of Attorney Fees in Civil Suits’, Arizona Journal of International & Comparative Law 16, 361. Dhonte, Pierre and Ishan Kapur (1996) Towards a Market Economy: Structures of Governance, IMF Working Paper WP/97/11.6. Dworkin, Ronald (1986) Law’s Empire (Cambridge, MA: Belkna Press). Elkin, Stephen L., Bartlomiej Kaminski and Cass Sunstein (1993) Communism, Constitutionalism and the Transition to Market-Based Democracy, IRIS Working Paper No. 91 (November). Fisher, William W. III. et al. (eds) (1993) American Legal Realism (New York: Oxford University press). Gerschenkron, Alexander (1965) Economic Backwardness in Historical Perspective, Praeger paperback edition, pp. 19–20 (Cambridge, MA: Belknap Press). Goodnow, Frank J. (1911) Social Reform and the Constitution (New York: Macmillan). Green, Donald P. and Ian Shapiro (1994) Pathologies of Rational Choice Theory (New Haven: Yale University Press). Grimke, Frederick (1968) The Nature and Tendency of Free Institutions, John William Ward (ed.) (Cambridge: Harvard University Press). Hahn, Erich J.C. (1971) ‘Rudolph von Gneist (1816–1895): The Political Ideas and Political Activity of a Prussian Liberal in the Bismarck Period’, Unpublished PhD dissertation, Yale University. Haley, John O. (1978) ‘The Myth of the Reluctant Litigant’, Journal of Japanese Studies 4, 359–90. Hamson, C.J. (1954) Executive Discretion and Judicial Control: An Aspect of the Conseil d’Etat (London: Stevens). Hart, H.L.A. (1958) ‘Positivism and the Separation of Law and Morals’, Harvard Law Review 71, 593. Hayek, Friedrich A. (1960) The Constitution of Liberty (Chicago: Chicago University Press). Hayek, Friedrich A. (1944) The Road to Serfdom (Chicago: Chicago University Press). Herr, David F. (2000) ‘A Parting of Ways?: Amendments to the Civil Rules – State and Federal’, LVII (VI) Bench & Bar of Minnesota, 29 (July), 35. Hong, Joon-Hyung (2000) ‘Administrative Law in the Institutionalized Administrative State’. In Dae-Kyu Yoon (ed.), Recent Transformations in Korean Law and Society (Seoul: Seoul National University Press), p. 47. Hovenkamp, Herbert (1991) Enterprise and American Law (Cambridge, MA: Harvard University Press). Hovenkamp, Herbert (1990) ‘Positivism in Law and Economics’, California Law Review 78, 815–52. Jayasuriya, Kanishka (ed.) (1999) Law, Capitalism and Power in Asia: The Rule of Law and Legal Institutions (London: Routledge). Kagan, Robert (1991) ‘Adversarial Legalism and American Government’, Journal of Policy Analysis & Management 10, 369. Kagan, Robert and Lee Axelrad (2000) Regulatory Encounters (Berkeley: University of California Press). Kaplow, Louis and Steven Shavell (1999) Economic Analysis of Law, Discussion Paper No. 251. John M. Olin Center for Law, Economics, and Business, Harvard Law School. Kennedy, Duncan (1976) ‘Form and Substance in Private Law Adjudication’, Harvard Law Review 89, 1685.

John K.M. Ohnesorge 87 Kim, Sang Hun (2000) The Legality of the Korean Government’s ‘Big Deal’ Reforms on the Chaebols, Unpublished Seminar Paper, Harvard Law School. Kloppenberg, James T. (1997) ‘The Reciprocal Visions of German and American Intellectuals’. In Transatlantic Images and Perceptions: Germany and America since 1776 (Cambridge, UK and New York: Cambridge University Press), pp. 155–70. Knack, Stephen and Philip Keefer (1995) ‘Institutions and Economic Performance’, Economics and Politics 7, 207. Korobkin, Russell B. and Thomas S. Ulen (2000) ‘Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics’, California Law Review 88, 1051–144. Lerner, Max (1933) ‘The Supreme Court and American Capitalism’, Yale Law Journal 42, 668–701. Reprinted in Robert G. McCloskey (ed.), Essays in Constitutional Law (1957). Levin, Jenny (1998) ‘No Win, No Fee, No Costs’, New Law Journal, 149 (15 January), 6871. Mears, Martin (2000) ‘The Mugging of Thai Trading’, New Law Journal 48, 150 (21 January), 6919. Napier, Michael and Nick Armstrong (1993) ‘Costs After the Event’, New Law Journal 12 (143) (8 January), 6582. Ohnesorge, John K.M. (2003) ‘The Rule of Law, Economic Development, and the Developmental States of Northeast Asia’. In Christoph Antons (ed.), Law and Development in East and Southeast Asia (London and New York: Taylor & Francis). Ohnesorge, John K.M. (1999) ‘RATCH’eting up the Anti-Corruption Drive’, Connecticut Journal of International Law 14, 467. Olson, Mancur (1993) ‘Dictatorship, Democracy, and Development’, American Political Science Review 87, 567–76. Olson, Mancur (1991) The IRIS Idea: The Needed Research. http://www.inform.umd.edu/ IRIS/needres.html. Pepper, Stephen C. (1961) World Hypotheses (Berkeley and Los Angeles: University of California Press). Posner, Richard A. (1998) ‘Creating a Legal Framework for Economic Development’, World Bank Research Observer 13(1), 1–11. Posner, Richard A. (1990) The Problems of Jurisprudence (Cambridge, MA: University of Harvard Press). Purcell, Edward A., Jr. (1973) The Crisis of Democratic Theory: Scientific Naturalism & the Problem of Value. Raz, Joseph (1977) ‘The Rule of Law and Its Virtue’, Law Quarterly Review 93, 195–211. Rubin, Edward L. (1997) ‘Discretion and its Discontents’, Chicago Kent Law Review 72, 1299. Ryerson, James (2000) ‘The Outrageous Pragmatism of Judge Richard Posner’, Lingua Franca (June), 26–34. Singh, Mahendra P. (1985) German Administrative Law in Common Law Perspective. Monograph. Skowronek, Stephen (1982) Building a New American State: The Expansion of National Administrative Capacities, 1877–1920 (Cambridge, UK and New York: Cambridge University Press). Tamanaha, Brian Z. (1995) ‘The Lessons of Law-and-Development Studies’, American Journal of International Law 89 (Review Article), 470–86. Tanaka, Kotaro (1959, 1960) ‘Democracy and Judicial Administration in Japan’, Journal of the International Commission of Jurists 2(2), 7–19. Tanzi, Vito (1997) The Changing Role of the State in the Economy, IMF Working Paper WP/97/114 (September).

88 Law Tomasic, Roman and Peter Little (1997) Insolvency Law and Practice in Asia (Hong Kong: FT Law & Asia Pacific). Trubek, David (1972) ‘Max Weber on Law and the Rise of Capitalism’, Wisconsin Law Review, 720. Trubek, David and Marc Galanter (1974) ‘Scholars in Self-Estrangement: Some Reflections on the Crisis in Law and Development Studies in the United States’, Wisconsin Law Review, 1062. Upham, Frank (1994) ‘Speculations on Legal Informality’, Law & Society Review, 28, 233. Upham, Frank (1987) Law and Social Change in Postwar Japan (Cambridge, MA: Harvard University Press). Vogel, Steven K. (1996) Freer Markets, More Rules: Regulatory Reform in Advanced Industrial Countries (Ithaca, NJ: Cornell University Press). Wade, Robert (1990) Governing the Market (Princeton, NJ: Princeton University Press). Weber, Max (1968) Economy and Society (New York: Bedminster Press). Weingast, Barry R., The Political Foundations of Democracy and the Rule of Law, Reprint No. 56 (Center for Institutional Reform and the Informal Sector/IRIS, University of Maryland at College Park, 1993). West, James M. (1998) ‘Kukje and Beyond: Constitutionalism and the Market’, Seggye h
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Part II Bureaucracy and Industrial Policy

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4 Re-engineering the Developmental State in an Age of Globalization: Taiwan in Defiance of Neoliberalism Yun-han Chu

Introduction Taiwan is one of the few East Asian economies that have emerged from the regional financial crisis relatively unscathed. Taiwan’s capacity to absorb the external economic shocks is built upon two outstanding characteristics. First, Taiwan was partially insulated from the external financial shock because both its dependence on foreign portfolio investment and its exposure to short-term foreign borrowings have been minimal. Unlike South Korea, where short-term foreign financing exposed highly leveraged firms to both exchange rate and interest rate shocks, the island’s economic growth were financed almost exclusively by domestic savings while most of its large companies ran a modest debt–equity ratio. Second, Taiwan was better equipped to withstand the regional economic downturn and the downward spiral of competitive currency depreciation because the island has been able to maintain its competitiveness in the export market through a constant upgrading and renewal of its industrial portfolio throughout the 1980s and 1990s. Unlike the Association of Southeast Asian Nations (ASEAN) economies that continued to compete both among themselves and with the People’s Republic of China’s (PRC) low-waged exporters in labour-intensive manufacturing, Taiwan has carved out different market niches for itself and widened its technological lead over the second-tier newly industrialized countries (NICs).1 Despite a sharp currency appreciation during the late 1980s, significant rises in labour cost and land prices and growing environmental concern throughout the last decade, Taiwan was able to keep up its international competitiveness through human resource development, technological upgrading and overseas outsourcing (Chu 1995). Most notably, the high-tech industries have replaced the traditional labour-intensive industries to become the backbone of Taiwan’s export sector.2 The importance of these industries grew from 27.4 per cent of manufacturing production in 1986 to 43.4 per cent in 1997. Their share of exports expanded from 27.6 per cent to 48.65 per cent during the same period. Also in traditional export sectors, the growth of higher-value-added 91

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export activities was made possible by creating a bottom layer of international subcontracting in the region and pushing local producers to move upward in the hierarchy of international subcontracting networks (Schive 1999). Thus, Taiwan was able to run a significant trade surplus year after year since the last oil shock of 1979–80 and accumulated a huge official foreign reserve (around US$90 billion by mid-1997), second only to Japan and the PRC. The state has played a critical role in nurturing these elements of economic resilience. More significantly for the sake of policy debate, neither Taiwan’s policy responses to the challenge of global economic restructuring nor its long-running policy guidelines for the financial sector and foreign portfolio investment conform squarely to the ‘neoliberal’ economic prescriptions or the so-called ‘Washington Consensus’.3 In response to the challenge of financial globalization, Taiwan has chosen a sequence of financial liberalization that gave priority to deregulating the domestic capital market over internationalization, that is, foreign participation. Despite the trend towards an integrated global financial market, the state has been keen in safeguarding its ability in setting monetary targets by preventing the internationalization of the local currency and controlling the volatility of cross-border movement of short-term capital. In response to the challenge of technological catching-up, the state has been able to act as a guiding element in a national effort to identify trajectories of technological diffusion and innovation and to serve as a catalyst motivating and enabling the local firms to invest, upgrade, innovate and internationalize. Despite the evangelist current of economic neoliberalism from the early 1980s on, Taiwan’s economic bureaucracy did not rush to undo its past learning and experiences in economic governance and industrial steering. How did the state in Taiwan manage to cope with the challenge of globalization and political transition in the 1990s more effectively than two other notable cases of the Northeast Asian developmental state model – that is, Japan and South Korea?4 In this chapter, I argue that what really set Taiwan apart are three sets of interrelated institutional evolutions during the 1980s and 1990s: first, the consolidation of the autonomy, pre-eminence and regulatory capacity of the central bank; secondly, the reinvigoration of the transformative capacity of the state economic bureaucracy, and, thirdly, the emergence of a robust structure of industrial governance in the high-tech sector. The three developments buffered the island against the regional economic crisis and facilitated Taiwan’s transition to a knowledge-based economy in the context of globalization and democratization. In the following, I focus on the three developments by turn. First, I track down the process by which Taiwan’s central bank has managed to impose its conservative macroeconomic agenda, regulate the scope and pace of financial liberalization, and build up the island’s shock-absorbing capacity. Next, I examine how the state economic bureaucracy re-engineered itself to acquire a more complex and strategic capacity when the economic competition involves cutting-edge technology and occurs on a global scale, in a much

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wider scope of industrial portfolio and at accelerating speed. More specifically, how did the state manage to address the structural deficiency of local firms in entering high-tech industries. Then I turn to the historical conditions under which Taiwan’s high-tech sector become dominated by start-up companies and endowed with an elaborate institutional arrangement that facilitates sector-wide collective actions and institutionalized coordination and consultation between the industry and responsible state agencies. In particular, this arrangement fosters the growth of a new type of state–business partnership and helps transform the state into a powerful locus for coordinating industrial changes.

Institutional foundation for monetary and financial stability A long-standing institutional characteristic of Taiwan’s economic decision making is the privileged status of the Central Bank of China (CBC) within the overall state apparatus. The bank occupies a unique position in the state apparatus because it is at the same time a part of the economic bureaucracy and a part of the national security apparatus, which falls under the exclusive purview of the president. As a result, the CBC has long occupied the commanding height of the state economic bureaucracy. The governor of the CBC is always considered the most senior economic minister.5 The CBC has been staffed by elite technocrats, who enjoyed a prestige unmatched by any other economic ministries. The governor of the CBC is protected by a renewable term of five years. Also, most governors stayed on for a long period of time, much longer than the cabinet.6 The CBC is more than just a monetary authority. It is also entrusted with an extensive regulatory authority over the banking sector and capital market. Some of its supervisory and investigative authority overlaps with the Ministry of Finance (Yen 1998). Unlike either Japan or South Korea where the central back has been historically subordinate to the finance ministry, in Taiwan, the Ministry of Finance traditionally played second fiddle to the CBC. Many finance ministers were themselves former deputy governors of the CBC. The bank can overrule the Finance Ministry, which deals with the constituencies in the financial sector more directly, over the sequence and timetable of financial deregulation and internationalization. The CBC also serves as a check on the expansionist tendency of the planning technocrats and sets the limits on the use of credit policy in industrial targeting. The steering power of the CBC over the banking sector was further buttressed by an array of state-owned banks which virtually monopolized the first-tier banking, that is, commercial banks. Before the opening up of the banking sector in 1992, the state-owned banks accounted for more than two-thirds of the total outstanding loans and discounts. Private participation was limited to the second-tier money banks consisting of regional savings and loans, city credit co-operative associations and credit departments of farmers and fishermen’s

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association at the grass root level. During the authoritarian years, the governor of CBC usually had more say than the premier, let alone finance ministry or the governor of Taiwan province, in the appointment of senior bank officials (Chen 1998: 64). As a result, the CBC can pull a number of disciplinary strings over the lending policy of state-owned banks, through the rediscount window, financial inspection and appointment power. This arrangement was originally designed to prevent a replay of the disastrous hyperinflation and currency crisis of 1947–48, which had contributed to the defeat of the Kuomintang Nationalist Party (KMT) leadership by the Communist regime in 1949 (Cheng 1993). The CBC was entrusted with the authority to protect the island’s economic stability in the name of national security and for the sake of the political security of the KMT regime.7 The CBC became the institutional embodiment of the incumbent elite’s overriding concern for monetary and financial stability. During the 1970s, the two oil shocks and the crisis of diplomatic recognition, which functionally replaced the fading memory of the civil war, reinforced the political rational for a privileged and autonomous CBC. Under the steering authority of the CBC and the Finance Ministry, for almost four decades the Nationalist government has invariably maintained a positive real interest rate, minimum public sector foreign debt, small fiscal deficit, a fixed exchange rate pegged to the US dollar, restrictions on the convertibility of the New Taiwan (NT) dollar, a rigorous regulatory regime over financial institutions, and a conservative ethos that permeated the entire banking sector. State-owned banks almost always demand collateral for their loans. Most state-owned banks have maintained their capital–asset ratio at above 12 per cent (Yen 1998: 127), much higher than the International Bank of Settlement’s 8 per cent requirement. In addition, Taiwan’s reserve requirement has been among the highest in the world, hovering around a weighted average reserve/deposits ratio of 9.26 per cent. As a check on the expansionist tendency of the planning technocrats at the Ministry of Economic Affairs (MOEA), the CBC and Finance Ministry have customarily insisted that targeted lending to the private sector be backed up by government-financed special funds, so that the ceiling of policy loans can be put under tight control. The deregulation of the financial sector of the late 1980s and early 1990s was prompted by economic exigency. A series of ominous economic signs, the mushrooming of underground financial institutions, bubble in the real estate and stock market and rapid deterioration of private sector investment, compelled the government to take decisive measures to overhaul the anachronous financial sector (Chu and Lee 1998). Since 1989, the government has introduced a series of measure to deregulate the banking sector. The fixed interest rate scheme was abolished. New licenses for commercial banks were issued to qualified private investors. Regional savings and loans were upgraded to medium business banks. Restrictions on the operation of foreign banks were relaxed. However, the privatization plan for state-owned

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commercial banks, the centrepiece of the banking reform, was held off until mid-1998.8 On the eve of the regional financial crisis, the seven leading commercial banks under the Provincial Government still accounted for close to half of the total outstanding loans of the banking sector. The CBC and Finance Ministry economic technocrats have a decisive say in devising the priority and timetable of deregulation and liberalization as well as the design of the new regulatory scheme and mechanism. The opening-up of the banking sector, the most far-reaching financial deregulation in recent years, was a case in point. The revised Banking Law was designed to ensure stability, promote diversified ownership and prevent the emergence of Japanesestyled Keiretsu. In its finalized version, the minimum capital requirement is set at NT$10 billion (US$400 million), which is extraordinarily high by international standard, and the share of a single corporate investor is limited to 5 per cent, and that of a diversified business group no more than 15 per cent. The CBC has also been keen to deflate financial bubbles before they become uncontrollable. A case in point is the high-handed measures implemented by the CBC to bring an overheated real estate market under control between 1989 and 1993. To curb the excessive capital flow into the real estate market, the CBC, on 28 February 1989, imposed a new ceiling capping the amount of secured loans that a bank could extend on real estate. The restriction was in force for almost six years. In 1992, upon the recommendation of the Finance Ministry and CBC, the Insurance Law was revised to lower the ceiling ratio of real estate investments to total capital from one-third to 19 per cent for insurance companies. The real estate bubble was effectively cooled down by 1993. Furthermore, in order to contain the encroachment of political cronyism, the CBC and Ministry of Finance have imposed on local financial institutions a strictly limited scope of deposit/loan operation and geographical span and a requirement to re-deposit their surplus reserve in designated stateowned banks. In addition, the CBC and Finance Ministry always stand ready to close down insolvent local financial institutions through forced merger and acquisition. Also as a measure of expedience and under nodding of the ruling party, the state-owned commercial banks were allowed to offer an implicit quota of soft loan to individual provincial assemblymen on an equal basis. With these controlling measures, the CBC and Finance Ministry have been able to keep the non-performing loan ratio of the overall banking system at a sustainable level.9 Also to prevent the weaker local financial institutions from crumbling over a protracted downturn in the real estate sector, the Finance Ministry pushed through a compulsory deposit insurance scheme in 1992 to cover almost 90 per cent local financial institutions despite strong resistance from local politicians. Under US pressures, since the early 1990s the Finance Ministry has lifted many restrictions on the operation of foreign banks. They were steadily allowed to provide the same line of products and services as domestic banks. However, the government controlled the number of new entrants under

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a scheme called ‘qualified financial institutions’ which only admitted a limited number of top-ranked foreign banks. Next, the foreign banks were never given a level playing ground. Subsidiaries of foreign banks were handicapped by their small number of branch offices and the inaccessibility of inter-bank overnight lending in the local market. Thus, the market share of foreign banks has grown slowly. They accounted for less than 10 per cent of the total outstanding loans by mid-1997. Through the 1980s and 1990s, the CBC has consciously built up Taiwan’s shock-absorbing capacity to withstand potential diplomatic shocks, military tension, or economic sanctions that the PRC might instigate to bring the island to its knees. The government has purposively built up not only a huge foreign reserve, but also an exceptionally large oil and food reserve. A big cushion was justified as Taiwan would have to survive on the basis of self-help. Since 1978, Taiwan has no longer been a member of the International Monetary Fund (IMF) and the World Bank. Unlike South Korea, Taiwan could not count on an international rescue package in a time of currency crisis, nor bilateral emergence loans from its security partner. With dwindling diplomatic recognition, official foreign reserve has almost become a benchmark measure of Taiwan’s self-confidence. This mentality explained why the CBC was very hesitant to remove foreign exchange control, despite a clear trend of soaring trade surplus since the early 1980s. It put off the foreign currency deregulation well until mid-1987, when the US Trade Representative started putting the undervalued NT$ under the political spotlight. By then the current account surplus had reached a staggering 19 per cent of gross national product (GNP) and the accumulation of the trade surplus and domestic savings started to wreck havoc on the real estate and stock markets. In July 1987, the CBC finally decided to remove most restrictions on private holding of foreign exchange and to nurture the growth of a foreign exchange spot market and later futures market. However, the CBC has since then established a panoply of monitoring schemes and continued to intervene heavily to prevent excessive short-term fluctuation. The restrictions on the future market were lessened only gradually. Until the end of 1996, the CBC still required banks to keep their foreign exchange derivatives positions below 33 per cent of their total foreign exchange positions. More importantly, the CBC was resolved to prevent the internationalization of its local currency. The Central Bank prohibited domestic banks from offering local currency accounts for their customers abroad and restricted the outbound movement of the NT dollar. In essence, the CBC has been keen in curbing the growth of an offshore foreign exchange market of the NT dollar. In so doing, the CBC can retain its position as the sole market maker of the NT dollar. Furthermore, the foreign borrowings for Taiwan’s banks were traditionally low, because the CBC restricted banks’ holding/owing foreign assets/ liabilities. Despite of the flooding of cheap yen onto the international money market in the early 1990s, Taiwanese banks did not engage in heavy short-term foreign borrowing nor participate actively in the global financial markets.

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Bowing to US pressure, around early 1991 the Taiwan’s stock market was opened to foreign institutional investors. Under the influence of the CBC, the Finance Ministry imposed a strict investment cap on foreign investors. Initially, each foreign institutional investor could invest up to US$50 million and the total quota will be $2.5 billion, which represents only about 2 per cent of total market capitalization. Each institution was allowed to buy up to 5 per cent of a single company and total foreign ownership of a company was limited to 10 per cent. As part of the down payment during the World Trade Organization (WTO) negotiations with the United States (US), the Finance Ministry was compelled to raise the investment cap step by step. By early 1997, the capital ceiling for individual foreign institutional investors has been steadily raised to US$600 million. The cap on ownership of individual foreign institutional investor in any listed company was raised to 15 per cent, and no more than 30 per cent for all foreign investors. In addition, all portfolio investment capital was required to stay in Taiwan at least three months before remission. The three-month requirement amounted to a hidden tax on ‘hot money’.10 In a nutshell, the CBC customarily compensates a measure of deregulation with adequate measures of re-regulation to limit the island’s vulnerability to financial market volatility. The island’s economic resilience was put to a rigorous test when the PRC employed sabre-rattling strategy in the summer of 1995 and March 1996. During the first missile crisis, the stock market lost about a third of its total value. And the local currency dived by 9 per cent. The CBC intervened heavily to support the NT dollar. The Finance Ministry was instructed to set up a stock market stabilization fund. All government-run investment funds were required to chip in and to buy in. Managing the missile crisis, as it turned out, functioned as an unintended rehearsal of the East Asian financial shock a year later. There is of course a downside to the CBC’s ultra-conservative approach. Local banks, as the principal financial intermediary, have not been very efficient in converting savings into productive use and they were also minimally internationalized. By the late 1980s, when the race for technological innovation was forced upon Taiwan, it became increasingly apparent that Taiwan’s banking sector was a drag on the process of industrial upgrading. High-tech startups were often turned down and sent away by domestic banks, which were utterly incapable of evaluating innovative business plans. To remedy the situation, the Finance Ministry moved with full speed to deregulate the capital market to provide the private sector an expanding source of direct financing. In 1988, the Finance Ministry lifted the long-time ban on setting up new brokerage houses. It also moved to lower the threshold and simplify the approval procedure for initial public offering. The accumulation of private savings instantly fuelled a boom in the stock market. By mid-1997, Taiwan’s stock market has grown to the sixth largest in the world in average trading volume and 15th in terms of overall capitalization.11 Also, since its take-off in 1994, Taiwan’s over-the-counter market has rapidly expanded into one of the most highly capitalized Over-the-Counter (OTC) markets in the world. In 1995, new private

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bills financing companies were licensed to compete with the three existing semi-official institutions to promote money market transactions. As a result, Taiwan’s financial sector witnessed the emergence of a dynamic capital market, which coexisted with, or complemented, a conservative banking sector. This also led to a paradigmatic shift in corporate financing. During the 1990s, Taiwanese corporations became much less dependent than their South Korean or Japanese counterparts on bank loans. Between 1990 and 1996, bank loans accounted only around 22 per cent of corporate financing (Chung 1998: 44). By mid-1997, the average debt ratio for large enterprises was only 109 per cent,12 much lower than the 400 per cent among South Korean Chaebol. Actually, Taiwan’s small and medium-sized firms typically incur a much higher debt ratio, around 200 per cent, than their larger counterparts (Yen 1998). This is because the large enterprises can raise most of their targeted capital through direct financing in the capital market. This corporate financing structure enabled large Taiwanese firms to withstand the credit crunch during economic downturns.

Re-engineering the developmental state Elements of Taiwan’s economic resilience have been nurtured not only by the incumbent elite’s overriding concern over monetary and financial stability and monetary discipline, but also by the state’s reinvigorated capacity in steering industrial change. Since the mid-1980s, much like other East Asian NICs, Taiwan has faced a new set of challenges that threatened its established mode of economic accumulation and pattern of state intervention. The phenomenal currency appreciation of the late 1980s (jumping 48 per cent between September 1985 and January 1989 in the case of NT dollars) wiped out the cost advantage of the Taiwanese producers in many labour-intensive manufacturing sectors, intensified the market pressure for industrial upgrading, and precipitated a wave of capital outflow, seeking out low-wage sites for transplant production and offshore sourcing. Also, under the mounting US pressure for correcting the trade imbalance and removing tariff and non-tariff barriers as well as unfair trade practices, the planning technocrats were forced to give up many of the existing instruments for industrial steering, such as protectionist measures, market order regulation, and export subsidies.13 At the same time, a wide range of industrial branches has overhauled their production process, with an emphasis on flexible manufacturing and custommade products and services and on higher-value-added, information-intensive market segments. The new economic trend operating at the global level began to diminish the competitive advantage of cheap labour and places the emphasis on skill and knowledge creation (Castells 1989). Acquisition of skills, productive assets, and comparative advantage in the production and utilization of three major technological families – microelectronics and computer software,

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advanced material components and biotechnologies – became critical for the entry of the East Asian NICs into the high-tech industries and for the adaptation of sophisticated manufacturing technologies. During the last phase of industrial upgrading in the 1970s, the planning technocrats relied heavily on the state-owned enterprises as a vehicle of import substitution industrialization for the development of the heavy industries (Chu 1989). The state-owned enterprises, however, were deemed intrinsically unable to cope with the dynamics and complexity of the technology-intensive industries. Thus, entering the 1980s, the economic officials felt compelled to help national private firms to vastly increase its indigenous research and development (R&D) and design capacity and absorb and socialize the risks associated with technological catching-up and industry creation. As the race for technological innovation was forced upon Taiwan, it became imperative that the state must reinvigorate its steering capacity. However, in Taiwan the process of state re-engineering did not take place in an institutional vacuum or ideological void. The planning technocrats relied on their experiences of past success for solutions and abided by certain long-standing policy objectives. Historically, the mainlander elite, the émigré group that fled to the island in 1949 after it was defeated in the civil war by the Chinese communists on the mainland, discouraged concentration of wealth for both political and ideological reasons. Overconcentration of industrial power and wealth in the hand of a few native Taiwanese was considered a potential political threat to the mainlander elite. By default, the KMT government converted all industrial assets under the Japanese colonial administration and Zaibatsu into stateowned enterprises. The monopoly or near-monopoly of the state-owned enterprises had pre-empted private participation in the financial sector, the public utility sector and most of the capital-intensive industries. Over the years, the state’s industrial policies were aimed at promoting export-oriented small and medium-sized enterprises (SMEs). The planning technocrats were restrained from an extensive use of discretionary credit policy, which tends to discriminate against the SME as the Korean experiences demonstrated. Instead, planning technocrats relied on blanket, non-discretionary incentives for promoting targeted industries. Thus, the possibility of developing Korean-style conglomerates had been precluded from the very beginning. During the 1960s and 1970s, a myriad of SMEs mushroomed under the statesponsored export-oriented industrialization strategy. A highly decentralized private sector generated a large number of owner-operators and enabled the KMT to broaden its social base as the emerging industrial structure addressed both the growth and equity issues with a high degree of effectiveness. By the late 1970s, Taiwan’s private sector evolved into a distinctive duality: the coexistence of oligopolized non-tradable sectors dominated by diversified business groups and fiercely competitive export-oriented sectors roamed by the SMEs. During the 1980s, the basic orientation of the official development strategy, which relied more on SMEs than big business as agent of industrial upgrading

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in the export-oriented sector, was largely kept in intact. The strategy was reinforced by both its past success and the accumulated experiences of the planning technocrats in addressing the functional deficiencies of the SMEs. However, since the mid-1980s, this strategy was confronted with a new challenge. The exodus of export-oriented manufacturing firms prompted the planning officials to devise and implement new strategies to prevent a ‘hollowing-out’ of local industry. The planning technocrats were wrestled with a daunting task of incubating a new generation of local firms that aspired to be dynamic instigators of industrial development in high-tech sectors and major suppliers to the transnational high-tech giants. As it turned out, this entailed more than just the provision of umbrella institutions within which the acquisition and diffusion of these heartland technologies and new work practices can take place by reforming the education, training, banking, capital market, legal system, and trade regime. It also required a major upgrading of the state’s analytical and planning capacity, an overhaul of the state’s economic apparatus for promoting high-tech industries, and a new approach to industrial steering that places emphases on close collaboration between state and industry in identifying and defining the trajectories of technological change, the research, development, dissemination and commercialization of new technologies, the diffusion and assimilation of new work practices, and managing the risk of integration into ever more complex transnational production networks. In a nutshell, Taiwan’s more decentralized industrial structure compelled the state to involve itself intimately with the creation of high-tech industries. The process of state re-engineering was not – indeed, and could not possibly be – planned in advance. It was necessarily a process of collective muddling through, carrying a strong element of learning-by-doing. In the retrospect, we can identify at least five functional areas where the state has significantly upgraded its transformative capacity during the 1980s and 1990s. The five areas are: internal policy planning and coordination, creating and maintaining an enabling environment, expanding and upgrading indigenous R&D capacity, accelerating the diffusion and assimilation of best-work practice, and serving as a catalyst of the internationalization of national firms. Internal planning and coordinating capacity As early as the mid-1970s, planning officials had felt the need to upgrade its internal planning capacity as the gravity of industrial upgrading gradually shifted from capital-intensive sectors, such as steel, petrochemicals, shipbuilding, automobile, and so on, to technology-intensive sectors. The existing state economic agencies were simply not equipped with the analytical capacity to identity the most appropriate points and level of entry for Taiwan and project the complex trajectory of technological evolution. The government decided to tap into outside experts and talents. First, the government undertook vigorously measures to mobilize the vast overseas Chinese science and

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engineering community. The government sponsored the creation of the North American Chinese Engineering Association, which brings together Chinese American working at national labs, the National Aeronautics and Space Administration (NASA), top universities and leading industrial R&D centres such as Bell Labs, Dupont and International Business Machines Corporation (IBM) for annual meetings and special workshops. The Association became the regular meeting point for Taiwan’s senior economic officials and top overseas Chinese scientists and engineers. Active members of the Association were also invited by turn to make field trips to Taiwan through the programme of National Development Conference, a forum for the government officials to solicit policy recommendations from the overseas Chinese scientific and professional communities. Through the network of the Association, the government was able to appoint a few prominent retired senior executives and scientists, both American and Chinese, from Texas Instruments, Bell Labs, IBM and leading universities to the newly created Science and Technology Advisory Group (STAG) directly under the premier.14 The STAG was entrusted with the responsibility to advise the government’s science and technology policy and formulate long-term development plans for upgrading the island’s indigenous research in general, and industrial R&D in particular. Around the early 1980s, the government introduced the STAG module throughout the economic bureaucracy. All development-related ministries were required to set up similar advisory units. During the 1990s, many of them were upgraded into a department, such as the Department of Industrial Technology Development under the MOEA. During the 1980s, the MOEA sponsored the launch of two semi-public economic think-tanks, the Taiwan Institute of Economic Research and the Chung-hwa Institute of Economic Research, to serve as the research arms of the planning agencies. The former specializes in tracking sector-specific developments while the latter concentrates on international and cross-Strait economic relations. In addition, the Institute for Information Industry, established in 1979, also has served as a public-sector think-tank, specialized in policies on the construction of the island’s information infrastructure. In addition, at the formative stage of certain high-tech industries, the government was advised to hire foreign consultant firms to augment its internal analytical and planning capacity.15 In addition, the government has constantly updated the way it taps into the overseas Chinese science and engineering community in response to the changing industrial dynamics. Around the late 1980s, as many overseas Chinese engineers and scientists turned into high-tech entrepreneurs, the government sponsored the forming of Monte Jade Association, with chapters in all major high-tech hotbeds such as Silicon Valley, Boston and Austin. The association provides the consultative mechanism that plug the Chinese founders and senior management of US-based high-tech start-ups as well as venture capital into the orbit of Taiwan’s high-tech policy planning.

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During the 1990s, as many of the local high-tech industries have grown beyond the formative stage and the indigenous science and technology community had risen to the international level, the economic planning officials relied more on some sector-specific consultative bodies that were created throughout the industrial policy apparatus. These consultative bodies, which typically involves officials of related agencies, researchers at universities, national labs and semi-public research organizations, and representatives of industry associations and leading firms, have become the economic ministries’ most important source for sector-specific information and policy recommendation. Since the early 1980s, the government has introduced new and more flexible mechanisms to enhance intra-state policy coordination for promoting high-tech industries. Special policy coordinating units in the forms of steering committee or taskforce office were constantly created or reorganized at all three administrative levels – cabinet, ministry and sub-ministry. The government set up special policy coordination mechanisms, which operate outside the regular conduit of economic policy coordination such as the Council for Economic Planning and Development (CEPD), to signify its policy priorities, to incorporate additional ministries and agencies, such as Education Ministry and Defense Ministry, into the economic policy loop and to break down the bureaucratic hierarchy as well as the government–business divide. At the cabinet level, it started out with the appointment of K.T. Lee, as a senior minister without portfolio, to chair the STAG in 1979 and later on to chair the Task Force for the Promotion of Information Industry in 1983.16 In recent years, the most important incidence was the instalment of the National Information Infrastructure (NII) Steering Committee in 1994. The Steering Committee was entrusted with coordinating all related ministries, councils, and commissions in the formulation and implementation of the NII Development Plan. Under the Steering Committee, there is one Civil Advisory Board and seven subcommittees: namely, Resources Planning, Network Construction, Applied Technology and Promotion, Education and Basic Applications, Automation of Government Administration and Public Services, International Cooperation, and General Affairs, each responsible for policy coordination in a specific functional area. The NII Development Plan, which was approved by the Cabinet in 1997, set forth 30 medium-term projects that range from the promotion of universal use of the Internet, enhancement of Internet education, development of Chinese content to network construction and promoting business-to-business electronic commerce. All projects set up numerical targets for objective evaluation.17 A more commonly used, but less elaborate way to enhance policy coordination is the instalment of coordinating mechanisms at ministry and subministry levels. The most notable incidence is the creation of industry-specific development programme office under the Industrial Development Bureau (IDB) of the MOEA.18 At present, there are five such offices, namely

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Aerospace Industry, Information Industry, Biotech and Pharmaceutical, Precision Machinery Industry and Digital Video Industry. Each office is responsible for the implementation of sector-specific industrial development plans. Typically, each programme development office involve the leadership of a senior economic official at the vice-minister or director-general rank and the participation of senior officials of related ministries and agencies, leading scientists from universities, national science projects and related governmentfunded research organizations, senior programme officers of the Executive Yuan Development Fund and senior executive of the Bank of Communication, members of the STAG and CEPD, presidents of related industrial association, senior executives of related state-owned enterprises and leading private firms.19 Creating and maintaining an enabling environment Since the early 1980s, the government has upgraded its capacity to provide and maintain an enabling environment in which high-tech companies, especially indigenous high-tech start-ups, can flourish. First, the government has vastly expanded its investment in the education. Most notably is the expansion of higher education enrolment in the engineering, medical and management fields. The public expenditure on education has increased from 3.69 per cent of the gross domestic product (GDP) in 1980 to 5.67 per cent in 1995 (compared to 5.3 per cent for the United States in the same year). College and university enrolment has increased 83 per cent between 1985 and 1995, reaching 31 per cent of relevant age groups, a level not much different from most Organization for Economic Co-operation and Development (OECD) countries. In the second half of the 1990s, most of the two-year colleges were upgraded into four-year universities or technology institutes. In addition, the National Science Council made substantial investments to advance the basic research. New research centres were created in collaboration with national universities or Academia Sinica. Seven large-scaled science projects were launched since 1986, including the National Space Project, the National Nano Device Laboratory involving R&D of semiconductor devices and materials,20 National Synchrotron Radiation Research Centre dealing with R&D in high-energy physics, and National Super Computer Centre. Starting in 1979, the National Science Council (NSC) was entrusted with the development and management of the Hsin-Chu Science-Based Industrial Park and other science park projects. Investors and especially high-tech startups were invited to the park with the attraction of easy access to the R&D facilities of publicly-funded research organizations and national laboratories, the brainpower of major universities, and the finance of state-owned development bank and semi-public venture capital. High-tech firms located in the park also received a range of assistance, including tax holidays, the duty-free import of key equipment and semi-finished goods, R&D matching fund and exemption of commodity taxes on exports. In essence, the government tried to create a business environment that mimics Silicon Valley

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(Schive and Simon 1986). In particular, the NSC actively sought after senior Chinese American engineers or managers who had worked for US high-tech firms and desired to become high-tech entrepreneurs themselves. The government even set up special bilingual schools and housing programmes to facilitate the transition of the returnee families. During the 1990s, the Park has witnessed a reversal of the brain drain. Large number of Chinese graduates of top US engineering schools returned home and capitalized on the opportunity. By the end of 1999, the Park hosts a total of 292 high-tech firms generating gross annual revenue of NT$651 billion. In particular, the Park accounts for the bulk of Taiwan’s semiconductor industry. All 20 but one Integrated Circuit (IC) fabrication companies are located in the Park, which also hosts 19 out of Taiwan’s 36 IC packaging companies and 45 out of the total 76 IC design shops. In 1996, the NSC broke ground for the construction a second park, Tainan Science-Based Industrial Park, as the Hsin-chu Park has reached the point of saturation. By 1998, the Tainan Park has already attracted 47 projects (including 19 start-up companies) with a total committed capital of NT$1.74 trillion (US$58 billion). The promotion of high-tech industry was buttressed by new financial vehicles – the Executive Yuan Development Fund, a revolving investment fund established in 1982 with an initial capital of NT$12 billion, and a rechartered industrial development bank, the Bank of Communication, for financing state-sponsored new investment projects in the strategic sectors. The Fund and the Bank provided the financial backing for all major commercialization projects undertaken by public-funded research organizations and their subsidiaries. An unexpected new partner in the promotion of hightech industry is the Kuomintang Central Finance Committee (CFC). The CFC participated in almost every major state-sponsored joint-venture in the high-tech sectors via its six holding companies. Initially, the governmentowned investment funds served the role of venture-capital fund and filled the void created by the unwillingness of the island’s conservative banks to invest in risky start-ups. They sold off their shares in the high-tech start-ups as soon as they began their initial public offerings and then reinvested the profit in new joint ventures. Riding on their demonstrated success, private venture-capital funds mushroomed. By mid-1998, 108 venture-capital funds, with a total pool of NT$60 billion, were licensed, making Taiwan the only place in Asia that has successfully followed the US lead in pursuing venture capital. Also, since its take-off in 1994, Taiwan’s over-the-counter market has rapidly become an important source of financing for the high-tech industries. High-growth firms have raised US$26.6 billion between 1994 and 1997 through rights issues and initial public offering.21 Finally, the government continued to provide generous fiscal incentives for the strategic industries under the Statute for Upgrading Industries. In the Six-Year National Development Plan (1991–96), the government identified ‘Ten Emerging Industries’, namely telecommunications, information, consumer

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electronics, semiconductors, precision machinery and automation, aerospace, advanced materials, speciality chemicals and pharmaceuticals, medical and health care, and pollution control and treatment.22 Start-up companies in the ten industries qualified for either a 20 per cent tax credit against shareholders’ income tax or a five-year tax holiday and loans at preferential interest rates from financial institutions. All companies in the ten industries enjoyed a favourable schedule for equipment depreciation, tax credit for R&D spending, and matching funding from the government for approved R&D projects. Expanding and upgrading indigenous R&D capacity The government started expanding its capacity to address the deficiency of national firms in indigenous R&D as early as the mid-1970s. In 1973, the United Industries Institute was merged with the Mining Industry Institute and reorganized into a semi-official entity, the Industrial Technology Research Institute (ITRI) under the MOEA. Since then, the ITRI has evolved into a flagship publicly-funded research organization serving a wide spectrum of hightech industries as well as traditional industries (Liao 1994). Under its roof are seven divisions and centres, including Aerospace, Chemistry and Chemical Engineering, Computer and Communications, Electronics, Energy and Resources, Environmental Protection, Industrial Health and Safety, Machinery & Automation, Materials, Metrology & Instrumentation, Medical Devices and Instruments, Micro-Electro-Mechanical Systems, and Opto-Electronics. The ITRI was entrusted with the mission of carrying out medium- and long-term applied research to develop generic, forward-looking, advanced technology as well as short-term research in line with the needs of the private sector to improve processes and develop new products. The ITRI has also served as the breeding ground for experienced engineers. The ITRI was constantly raided by the private sector headhunters. Two other major missions of the ITRI are disseminating research results in the industrial sector in a timely, fair and open manner and undertaking trial mass production to ensure feasibility of new industrial technologies as well as planning strategic withdrawal after project completion. The ITRI also operate an incubator centre which is designed to help entrepreneurs start up their new technology-based businesses and to provide a favourable environment to smooth the way for the entrepreneurs to shape their technological ideas into new businesses. By 1998, the ITRI has grown into Taiwan’s largest R&D organization with 5,953 employees on its payroll and generated an annual revenue of NT$15.5 billion, more than half of which came from carrying out government-commissioned projects. Following the model of ITRI, a dozen of smaller publicly-funded research organizations were created under the MOEA over the last two decades. They include the Automotive and Testing Centre, the Metal Industries Development Centre, the Food Industry Research Institute, the Development Centre for Bio-technology, the China Textile Institute, the Development Centre Precision Machinery, the Ship-Design Centre, and so on. All of these perform functions

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similar to those carried out by the ITRI. Their most important task is to carry out government-commissioned R&D projects under the Program for the Development of Critical Components and Parts. In 1999, the MOEA alone channelled NT$13 billion into ITRI and other semi-public research organizations. Up until the late 1990s, all the most complex and expensive research projects, such as the Very-Large-Scale-Integration (VLSI) project of the late 1980s, the sub-micron microelectronics technology and high definition television of the early 1990s, the PowerPCs and the 1.5-litre car engine project of the mid1990s, and high-frequency telecommunication technology of the late 1990s, were carried out by state-sponsored R&D consortia, which were typically organized around public-funded research organizations. At the completion of these projects, the developed technologies were transferred to participating private firms or new semi-public joint ventures (with government’s initial equity participation) for commercialization. The second module was more commonly applied at the formative stage of a new industry. Notable examples included the creation of United Microelectronics (in 1979), Taiwan Semiconductor (in 1986), Taiwan Photomask (in 1987), Lifeguard Pharmaceutical (in 1988), and Taiwan Aerospace (in 1991). Before 1990, virtually all consortia were in fact forms of direct provision of technology services by public R&D institutes. Firms provided only funds to the projects, most of which were highly subsidized by the MOEA. After about 1990, the consortia was transformed from simultaneous subsidized technology transfer to genuine consortia with horizontal and vertical dependence among firms, and a significant degree of cooperation among competitors (Noble 1998). Since 1994, the Sun Yat-sen Institute for Scientific Research under the Ministry of National Defense was also partially incorporated into the industrial policy apparatus. On top of its mainstay activities in weapons development, the Sun Yat-sen Institute, which is comparable to ITRI in size, was required to undertake government-commissioned industrial R&D projects and engage itself in the commercialization of its research output through technologytransfer agreements with suitable private firms. The institute also converted its Aerospace Development Centre after the completion of the IndigenouslyDesigned Fighter Project into a spin-off state-owned firm, the Aerospace Industrial Development Corporation in 1995. With the government taking the lead, the gross expenditure on R&D in Taiwan has risen from 1.01 per cent of the GDP in 1986 to 1.92 per cent in 1997, a level comparable to the United Kingdom (1.94 per cent) but still far behind the United States (2.64 per cent). Nevertheless, over the last ten years, private sector’s expenditure on R&D began to pick up more rapidly than government’s expenditure, indicating the rapid expansion of private R&D capacity. In 1988, the government/private sector ratio of R&D expenditure is 56.5/43.5. In 1997, the ratio is virtually reversed, standing at 40.8/59.2 (Schive 1999). The figures suggest that entering the second half of the 1990s Taiwan’s high-tech industries have gradually moved out of the phase of

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borrowing, emulation and adaptation and into the phase of innovation. Many of the leading firms have moved up its position in the global production network from original equipment manufacture (OEM) to original design manufacture (ODM).23 The diffusion and assimilation of best-work practice Another important component of the industrial policy apparatus under the MOEA is a series of semi-public institutions destined to disseminate the latest managerial know-how, the best practice in the application of information technology, and information about cutting-edge industrial design throughout the private sector, in particular among the small and medium-sized enterprises. A notable example is the Institute for Information Industry (III). The III was founded as a non-profit organization with an aim to enhance national competitiveness, cultivate information technology-(IT) related specialists, promote IT applications, and improve industrial productivity and efficiency. In additional to its think tank function, over the years, the III has devoted its major effort to promote application of information technologies and develop advanced software technology. The III provided technical assistance to government agencies and private firms to find solutions to their office automation, database management, intranet construction, and electronic administration and commerce needs. The III was also the designated problem-shooter for tackling the island’s Y2K mess. In addition to the III, under the auspice of the MOEA, the China Productivity Centre (CPC) has emerged as the training centre for private sector to acquire factory automation and quality control know-hows. Corporate Synergy Development Centre (CSD) fostered the development of a system of management for linking upstream, midstream and downstream industries in all vertically integrated sectors, such as aerospace and automobile.24 For the purpose of marketing research, collecting and disseminating information on cutting-edge industrial design, and recruiting design talents for Taiwanese firms, the IDB has founded a series of Taipei Design Centres at strategic locations worldwide. The IDB opened the Taipei Design Centre in Dusseldorf in 1992 in collaboration with the China External Trade Development Council (CETRA). Between 1992 and 1994, three more Taipei Design Centres were opened – in Milan, Osaka and Paris. Serving as a catalyst of the internationalization of national firms Since the late 1980s, the government has reversed its policy towards both outflow investment and foreign direct investment. First, the government introduced new measures to facilitate business expansion abroad. Since April 1990, the Central Bank started lending US dollars to Taiwanese enterprises via the Bank of Communications, the Export–Import Bank, the International Commercial Bank of China, and the China Development Corporation to cover up to 80 per cent of the cost of individual investment projects abroad.

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Priority was given to establishing sales and marketing networks and the acquisition of technology. The government backed up some important merger plan to acquire US high-tech companies, such as the acquisition of Altos by Acer Computer, the acquisition of WYSE by a consortium organized by Taiwan Semiconductor, and the recent acquisition of New Nippon Steel’s semiconductor division by United Microelectronics. The government also encouraged national firms to finance overseas investment projects through the issuance of corporate bills and convertible bonds in the international financial market. For business expansion in the ASEAN countries, private investment was supplemented by official development assistance. Taiwan began to launch its foreign aid programmes since late 1980s. The government earmarked US$1.25 billion in April 1988 for the endowment of a new Economic Cooperation and Development Fund. Following the past practice of Japan, the management of the fund in the Asia-Pacific region was closely tied to the expansion of trade and investment. The allocation of the funds concentrates on infrastructure projects in areas where the investment activities of national firms cluster, such as Indonesia, the Philippines and Viet Nam. The government also vigorously pushed for a ‘Southward Policy’ to channel the outflow investment into the ASEAN, instead of mainland China.25 At the same time, Taiwan has adopted a range of measures to channel foreign investment into strategic sectors and to enhance the capability of local firms in these sectors to develop strategic alliances with transnational firms. Specifically, the state used the leverage of big-ticket purchase to enable local firms to enter technical cooperation or joint venture with transnational corporations. A notable example is the creation of the aerospace industry. Taiwan’s aerospace industry took off from the development and production of the indigenously-designed fighter (IDF) with technical assistance from Northrop Corporation. The project involved the production of 250 fighters over ten years. Many local firms were signed up to supply parts and components, which laid the foundation of an indigenous aerospace industry. In 1991, a new semi-public joint venture, Taiwan Aerospace, was established by the former director of the IDF project with the participation of state development funds and five leading business groups. With assistance from the government, Taiwan Aerospace successfully piggybacked a technology-transfer agreement to a business deal between Boeing and a newly-licensed airline, Eva Airline, over the purchase of 22 jumbo jets. In 1996, the government also leveraged its purchase of 60 F16 fighters, persuading General Dynamics to sign a local sourcing agreement, in which General Dynamics pledged to subcontract some parts and components manufacture to Taiwanese firms. Since 1993, the practice has been institutionalized into the Industrial Cooperation Program. The Steering Committee of the Industrial Cooperation Program under the MOEA screens all big-ticket public-sector procurement plans, such as electric power, waste incinerators, weapons, airplanes, and identifies opportunities for relevant domestic industries to acquire advanced technology or

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enter technical cooperation. Then the MOEA worked with the relevant government agencies to attach the items targeted for the industrial cooperation programmes to the procurement package. Since the establishment of the Industrial Cooperation Program, by mid-1998 the MOEA has obtained the commitment of industrial cooperation credits totalling US$4.5 billion. Of this amount, US$2.7 billion has been applied to activities such as local procurement, technology transfer and training, assistance in international marketing, R&D, local investment, evaluation and certification.26

Industrial governance in the high-tech sector Taiwan’s high-tech sector has expanded rapidly since the mid-1980s, with the information industry taking the lead. By the mid-1990s, the high-tech industries emerged as the new backbone of Taiwan’s export sector.27 Since 1995, Taiwan has surpassed Germany and become the world’s third largest exporter of ‘information products’ (semiconductor, computer, telecommunications equipment, computer software, and so on) after the United States and Japan. The expansion of the high-tech sector came with a more robust structure of industrial governance, which greatly facilitate sector-based cooperation and state–business coordination. Historically, with a less centralized business structure, the island’s structure of business ownership has been less ‘cumulative’ or ‘integrated’ than that of South Korea or Japan. In Taiwan, different generations and groups of entrepreneurs dominated in different sectors and at different phases of industrialization. The pace of economic restructuring of the 1990s was unprecedented even by Taiwan’s own historical benchmark. Unlike South Korea, where Chaebol remained the dominant player in both the trend of overseas business expansion and the rush to go high-tech. In Taiwan, it was the export-oriented SMEs that took the lead in building up new transnational production networks throughout the region and the start-ups that laid the foundation for the island’s hightech sector. The established diversified business groups have been laggard on both scores. Instead, aiming for the rising consumption power of the domestic market, most of them expanded more vigorously into the service sector. During the 1990s, an array of sunrise sector companies has grown around the strategic nodes of public universities, public R&D organizations and state-run science parks. By the end of the 1990s, some of the fastest-growing high-tech firms have rivalled or even surpassed the established diversified business groups. In 1989, among Taiwan’s top 25 manufacturing firms (see Table 4.1), there was not a single national high-tech company.28 By 1999, ten national high-tech companies had joined the rank of the top 25 and eight of them were less than 15 years old. In addition, subsidiaries of foreign high-tech firms have lost ground to national firms because only the latter was allowed to be listed on the Taiwan Stock Exchange, a critical financial leverage for raising low-cost capital as well as recruiting and retaining the best brains.

110 Bureaucracy and Industrial Policy Table 4.1

Taiwan’s top 25 manufacturing firms, 1998 and 1988 1998

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Chinese Petroleum Taiwan Tobacco & Wine China Steel Corporation Acer Inc. Nan Ya Plastics Philips Electronic Building Element Yulon Motor Co. China Motor Co. Quanta Computer Inc. Taiwan Semiconductor Philips Electronics Industries Inventec Corporation Tatung Co. Formosa Chemicals & Fibre Hon Hai Precision Industry Compal Electronics Inc. Mitac International Kuozui Motors Ltd. Formosa Plastics Corporation Motorola Electronics Taiwan Asustek Computer Inc. Texas Instruments Taiwan Acer Peripherals Inc. Arima Computer Corporation Sanyang Industry Co.

1988 S S S H D F

Chinese Petroleum Taiwan Tobacco & Wine Nan Ya Plastics China Steel Corporation Formosa Plastics Corporation Tatung Co.

S S D S D D

D D HS H F HS D D HS HS H F D F HS F HS HS D

Ford Lio Ho Motor RSEA Engineering Formosa Chemicals & Fibre Sanyang Industry Co. Far Eastern Textile Taiwan Sugar Chi Mei Co. Yulon Motor Co. Matsushita Electric Philips Electronics Industries President Enterprises Tang Eng Iron Works China Petrochemical Sampo Co. Chung Shing Textile Taiwan Cement Hualon Corporation Teco Electric Philips Electronic Building Element

F S D D D S D D F F D S S D D D D D F

Notes: S: state-owned enterprises; D: diversified business groups; H: high-tech; HS: high-tech start-ups; F: foreign-owned companies. Source: Commonwealth Magazine Inc.

The emerging business structure in the high-tech sector was very conducive to a growth of a robust structure of industrial governance. Unlike the traditional Chinese-style family-owned firms, most high-tech start-ups have established the division between ownership and management from the very beginning because most of them were created or run by returned Silicon Valley professionals. Also in the high-tech sector a more transparent and accountable corporate governance structure is not just a virtue but a necessity for business success. As the high-tech firms rely heavily on venture capital funds and initial public offering as principal source of corporate financing, they must adopt the best-practice accounting rules to convince institutional investors, including foreign institutional investors. Also, companies that do away with nepotism and establish a transparent corporate governance structure

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are more attractive to quality professional employees, the most valuable asset to a high-tech company. Lastly, unlike the established diversified business groups, high-tech firms tend to have a much sharper business focus because their mainline business promises ample room for fast expansion. Out of this business structure, most high-tech firms have acquired a rather different orientation from the established diversified business groups when it comes to sector-based collective action and state–business relations. In the past, family-owned diversified business groups are more interested in developing personal ties with the high-ranking state officials or cultivating political affiliation with the KMT’s central leadership than building up the institutional infrastructure and social capital necessary for sector-based cooperation and coordination. The former is more valuable because sector-based collective actions might benefit both their subsidiaries and their rivals in the same industry, while investing in particularistic ties generated proprietary return exclusive for the sibling firms in the family-owned business group across many sectors. Under a protracted one-party dominance, securing particularistic ties was always considered a long-term investment because both the owner/operator of the business group and the incumbent elite were expected to stay on for a long time. Thus, leading firms in the non-tradable sector typically confined the scope of sector-based collective action to striking out collusive pricing strategy to maximize the oligopoly premium and/or protecting the industry from foreign competition, generating little collective gains in technological innovation or international competitiveness for the sector as a whole. Business elite competed for leadership position in the statesanctioned industrial associations and peak organizations for direct access to the KMT’s central leadership. High-tech firms, on the other hand, are much more inclined to build up the necessary institutional infrastructure and social capital for sector-based cooperation and coordination. Most high-tech firms concentrate on their mainline business and therefore have a higher stake in the sector-based collective actions. Furthermore, most Taiwanese high-tech firms face very similar market pressures for technological catching-up and upward mobility in the transnational production networks and are equally constrained by their limited business scale and inability to reap the full benefit from R&D investment. In addition, most of them, in the absence of the strong financial backing of a giant parent company, could not shoulder the huge financial risk of product development and market entry on their own. For them, the incentives for forming sector-based collective actions of a progressive kind, such as forming R&D consortia, joint development of key components and parts, or generating sector-based collective goods (namely information sharing, standardization, training, testing and certification, joint-marketing, and so on), are much stronger. At the same time, the professional management of the high-tech firms does not value the investment in particularistic political ties as much as the owners of the established diversified groups because there is little

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proprietary return. More importantly, their business grew up in a very different political environment, in which the KMT’s coveted political dominance was increasingly challenged by a growing opposition and the owners of the established diversified groups have already locked up all the strategic positions in the existing state-prescribed and KMT-directed corporatist arrangements.29 As a result, most of the industrial associations in the high-tech sector have been able to operate on the basis of self-governance with a minimal degree of KMT control and manipulation and the leadership role usually rotates among leading firms, rather than being the captive of one business group. Because of the intimate involvement of the state in their creation, many high-tech industries were endowed with a dense policy network. The policy network lined up industrial planning agencies, state-owned industrial banks and investment funds, private venture capital, high-tech start-ups, public research organizations, university research centres, foreign consultants, the Chinese-American science and engineering community, and Chinese-American entrepreneurs in Silicon Valley and other high-tech hotbeds. The policy networks later on were institutionalized in the form of an array of tripartite consultative mechanisms involving the scientific community, business and the government. These institutionalized mechanisms for consultation and coordination not only facilitate sector-based collection actions among independent firms, but also smooth the transition in the role of the state from an incubator to a coordinator once a cluster of high-tech industries was successfully created. Once a new industry is firmly established, the economic justification for discretional allocation of fiscal incentive, state’s equity participation, and direct public support in R&D diminishes over time. But the need for the state to engage the private sector in a national effort of identifying trajectories of technological diffusion and innovation, points of entry, and priorities for state actions and to serve as a locus of coordinating joint R&D activities and collaborative business strategies remains strong. Since the mid-1980s, a new array of tripartite consultative mechanisms has come into being. The tripartite consultative mechanisms operate at four levels: At the first level, the consultative mechanisms generate consensus on a long-term vision for Taiwan’s ascending role in the global economic system, on the trajectory of technological innovation and its socioeconomic implications, socioeconomically desirable industrial profile and on the role of the government in the provision of overarching institutional framework and socioeconomic infrastructure. At the next level, the consultative mechanisms help to identify the emerging strategic industries over the medium term and the blanket measures to promote the growth of these sectors. At the third level, the consultative mechanisms help to formulate a medium-term development plan for a given industry and the government’s action plan. At the final and operational level, the consultative mechanisms help to evaluate individual product-specific or firm-specific project within the guideline of industry-specific development plan.

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There are three important consultative mechanisms operating at the first level: the annual STAG meeting, the National Science and Technology Conference (NSTC) under the auspice of the Executive Yuan, and the Civil Advisory Committee under the NII Steering Committee. The Executive Yuan regularly hold the annual STAG meeting since its founding in 1979 to review the implementation of science and technology policies and national science projects. The Executive Yuan also organized the NSTC every five or six years since 1978. The NSTC, which always is proceeded with numerous preparatory meetings, which provide the most important forum for business leaders, leading scientists and top government officials to generate consensus on national science and technology development plan and vision for a technology-based economy. The direct output of the last NSTC, held in 1996, was the Republic of China (ROC) Science and Technology White Paper, published by the National Science Council in 1997.30 The drafting process of the White Paper typified the tripartite consultation process. At the next level, the most important mechanism is the Industrial Development Consultation Committee (IDCC) under the auspice of the MOEA. The IDCC and its subcommittees have been directly involved in the bi-annual review of the list of industry qualified for the fiscal incentives under the Statute for Upgrading Industries and, more significantly, in the bi-annual review of the scope for the each of the ‘Ten Emerging Industries’. The purpose of the bi-annual review is to constantly push forward the national technological frontier. For instance, during the latest bi-annual review, the IDCC proposed to eliminate lower value-added and/or technologically mature products, such as keyboard, mouse, desktop computer and printed circuit, and replace them with higher value-added and leading-edge products such as Internet computer, digital camera and camcorder, and high-capacity harddisk drive. Once a product is declared a graduate, its producers are no longer qualified for R&D subsidies, tax credit for R&D expenditure, equity-investment from the government’s investment funds or development banks, long-term finance with favourable interest rate from state-owned banks, priority in leasing or purchasing industrial land from the government, priority in applying for tenancy in the science-based parks, and so on. The IDCC also help the MOEA from time to time identify a few select strategic industries which promise to bring about economy-wide spill-over effects and require a comprehensive approach and focused promotion. At the third level, for each of the select industries the IDB works either with the relevant IDCC’s subcommittees or with the steering committee of a newly-installed development programme office to formulate medium-term development plans. Each plan typically identifies Taiwan’s entry barriers and the functional deficiency of existing domestic firms, stipulates the development targets, identify strategic points and levels of entry, and spell out appropriate measures to be undertaken by relevant government agencies and semi-public institutions. Each programme development office typically

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coordinates policies in the following functional areas – provision of industrial land, provision of tax incentives, equity investment in the start-up companies by the Executive Yuan Development Fund and the Bank of Communication (or its subsidiary venture capital companies), human resource planning, formation of R&D consortium among private firms and government-funded research organizations, subsidies to the development of key components and parts, promoting international cooperation, and promoting industrial alliance between final assemblers and upstream suppliers. Lastly, at the operational level, a variety of consultative mechanisms help the IDB and other point agencies to evaluate individual projects during the implementation phase of each industrial development plan. For instance, the IDB implements the Program for the Development of Critical Components and Parts through the Leading Products Screening Committee. For leading products within the scope of the ‘Ten Emerging Industries’, the IDB regularly revises its list of ‘Critical Components and Parts’. The items selected for development are considered to be high value-added, with good development potential and critical to the competitiveness of downstream products. A case in point is the liquid crystal display (LCD) monitor, which is a high value-added key component for notebook computer, palm digital assistant, wireless application protocol (WAP) mobile phone, and many kinds of video product and, typically, a product over which Japanese producers still enjoy world market dominance. For each item, the IDB customarily commissions appropriate research units within a public-funded research organization to undertake a product development project with either full public funding support or substantial private financial input through the formation of the R&D consortium among the prospective domestic producers. By mid-1999, the IDB has selected 66 items for development. It was estimated that the items developed will generate US$11 billion in production value; the extended effect may reach a value of US$50 billion. With these elaborate multi-level consultative mechanisms in place, Taiwan’s economic bureaucracy has acquired the kind of strategic capacity unmatched by any other East Asian countries, South Korea and Japan inclusive. Many East Asian countries have established seemingly identical tripartite consultative mechanisms but few are as comprehensive and action-oriented as the Taiwanese model. Taiwan’s economic bureaucracy is not only exceptionally resourceful; it is also unusually versatile in mobilizing resources and soliciting policy inputs outsides the state apparatus and beyond Taiwan’s border. The various forms of direct assistance that the state has extended to the hightech sector should be best conceived as ‘developmentalist rents’. What makes it possible for Taiwan’s elaborate high-tech policy networks to be relatively free of rentier abuse and for the various review bodies within the state economic bureaucracy to dispense these gingerly and productively? Four elements are of particular relevance here. First, the strong presence of senior advisors representing the local and/or overseas Chinese science and engineering

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community and serving as independent jury of expert in the tripartite consultative mechanisms. Secondly, the prevailing business structure in the high-tech sectors enhances sector-level collective action while inhibiting the growth of political cronyism. Thirdly, a robust industrial association operating on the principle of self-governance and accountability enables a targeted industry to generate coherent, consistent and balanced policy recommendations to the state. Finally, the existence of dense policy networks lining up all the relevant parties facilitates the construction of consensus on a socioeconomically desirable industrial profile and a common vision for the island’s transition to a knowledge-based economy.

Conclusion Taiwan’s experience in coping with the challenge of financial liberalization is of significance for other East Asian countries not only because the island economy has emerged from the regional financial crisis relatively unscathed but also because its unorthodox approach poses a creditable challenge to the neoliberal call for ‘one-size-fits-all’ institutional reform which has perilously led policy makers in the crisis-affected East Asian countries to see their future options in terms of either maintaining the discredited status quo or embracing neoliberalism in its entirety. The evolution of Taiwan’s financial regulatory regime of the 1980s and 1990s did not take place in an institutional vacuum or ideological void, and, therefore, it may not be readily transferable to other developing countries. Nevertheless, Taiwan’s experiences did offer two valuable lessons for the rest of the region: First, a country should choose its pace of financial opening in accordance with its tolerance for short-term fluctuation and in tandem with the strengthening of its regulatory and monitoring capacity. Second, developing countries should give priority to developing the domestic capital market, including developing a robust stock market as alternative funding source, over its internationalization. Taiwan’s experience in coping with the challenge of globalization shows that some aspects of globalization, in particular the integration of world financial markets, concurrent movements in trade liberalization, the intensity, velocity and speed of cross-border business transactions and the diffusion of economic neoliberalism, tend to constraint the state’s capacity in managing national economy and steering industrial change (Boyer and Drache 1996). It becomes more difficult for the state to help the private sector absorb and socialize risk through traditional policy tools such as tariff, import controls and export subsidies. It also becomes more difficult for the state to monitor the performance of the targeted firms as the cleavage between domestic and international financial sectors break down and national firms expand their business organizations abroad. However, globalization and state strength may not be antagonistic. Other aspects of globalization, in particular, the

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trend of regional economic grouping, the expansion of transnational production networks and unprecedented time compression in technological transformation, tend to accentuate the importance of the state. The state is called upon to provide new umbrella institutions within which the acquisition and diffusion of new technologies can take place. The state must also increasingly act as catalyst for the ‘internationalization’ of national firms. Thus, depending on the varying national orientations and capabilities, globalization may prompt the state to reinvigorate its transformative capacity and defines new tasks for state–business collaboration in ensuring more equitable participation in the global economy.

Notes 1 For an extensive treatment of Taiwan’s economic resilience, see Chi Schive (1998) and Yun-han Chu (1999b). 2 See Mai and Chang (1998: 7–10) for a detailed account. 3 The so-called ‘Washington Consensus’, dubbed by the Institute for International Economics in 1990, refers to the new prevailing ideology on the primacy of market-based policy reform as being promoted by the IMF and Reagan administration since the late 1980s. See John Williamson (1990) and Barbara Stalling (1995: 349–89). 4 See the chapter by Bai Gao in this volume and Pempel (1998) for an institutional analysis of Japan’s inability to adjust and the resultant economic crisis of the 1990s. Also, see the chapter by Meredith Cummings and Michael Loriaux in this volume on the structural sources for the rigidity in the Korean political economy. 5 Two former CBC governors, Yu Hong-jun and Yu Kuo-hua, later became premier. Also, two governors have served formerly as minister of finance, while quite a few ministers of finance were formerly vice-governors of CBC. 6 Before the political opening of the late 1980s, the average tenure of a premier was five years and eight months, while the average tenure of the governor was nine years and four months. See Chen (1998: 65–6). 7 Between 1949 and 1961, as a temporary measure, the Bank of Taiwan actually performed the function of the central bank. After 1961, the Central Bank of China was reinstated as the Nationalist government retreated from its goal of ‘recovering the mainland’. 8 Even after the privatization, the government will remain the largest shareholder. 9 During the 1980s, the non-performing loan ratio of the local financial institution was kept below 2.0 most of the time. However, it once reached an alarming 7.6 per cent level for credit cooperative associations in 1985 due to the bankruptcy of Taipei’s Tenth Credit Cooperative Association. Two finance ministers, former and incumbent, were forced to resign over the Tenth Credit incident. 10 The requirement was not lifted until late 1996 and has been one of the main reasons why foreign investors have chosen to stay out of Taiwan’s stock market. On the eve of the regional financial crisis, foreign investment totalled only US$11.1 billion, well below the legal limit (equivalent to US$91.4 billion or 30 per cent of the market’s total capitalization). 11 In comparison, as of mid-1996, the size of Taiwan’s stock market in terms of market value was twice as big as South Korea. The market value of Taiwan stood at

Yun-han Chu 117

12

13 14

15

16 17

18

19

20 21 22 23 24 25 26 27 28 29 30

US$274 billion (or 87 per cent of GDP) while the South Korea market stood at US$139 billion (or 40 per cent of GDP). It is worth noting, however, many business groups in Taiwan, the degree of leverage could be much higher than the apparent figure, because of the cross-holding of stocks and the mutual endorsement of checks (Chu and Lee 1998). For an analysis of the past practice of industrial steering, see Robert Wade (1990). The STAG was created in 1979. The founding members included Pat Haggerty, the former board chairman of Texas Instrument, Bob Evans the former vice president for development at IBM and Fred Seitz, a major figure in the US semi-conductor industry. See Meaney (1994). For instance, in the early stage of the development of the semiconductor and computer industries, the government commissioned Arthur D. Little and Data Quest to identify points and level of entry and set up priorities for focused state support. After the information industry grew beyond the take-off stage, the task force was downgraded, reorganized and transferred to the MOEA. For instance, the NII Steering Committee set up the goal of ‘having 3 million Internet users in three years (by September 1999)’ as the overall benchmark and the goals of ‘having all the middle schools and primary schools in Taiwan equipped with computer classrooms with access to Internet via ADSL technology by July 1999’ as the designated target for the Education Ministry and MOEA, respectively. Both stated targets were achieved before schedule. See En-Pu Hsu, ‘National Information Infrastructure Development in Taiwan,’ NII Steering Committee, Executive Yuan, at http://www.nii.gov.tw/niieng/y1999/nii0909.htm. The official English translation of these offices is very chaotic. Sometimes they are called programme development offices or task force offices and in other instance they are called committees. For instance, the Aerospace Industry Development Program Office is chaired by the head of IDB and composed of 27 members, including the Director of the National Space Project under the National Science Council, the head of Sun Yatsen Institute under the Ministry of Defense, and Director of Civil Aviation Bureau under the Ministry of Communication and Transportation a vice president of the Bank of Communication, the president of Taiwan Aerospace, the president of the Aerospace Industry Association, the Chairman of the Industrial Technology Research Institute, see http://www.casid.org.tw/english/ea/ea000-1.html. See http://www.ndl.gov.tw/English/ndl1.html. Far Eastern Economic Review Sept. 10, 1998: 62–3. The Ten Emerging Industries Program was an extension of the Strategic Industries Program launched in 1982. For an analysis of the upward mobility, see Chu Wan-wen (2000). The CSD is also known as Core-Satellite Development Centre. For an analysis of its function, see Chi Schive (1999). For an analysis of the strategic calculation behind the government’s ‘Southward Policy’, see Yun-han Chu (1997). Please refer to http://www.moeaidb.gov.tw/idb/indintro/etext/contente.htm. See Mai and Chang (1998: 7–10) for a detailed account. The only two companies of high-tech nature were both foreign subsidiaries. For an account of the historical development the corporatist arrangements, see Yun-han Chu (1994). National Science Council (1997).

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References Biersteker, Thomas (1995) ‘The “Triumph” of Liberal Economic Ideas in the Developing World’. In Barbara Stallings (ed.), Global Change, Regional Response (New York: Cambridge University Press). Boyer, Robert and Daniel Drache (eds) (1996) States Against Markets: The Limits of Globalization (London: Routledge). Castells, Manuel (1989) ‘High Technology and the Changing International Division of Production’. In Randall Purcell (ed.), The Newly Industrializing Countries in the World (Boulder, CO: Lynne Rienner). Chen, Shang-mao (1998) The Political Economy of Taiwan’s Banking Policy, MA Thesis (in Chinese) (Department of Political Science, National Cheng-chi University). Cheng, Tun-jen (1993) ‘Guarding the Commanding Heights: the State as Banker in Taiwan’. In Stephan Haggard and Chung Lee (eds), Politics of Finance in Pacific Rim Countries (Ithaca, NY: Cornell University Press). Chu, Wan-wen (2000) The OEM Model of Development: Can the East Asian NIC Catch Up, paper delivered at MIT/IPC seminar on Networked Production & Globalization, Academia Sinica, Taipei, 14 July. Chu, Yun-han (1999a) ‘The Institutional Foundation of Taiwan’s Industrialization: Exploring the State–Society Nexus’. In Cheng-sheng Hu and Yun-peng Chu (eds), The Economics and Political Economy of Development in Taiwan into the 21st Century (London: Edward Elgar Publishers). Chu, Yun-han (1999b) ‘Surviving the East Asian Financial Storm: The Political Foundation of Taiwan’s Economic Resilience’. In T.J. Pempel (ed.), The Politics of the Asian Economic Crisis (Ithaca, NY: Cornell University Press). Chu, Yun-han (1997) ‘The Political Economy of Taiwan’s Mainland Policy’, Journal of Contemporary China, 15 ( July), 229–57. Chu, Yun-han (1995) ‘The East Asian NICs: A State-led Path to the Developed World’. In Barbara Stallings (ed.), Global Change, Regional Response (New York: Cambridge University Press). Chu, Yun-han (1994) ‘The Realignment of Business–Government Relations and Regime Transition in Taiwan’. In Andrew MacIntyre (ed.), Business and Government in Industrializing Asia (Ithaca, NY: Cornell University Press). Chu, Yun-han (1989) ‘State Structures and Economic Adjustment in the East Asian Newly Industrializing Countries’, International Organization, 43 (August), 4. Chu, Yun-peng and Thomas Tunghao Lee (1998) ‘From Bubbles to New Rounds of Asian Monetary Cooperation – With Reference to the Taiwanese’. Paper delivered at a conference on contemporary Taiwan, co-sponsored by the Institute for National Policy Research and the French Centre for Contemporary China Studies, Taipei, December, pp. 16–17. Chung, Chun-wen (1998) ‘A Study of Direct Financing and Indirect Financing.’ In Po-chi Chen (ed.), Proceedings of A Seminar on Monetary and Banking Policy (in Chinese) (Department of Economics, National Taiwan University). Evans, Peter B. (1995) Embedded Autonomy: States and Industrial Transformation (Princeton, NJ: Princeton University Press). Liao, Kun-Jung (1994) High Technological Development and the State: The Case of Taiwan, PhD Dissertation (Department of Political Science, University of Kentucky). Meaney, Constance Squires (1994) ‘State Policy and the Development of Taiwan’s Semi-conductor Industry’. In Joel D. Aberbach, David Dollar and Kenneth L. Sokoloff (eds), The Role of the State in Taiwan’s Development (New York: M.E. Sharpe).

Yun-han Chu 119 Mai, Chao-cheng, and Pei-cheng Chang (1998) Asian Financial Storm: Taiwan’s Experience and Prospect, mimeo (Chung-hua Institute for Economic Research). Mo, Jongryn and Chung-in Moon (1998) ‘Democracy and the Origins of the 1997 Korean Economic Crisis’. In Chung-in Moon and Jongryn Mo (eds), Democracy and Korean Economy: Dynamic Relations (Stanford: Hoover Institution Press). National Science Council (1977) The ROC Science and Technology White Paper (Taipei: The National Science Council). Noble, Gregory (1998) Regimes and Industrial Policy: The Politics of Collective Action in Japan and Taiwan (Ithaca, NY: Cornell University Press). Pempel, T.J. (1998) Regime Shift: Comparative Dynamics of the Japanese Political Economy (Ithaca, NY: Cornell University Press, 1998). Schive, Chi (1999) A Study on Taiwan: High-tech Industries in the Spotlight, paper delivered at Geneva–Hong Kong Conference on Global Production: Specialization and Trade (Hong Kong, 25–7 October). Schive, Chi (1998) Taiwan’s Economic Role after the Financial Crisis, paper delivered at a Conference in Memory of Kuo-Shu Liang (Taipei: National Taiwan University, 14 September). Schive, Chi and Denis F. Simon (1986) ‘Taiwan’s Informatics Industry: The Role of the State in the Development of High-tech Industry’. In Francis W. Rushing and Carole Ganz Brown (eds), National Policies for Developing High Technology Industries – International Comparisons (Boulder, CO: Westview). Stallings, Barbara (ed.) (1995) Global Change, Regional Responses (Cambridge and New York: Cambridge University Press). Wade, Robert (1990) Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton, NJ: Princeton University Press). Wang Chien-chuan et al. (1998) The Role of SMEs in High-tech Industries (in Chinese) (Taipei: Chung-hua Institute for Economic Research). Weiss, Linda (1998) The Myth of the Powerless State (Ithaca, NY: Cornell University Press). Williamson, John (ed.) (1990) Latin American Adjustment: How Much Has Happened? (Washington: Institute for International Economics). Woo-Cumings, Meredith (1997) ‘Slouching Toward the Market: The Politics of Financial Liberalization in South Korea’. In Michael Loriaux et al., Capital Ungoverned: Liberalizing Finance in Interventionist States (Ithaca, NY: Cornell University Press). Woo, Jung-En (Meredith Woo-Cumings) (1991) Race to the Swift: State and Finance in Korean Industrilization (New York: Columbia University Press). Yen, Ching-Chang (1998) Taiwan’s Fiscal Policy: Its Role in the Asian Financial Turmoil, mimeo (Taipei: Ministry of Finance).

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Appendix

Executive Yuan

Executive Yuan Development Fund

Science and Technology Advisory Group (STAG)

National Science Council

Ministry of Economic Affairs

Ministry of Finance

Science Parks

Industrial Development Bureau and other agencies

Bank of Communication

National Science Laboratories

National Science Projects

Figure 4.1

Industrial Technology R&D Organizations

Council for Economic Development and Planning

Ministry of Communication and Transportation

National Information Infrastructure Steering Committee (NIISC)

Ministry of Defense

Chung-hwa Telephone and Telecommunication

Sun Yat-sen Institute for Scientific Research

Telecommunication Technology R&D Institutes

Aerospace Industrial Development Corporation

KMT-owned Investment Funds

Product Development Consortium

Taiwan’s policy apparatus for high-tech industries

Academia Sinica

Ministry of Economic Affairs

Industrial Development Consultation Committee Industrial Development Bureau

Department of Industrial Technology Development

Medium and Small-sized Business Administration

Industrial Parks

Corporate Synergy Development Center (CSD) The Planning and Reviewing Committee of Industrial Technology

Medium and Small-sized Business

China Productivity Center Quality Institute

Development Program Offices: Aerospace Industry Information Industry Biotech and Pharmaceutical Precision Machinery Industry Digital Video Industry

Industrial Technology Research Institute (ITRI): Divisions and Centers: Aerospace, Chemistry and Chemical Engineering, Computer and Communications, Electronics, Machinery & Automation, Metrology & Instrumentation, Micro-Electro-Mechanical Systems, Opto-Electronics, etc. Incubation Center

Leading Products Screening Committee Institute for Information Industry (III) Software Industrial Parks

State-subsidized Technology Research Projects

Public R&D Institutes and Labs: Automotive and Testing, Biotech, Ship-Design, Metalurgy, Textile, Shoe-Design, Food, Precision Machinery, Bicycle, Plastic, etc

Critical Components and Parts Development Program Taiwan Institute of Economic Research Steering Committee of the Industrial Cooperation Program

High-tech Product Development Consortium

The Taipei Design Centers: Paris, Milan, Osaka, Dusseldorf

Industrial policy apparatus under the ministry of economic affairs

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Figure 4.2

5 Developmentalism as Political Culture and Liberalization in France Michael Loriaux

France, once the European representative of state-led ‘developmentalism’, has shown such zeal in liberalizing its political economy that today it looks like the poster child of global capitalism. High public officials, sensitive to national economic interest, carried out sweeping liberalizing reforms and sit today, on leave from their public duties, on the governing boards of dynamic international firms whose capital is largely American. It is true that reform was linked to the construction of an integrated regional market, the EU. But the most significant liberalizing reforms preceded, and indeed enabled, the EU initiatives (notably the Single European Act1 and the single currency) that contributed most to the construction of that regional market. The temporal ordering of French reform and EU initiative suggests that globalization is not some occult force that compels nations to liberalize. Rather, it is the product of political initiative. The United States (USA) has been the source of much of that initiative, but France is responsible for no small part of it. But, despite France’s aggressive embrace of liberal reform, its political economy remains recognizably French. Even after reform and market integration, the French case lends support to scholars who claim that globalization has not brought about institutional and cultural convergence around the American model, but has proven to be compatible with a variety of forms of capitalist political economy. But France’s specificity is not found in the survival of those institutions, discussed below, that once enabled the state to deploy an ambitious industrial policy. Rather, it is found in a style of corporate governance that is more autocratic, autonomous, often financially aggressive, and relatively more interested in long term development than one customarily finds in the United States. That style, in turn, has its source in institutions whose origins go back generations, the purpose of which is to produce, train, and socialize a state elite. The institutions of industrial policy making have largely disappeared, but the institutions of elite formation endure. 122

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French developmentalism Prior to the reforms of 1983–85, France pursued a developmentalist industrial policy supported by subsidies, credit controls, indicative planning, and direct intervention in state-owned industries. The principal source of subsidies was the Fund for Economic and Social Development (Fonds de développement économique et social, or FDES), which was financed directly by the budget. The FDES was the workhorse of industrial policy under the Fourth Republic (1945–58). Its importance shrank under the weight of Charles de Gaulle’s (1958–69) fiscal conservatism, but the oil and monetary crises of the mid-1970s, and the subsequent need to reform finances and reorganize industry (discussed below), gave the Fund new life. In the mid-1970s, the Fund was still funnelling billions of francs to key industries, especially to automobiles and steel. The Fund for Economic and Social Development contributed to other subsidy programmes created in the wake of the oil crisis, such as the Interministerial Committee for Industrial Restructuring (CIRI), established in 1974 to help small and medium-sized firms in which jobs were at risk. It also contributed to the Interministerial Orientation Committee for the Development of Strategic Industries (CODIS), which subsidized investment in innovative technologies, and favours large firms. The Interministerial Committee for the Development of Investment and Defence of Employment (CIDISE) supported investment in medium-sized firms. The Institute for Industrial Development (IDI) was created to aid adaptation in declining industries. The Special Fund for Industrial Adaptation (FSAI), created in 1978, was designed to promote investment in regions of high unemployment. Most of its aid went to heavy industry: shipbuilding and automobiles. Finally, the National Agency for the Promotion of Research (ANVAR) directed its aid to small and medium-sized firms that invest in innovative products or techniques. Most of these subsidy programmes survived the liberalization of the mid1980s, though much diminished. Inversely, liberalization all but eliminated what had served as the principal tool of state intervention for almost three decades: state control over the allocation of credit by banks and other financial institutions. France had a dozen or more public and para-public financial institutions that were either state-owned or operating under a state charter. They included the Caisse des dépôts et consignations (CDC), which acted as the ‘bank’ for local administrations, the Crédit national, which specialized in industrial loans, and the Crédit foncier, which specialized in home mortgages. Law required that state and para-state financial institutions, including the post office (which, as in most European countries, manages checking accounts), deposit a part of their resources with the Treasury. The Treasury, in turn, kept an account of its own with the post office to pay government fees and salaries and to facilitate the collection of revenues. The banking system was partially integrated into this ‘Treasury circuit’ in fulfilment of the requirement that banks retain a certain fraction of their reserves

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in Treasury bonds. This criss-crossing of liabilities between the Treasury, the post office, the banks, and the public and semi-public financial institutions allowed Treasury officials in the 1950s to draw on multiple accounts to finance public spending without issuing bonds or relying on deficit spending, transforming short-term deposits into long-term loans and subsidies. The Treasury used money deposited in post office accounts in much the same way that a bank uses its reserve assets to create more money, that is, by inscribing transfers onto the post office accounts of households (the salaries of civil servants, for example) and firms (subsidies and grants). But because the money borrowed by the Treasury from one of these institutions to pay off the state’s creditors ultimately found its way back to the banks, the post office, or one of the financial institutions that composed the treasury circuit, a fraction of the money that was created made its way ipso facto back to the Treasury. Thus the Treasury had the unusual capacity to feed its ‘reserves’ with money of its own creation (see Loriaux 1991: 65–72, 150–3). Properly handled, the treasury circuit offered policy makers a tool that they could use to redistribute money while avoiding the dangers of inflationary financing as well as the political liability of increasing state revenues through higher taxes (Patat and Lutfalla 1986: 140–1). De Gaulle’s fiscal conservatism made it impossible for the Treasury in the 1960s to continue to serve as the French economy’s principal source of capital. But bank reforms in 1966–67 allowed the French to disengage the Treasury from industrial policy while keeping intact the interventionist logic of the Treasury Circuit (Patat and Lutfalla 1986: 163). The reforms moved the principal site of ‘transformation’ (of short-term capital into long-term loans) to the banks. They encouraged the banks to extend medium-term (5–7 year) loans to certain types of activity by extending the eligibility of such loans for rediscounting at the central bank. Simultaneously, the state discouraged the banks from making other types of loans by placing quantitative restrictions on the overall growth of credit. Those restrictions were referred to as encadrement du crédit. Encadrement du crédit supplied the state with a powerful interventionist tool. In effect, the state had only to exonerate a particular sector from encadrement to direct credit to it. The attractiveness of exonerated sectors to the banks was enhanced by making medium-term loans to such sectors eligible for discount at the central bank. Developmentalist finance, whether in the form of the Treasury circuit or encadrement, bears close comparison with South Korean ‘financial repression’, as analysed by Meredith Jung-En Woo (Woo 1991). France, unlike East Asian states that have been characterized as developmental, has used some form of ‘indicative’ planning since the Second World War (Hall 1986: ch. 6). The first three plans promoted overall expansion of the economy by funnelling investment to basic industries. This practice increased French demand for imported capital goods. The state assured France’s balance of payments by manipulating quotas and tariffs. When trade liberalization stripped away these safeguards, the French redirected the

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Plan to promote competitiveness in newly internationalized markets. The plan fostered contractual agreements with firms, according to which the state provided financial support in exchange for firm-specific strategies approved by the state. Such agreements produced a series of mergers in the 1960s and 1970s designed to develop ‘national champion’ firms. Businessmen never felt any real compunction to refer to the Plan except as a statement of the medium-term intentions of the state with regard to public procurement and subsidies (McArthur and Scott 1969; Caron 1979: 247–9). In the estimate of Pierre Rosanvallon (1990: 247–50), the ‘latent functions’ of the Plan – the promotion of alliances between industrial sectors and the state to reform industrial structures, and the promotion of a certain ‘apprenticeship’ in social change – were more important than the economic coordination it sought to foster. Planning proved ineffectual in achieving more abstract macroeconomic objectives, such as price stability, demand management, and employment. These were too sensitive to short-term pressures. In the 1970s, planning lost much of its attractiveness as France confronted problems that required more radical change in the thrust of fiscal and monetary policy. Industrial policy turned its back on the plan to focus on the more immediate problems of preserving employment and propping up firms threatened by bankruptcy (Berger 1981). The Socialists, in power from 1981 to 1986, resurrected planning after nationalizing many of France’s larger industrial and financial firms (see below). Priority programmes (programmes prioritaires d’exécution) committed the state to support projects on a multi-year basis. Planning contracts (contrats de plan), signed between the state and chosen industrial firms, provided financial support to pursue state goals while leaving firm management largely autonomous in determining how those goals might be achieved. But the Plan was more the emblem than the vehicle of industrial policy in France. Industrial policy was, in reality, more ad hoc and centred on the development of sectors that were, however arbitrarily, designated as being of national interest, such as steel and computer technology in the 1960s, nuclear power and telecommunications in the 1970s, and electronics in the 1980s. In the post-Organization of the Petroleum Exporting Countries (OPEC) period, in France as in the developmentalist political economies of East Asia, industrial policy was driven as much by the desire to avoid bankruptcy and unemployment as by the enlightened vision of economic development. Critics have shown that industrial policy was frequently ‘captured’ by the economic sectors it was designed to serve and develop, with the result that the state became the provider of sectoral rents rather than the instrument of national economic modernization (Feigenbaum, Hayward). Nevertheless, industrial policy did exist and function, and did provide the French state with outcomes that it desired. Between 1981 and 1986, the principal tool of developmentalism was not the Plan, but rather direct ‘stockholder’ intervention by the state. The Socialist– Communist alliance that acceded to power in 1981 nationalized 38 banks and six major industrial firms (including the chemicals firm Rhône-Poulenc,

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the glassmaker Saint-Gobain, the aluminium firm Péchiney, and the electronics firm Thomson). The state’s share in industrial production doubled from 15 to over 30 per cent, making socialism, to paraphrase Lenin, ‘the highest stage of Dirigisme’ (Levy 1996: 43). Because nationalization occurred at a time of low business profitability, the state used the leverage of ownership to restructure French industrial firms. Restructuring by the state was probably more effective, and, ironically, less coercive, than South Korea’s simultaneous effort to restructure and rationalize its chaebol. Low profitability had two sources, one in the structure of the French political economy, and the other in the international business conjuncture. The structural source was the high level of business indebtedness to banks. The similarity between French firms, indebted and unprofitable, and those of the East Asian developmentalist political economies is patent.2 The conjunctural source was provided by the two oil shocks that accompanied first the Iranian revolution then the Reagan dollar. The effects of low profitability were aggravated by the impact of the reflationary economic programme of the Socialist–Communist alliance and by a world recession. Inflation priced French goods out of range in a depressed international (especially European) market. State ownership made possible structural adjustments that the traditional tool of credit policy could no longer achieve because of high levels of business indebtedness. The state reduced debt and funded industrial restructuring programmes that lowered production and operating costs. Between 1981 and 1985, the state invested 5 billion francs in nationalized firms, a level of investment that Vivien Schmidt (1996) estimates at roughly 20 times the level of private investment between 1965 and 1980. Many of these programmes came at the expense of employment. Restructuring and rationalization eliminated about one-quarter of the workforce in automobiles and about half the workforce in steel. Socialist reforms also induced state firms to turn to subcontractors for components, thus cutting the cost of managing large inventories and of investing in the research and development of components (Hancke and Amable 2001: 11). Finally, French firms, both stateand privately owned, adopted a strategy of merger and acquisition in radical innovation markets, particularly through the acquisition of non-French – especially American – firms. The stock market value of American firms acquired by French companies between 1985 and 1995 was double the value acquired by their German counterparts. American subsidiaries became an important element in the strategic thinking of French firms. In sum, the French redesigned institutional support for state-led developmentalist policy several times. That support changed from one of budget-funded subsidies to credit controls to nationalization of the most important banks and industrial firms. One set of institutions that did not change in this period, however, was that of the Grands corps de l’État, the corporations of high civil servants.3 France’s administrative elite is powerful and pervasive – more so than its East

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Asian counterparts. It is recruited from France’s grandes écoles, specialized professional schools that function independently of the French university system. Highly selective competitive examinations guard access to the grandes écoles. The Grands corps co-opt the top students of the grandes écoles, especially the École nationale d’administration.4 Co-optation means a job with tenure and the possibility of extended leave from the administration without loss of tenure. The high-ranking civil servant is free to move about, from administration to politics to business, without professional risk. Thus one finds the administrative elite not only in the state, but also throughout the world of business and politics. They dominate ministerial cabinets and abound on the boards of large firms, both public and private, and in the inner circles of France’s principal political parties. The pervasiveness and power of France’s civil service elite creates a political economy in which the boundary between public and private is extraordinarily porous. If we look at the various manifestations of developmentalism in France – budget-based, bank-based, state-ownership-based – the common thread that ties them together is the presence of this state elite. Developmentalism in France is rooted not only in organizational structures, but also in the ubiquity of an elite that shares a common education, language, socialization, and self-confidence. French thinking about industrial strategy is informed by the cultural fact of this elite’s existence and its socialization into a system of values that encourages thinking in terms of France’s place in the world political economy (Loriaux 1999). The French state, embodied by the Grands corps, engaged, in the interwar period and particularly after the Second World War, in actions designed not only to nurture industrial growth, but to shelter society from the dislocations caused by industrialization.

Structural change in the international political economy and liberalization in france France has changed remarkably since the mid-1980s, ‘so remarkably’, Vivien Schmidt writes (2002: 183), ‘that one can ask whether the most idealtypically state capitalist of countries still conforms in any way to the model’. First, France assigned monetary policy instruments, especially interest rate policy, to the defence of the exchange rate of the French franc. Concern for the franc no longer took a back seat to concern for industrial development. Secondly, the state cut back significantly on direct and indirect subsidies to business. Thirdly, the state implemented reforms that strengthened French financial markets. Fourthly, institutional investors, especially American, began to invest heavily in French business. One also encounters change in the instruments of policy implementation, for example, in the laws regulating the banking industry, on which the state had relied to guide bank lending to priority borrowers. There was also significant change in the very institutional structure of the French political economy. For example, before

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the mid-1980s there was no money market in France in the usual sense of the term. But financial reforms made the money market the principal locus of central bank efforts to control interest rates, as in the United States and Great Britain. As for the central bank, it was until the 1990s the agent of the Treasury, which had actual ‘legislative power’ over monetary affairs. But the bank was made independent in 1994, given control over monetary policy, which it then surrendered to the European Central Bank in 2000. Because of the single currency, France no longer has its own monetary policy. Do such changes in the instruments of policy making mean that globalization has rendered developmentalism obsolete and ‘Americanized’ the institutions and conduct of capitalist political economies? Care must be taken in answering this question. First, it is not apparent that developmentalism failed. According to its critics, French-style state-led capitalism was unable to adjust to a new economic environment ‘in which Fordist mass production no longer offered a solution’. The new environment required greater flexibility in investment decisions than the statist economy could supply (Levy 1999: 55). But Ezra Suleiman and Guillaume Courty (1997) find both flexibility and dynamism in French developmentalist projects: ‘How does one reconcile the TGV [the very fast train], Airbus, Minitel [a French public precursor of the Internet], and nuclear energy with writings that bemoan the incapacities of the public sector?’ (Suleiman and Courty 1997: 32). The authors characterize the success of such ventures as ‘state magic’ (316). Secondly, as shown above, change in the instrumental mechanics of developmentalism is not new, and whatever instrumental change we observe must be weighed against the permanence of a developmentalist culture and the influence of that culture at centers of economic and political decision-making. Change in the hegemonically structured international political economy caused reform in France, as in other trade-dependent, developmental political economies. But it did not cause change in habits of thought about the role of the industrial firm in the development of the French political economy, nor in the institutions that engender and protect those habits of thought. To see the structural origins of French reform, one must go back to the post-Second World War origins of French developmentalism. In the 1950s American monetary and fiscal policy gave support to new, postwar international trade and monetary arrangements that sought to make Keynesian policy possible under free trade. But American policy began to turn more nationalist in the 1960s in response to international and domestic conflict. Nationalism in monetary affairs, especially the refusal to address inflation in the dollar, the key international currency, brought down the Bretton Woods system of fixed but adjustable exchange rates in 1973. The demise of fixed rates left the French political economy in a difficult situation. French developmentalism arose within the framework of a forgiving international monetary environment. The possibility of multilateral management of fixed (but

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adjustable) monetary parities internationalized the inflation that developmentalism tended to engender, in France as in other developmentalist economies. But the post-1973 system of floating rates made that kind of internationalization impossible. The cost of price inflation was borne entirely by the inflationary country’s balance of payments. For a trade-dependent country like France the cost was high.5 Floating rates gave rise to a threat of vicious circles of inflation and currency depreciation. Inflation depressed the market for French exports and thus the value of the franc on the currency exchange. But French demand for certain imports, notably petroleum and other raw materials purchased in dollars, proved insensitive to the franc’s depreciation. Rising import prices, occasioned by a rising dollar, percolated through the economy, aggravated inflation, and thus further sapped market confidence in the franc. To combat such vicious circles French authorities had, by 1974, assigned importance to stabilizing the currency. The French reinforced the commitment to currency strength in the mid-1980s following three devaluations of the franc (within the European Monetary System).6 The shift of emphasis in monetary policy brought reform to French finances. Under fixed rates, French statism had given rise to what French economists called an économie d’endettement or overdraft economy, according to which hikes in interest rates had little or no impact on business demand for credit. Businesses, operating under the policy-induced expectation of assured borrowing power, responded to increases in the cost of credit by simply asking for more credit (higher interest rates, for example, produced cash-flow problems that firms addressed by borrowing more). The expectation of assured borrowing power vitiated the government’s efforts to use interest rate policy to slow money supply growth and thus regulate the supply of money to currency markets. In the mid-1980s, under a Socialist government, France implemented deep-rooted liberalizing reforms in order, first, to wean business off state-controlled bank credit and direct it to the market for stocks and bonds and to international lenders, and, second, to make the French economy attractive to foreign capital so that foreign investment might compensate for the reduction in state-sponsored or supplied funds. ‘Reaganomics’ reinforced structural pressure on French policy. The combination of monetary rigour and deficit spending spurred the United States, a powerful economy with a sound financial reputation, to address a high level of demand for money to the world’s markets. That policy raised interest rates globally, as well as the exchange rate of the dollar (which was still the currency of choice in international transactions). In response, France (and other nations) multiplied liberalizing reforms to make its economy more appealing to – and better able to compete for – international capital. Accompanying such reforms were efforts to promote greater European market and monetary integration (Schmidt 2002: 81). Domestic reform thus went hand in hand with policies that contributed to the creation of a more open European and global marketplace.

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No ideological shift away from statism produced these reforms. It is true that support for liberal policy in France grew in the 1970s and 1980s, but the link between ideological debate and policy is tenuous and indirect at best. Socialists, after resorting heavily to statist interventionism in the form of nationalizations and planning agreements, soon abandoned interventionism and liberalized the economy. There had always been strong pro-liberalization voices in French debate. That such voices should prevail at this particular moment, rather than in, say, 1959, when Charles de Gaulle brought in the very orthodox Jacques Rueff to reform public finances, suggests that there was a ‘right time’ for liberalizers. Nor was ‘globalization’ the cause of French reform. Setting aside the fact that the term is ill defined, it suffices to observe that French reformism antedated, and indeed contributed to the emergence of an open, global financial market, which is the principal characteristic of the ‘globalized economy’. In the same vein, it is important to note that French reformism antedated and contributed to further monetary integration in Europe. The decision to move to a single currency was made in 1987 (Moravcsik).7

Liberalization within the cultural framework of developmentalism The history of developmentalist policy in France reveals frequent change in the policy instruments and even in the underlying institutional structures of the French political economy, such that one wants to identify the ‘location’ of French developmentalism, not in the instruments and institutions of financial and industrial policy, but rather in the ‘heads’ of Frenchmen who seem constantly to ‘fiddle’ with those institutions in order to adapt them to changing conditions. But there is one set of state institutions that is invariant. It is that of the Grands corps of the French civil service. The Grands corps are home to an elitist culture characterized by habits of thought, language games, and norms that inform, enable, and constrain the way the French think about industrial development, both inside and outside the formal institutions of the state. Under the pressure of structural imperatives, the French liberalized the tools and institutions of the political economy. But liberalization was informed by developmentalist culture. The minds that conceived the liberalizing reforms laboured within the discursive framework that was the legacy of France’s developmentalist past. Liberalization in France resulted from the encounter of structural constraint and cultural (not necessarily institutional) resistance. Structure pushed toward global convergence. Culture preserved a distinctly national style and outlook. The influence of developmentalist culture is apparent in the privatization of state-owned industrial firms in the late 1980s and 1990s. As noted above, the Socialists who assumed power in 1981 nationalized banks and large industrial firms, and used state ownership to effect structural reform. The

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legislative elections of 1986 returned the Right to power on a platform of privatization. The Right, however, no less than the Left, was concerned that low profitability exposed French firms to buyouts by foreign capital. Therefore the conservative government arranged privatization in such a way that the ‘nationality’ of French firms was preserved. They divided shares to be sold into five categories, each earmarked for a particular kind of buyer: employees of the firms undergoing privatization, the general public, French institutional investors, and, finally, foreign institutional investors. The fifth category of buyer was the most important. It was to form the ‘hard core’, or noyau dur, that enmeshed ownership of controlling stock in a net of crossshareholdings with other major French firms, both private and public. Two such networks emerged, each anchored by a major utility company, a holding company, a major bank, and a large insurance company.8 Within each network, firms retained direct and indirect controlling stakes in one another. Control of most publicly quoted firms was located within these hard cores (Schmidt 1996: ch. 4). The hard cores reflected the legacy of economic ‘patriotism’ (Hayward 1986) under conditions of liberalization. They constituted a kind of French chaebol or zaibatsu. They also came dangerously close to embodying a kind of French ‘booty capitalism’ like that which emerged in Asian developmentalist economies (Woo-Cumings 1999). Other aspects of privatization revealed an enduring developmental prejudice. Under rules set by the government, privatization gave chief executive officers (CEOs) the right to appoint most board members. Privatization concentrated power in top management, where the Grands corps elite remained ensconced (Schmidt 1996). The power of the French CEO was greater than found anywhere else in Europe. Cross ownership arrangements and CEO power sheltered decision makers from interference by labour, foreign capital, and even the state itself. Thus structured, large firms continued, after privatization, to pursue radical and generally successful internal reorganization strategies in a way that differed little from statist restructuring in the period 1981–87. Management enjoyed considerable freedom to lay off labour, to subcontract, and to enter into international corporate alliances. Autonomy from capital markets made long-term planning possible. The hard cores sheltered the firms from hostile takeovers and provided them with capital. Management was free to position firms in new market segments. Top managers and engineers controlled most decisions regarding product architecture, development, work organization, and parts specifications. The French experience departs from the Asian model to the extent that French firms organized their activities around core competences. They were particularly successful in the area of complex, high-tech engineering goods – such as nuclear power technology, telecommunications, complex armament systems, high speed trains and aerospace technology – and in the area of ‘flexible mass production’ (which combined relatively hierarchical shopfloor and supplier relations with modular product architecture).

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French firms in this latter category – particularly automobile, household appliance, and simple electronics firms – could compete successfully with German and Japanese rivals. It is helpful to contrast privatized firm strategy with that of Electricité de France (EDF), the state-owned power monopoly. EDF responded to pressures from Brussels to liberalize by digging in and defending its territorial monopoly. But in 1998 it adopted a strategy of internationalization and diversification designed to make it one of Europe’s – and the world’s – leading energy groups. It lobbied a very hesitant government to open up the French market to foreign producers. Under the direction of the Grands corps engineer, François Roussely, the company internationalized its board of directors. It set a goal of earning half of its income from activities other than electricity by 2005. It increased such earnings, having increased such earnings from 12 per cent in 1998 to 18 per cent in 1999. EDF’s strategy and performance is consistent with that of a publicly traded firm. Yet there is no plan to privatize EDF, nor is there even talk of such a plan, much to the consternation of EDF’s European competitors (The Economist 2000: 71). The survival of a certain developmentalist ethos in the absence of direct state intervention is visible in other areas of the French economy. The institutional insertion of Grands Corps engineers in the information technology (IT) sector, anchored in complicities between directors of firms and state officials, still reveals a prejudice for developmentalist missions. In IT, the old strategy of nurturing national champions saddled France with the computer firm Bull, a minor player inextricably entwined in the slow-growth sector of computer mainframes. But the developmentalist, mission-oriented prejudice nevertheless produced movement in French IT that has made it competitive in European markets. French firms established themselves successfully in IT system integration servicing and in the development of applications. That success owes much to prior missions that concentrated high-tech industries in regional ‘technopoles’ (Grenoble, Toulouse and Cannes) through the location of public sector research establishments (CNRS, INRIA, CEA, and CNET. That policy created a Silicon Valley-like environment that encouraged the development of innovative technologies. Certain firms benefited from their proximity to state-nurtured aerospace and nuclear industries to develop and market scientific software. The state also responded to perceived national vulnerability in IT by launching a programme to increase the supply of engineers by the engineering grandes écoles. France’s engineering schools increased the supply of newly minted computer scientists from 4,200 in 1982 to 20,100 in 1997 (in sharp contrast with the 6,600 IT graduates supplied to the German economy by its engineering schools). In genomics, initiatives by private foundations, the Centre d’études sur le polymorphisme humain, and the Association française contre les myopathies, attracted state attention. The state created the Bioavenir programme in 1992, which subsidized private research and offered incentives to public research

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centres to collaborate with the privatized pharmaceutical firm Rhône-Poulenc. In doing so, the state tried to compensate for the absence of a tradition of cooperation between public and private researchers. That absence has seriously hampered French efforts to promote technological innovation and explains French interest in acquiring US technology firms. In 1999, the Socialist government liberalized legislation in order to facilitate genomic start-ups. It also created the Évry Génopole, a mission-style, ‘national champion’ research and administration centre designed to coordinate research efforts at the national level. Critics complain that the Bioavenir programme, an integrated programme aimed at both fundamental research and industrial development, discourages the creation of smaller, more flexible and dynamic centres of gene therapy research in the teaching hospitals. But after a slow take-off, French genomics has become competitive in Europe. The sector in 2000 numbered 140 companies in France, compared with 220 in Germany and 280 in Great Britain. In sum, as Vivien Schmidt observes, with regard to innovation, France remains somewhere between Britain and Germany. Its most notable capacity for innovation has been in sectors that are still heavily state-dominated and based on networking capacities provided through the state and cross-shareholdings in sectors such as telecommunications, high-speed trains, and nuclear-powered electricity. But it also does well in some aspects of mechanical and electrical engineering and autovehicles – ahead of Britain although behind Germany – as a result of a financial system which continues to be largely ‘insider dominated’. (2002: 140)9 Developmentalist culture has informed a kind of adaptation to change in the international political economy that one observer has characterized as ‘globalization by stealth’ (Gordon and Meunier 2002: 13). Nevertheless, the change within just one generation has been dramatic. Trade (exports plus imports) as a share of gross domestic product (GDP) has risen from 25 per cent in 1962 to about 50 per cent in 2000 (a figure that equals Germany’s and surpasses the United States at 25 per cent and Japan at 21 per cent). Foreign trade went from protracted deficit to surplus by the end of the 1980s. French GDP growth has been higher than that of Germany and Italy since 1995, and about the same as that of the EU as a whole. Industrial growth equals that of Germany and exceeds that of Italy and Great Britain. Labour productivity growth in France exceeds that of Germany and the United States. Capital stock has grown more rapidly in France than in Great Britain and Germany. Profitability, a principal concern of the French since the mid-1980s, has doubled. Forbes mazagine’s 2002 ranking of the top 400 global firms placed France second – far behind the United States, but ahead of Japan, the United Kingdom, and Germany. ‘The notion of a dynamic France as an economic motor of Europe, pulling even Germany along, might have seemed absurd a decade ago, but it is no longer so far-fetched’ (Gordon and Meunier, 14).

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But success has come at a price. Unemployment grew inexorably from the mid-1970s until the mid-1990s, when it peaked at more than 12 per cent.10 In France, as in East Asia, many worker benefits, such as housing subsidies, are tied to employment. Nevertheless, most benefits in France are made available directly by the State so that unemployment does not have the same disruptive impact as in East Asia. Nevertheless, French welfare depends greatly on payroll taxes, thus making unemployment a significant strain on state finances. For this and other reasons, the state has surrounded employment with all sorts of regulatory safeguards, with the result that the burden of unemployment has fallen disproportionately on young people seeking their first job. Among young people, descendants of recent immigrants have found themselves most disadvantaged. This has given rise to a new and challenging source of social and political tension. The Socialist government of Lionel Jospin (1997–2002) intervened heavy-handedly in economic life to combat unemployment by imposing a 35-hour working week and creating a jobs programme for young people. Those policies, higher growth, and demographic trends brought unemployment below 9 per cent by 2002.

Developmental culture and disaggregation of the Noyaux Durs The noyau-dur cross-ownership structure of French capitalism attained to its ideal type in 1996 following the merger of two insurance giants, AXA and UAP. The resulting ownership structure of French firms was relatively concentrated. The average equity stake of the principal shareholder group varied between 18 and 43 per cent. Cross-shareholdings among Computer Applications Company (CAC) 40 corporations was widespread: 33 firms had significant cross-shareholdings with at least one other firm. The aggregate average value of these cross-shareholdings was 5.8 per cent, ‘a figure similar to the equity stake held by Japanese main banks’. This pattern of equity ownership ‘reproduced the relationships that had prevailed prior to the nationalisations’ of 1982 (Hancke and Amable 2001). By the year 2000, however, the ownership structure looked dramatically different. Firms, especially financial companies, sold their cross-shareholdings. ‘The fact that French financial companies came nowhere near the Germans in size, solidity, or experience, and that industrial enterprises gained the bulk of their capital from self-financing rather than from bank borrowing, meant that the French financial enterprises were to be at best junior partners of industrial enterprises’ (Schmidt 2002: 191). Axa, a rare French firm that owed none of its success to state support, showed no interest in playing the role the state wanted it to play, and sold off its hard core holdings. By 1998, the average equity stake of the core shareholder group in CAC 40 firms had fallen to 20.5 per cent (from an average of 28 per cent in 1995). For the following blue chip firms, that stake was: Accor, 14.5 per cent; Air Liquide, 7.8 per cent; Danone, 12.9 per cent; Elf, 8.2 per cent; Paribas, 12 per cent;

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Rhône-Poulenc, 6.5 per cent; Saint-Gobain, 16.9 per cent; and Vivendi, 14.4 per cent (Hancke and Amable 2001).11 The hard core now represents less than 30 per cent of the capital in half of France’s blue chip, CAC 40 enterprises, less than 20 per cent in 15 of the 40, and less than 10 per cent in 5 of the 40. The importance of foreign, especially American institutional investors has grown in an economy that is now more market-oriented than at any time since the Second World War. Market capitalization climbed from 5.6 per cent of GDP in 1982 to 111.5 per cent in 1999. The volume of transactions on French equity markets climbed from 1.8 per cent of GDP in 1982 to 54.6 per cent in 1999. Ten per cent of the French population owns shares, as opposed to 15 per cent of Britons and 22 per cent of Americans (Schmidt, 2002: 189). As the market has grown, France, among major industrial powers, has become the one that is most open to foreign capital. About 40 per cent of French shares are now held by foreigners. ‘France is far more “globalized” than the United States (where about 7 per cent of shares are held by foreigners), Japan (around 10 per cent), Germany (around 10 per cent), or even the United Kingdom (under 16 per cent)’ (Gordon and Meunier, 24). France ranked third as recipient of foreign investment in 2001, behind the United States and Great Britain. Foreign investments climbed to 4 per cent of GDP in 2002, from 3.3 per cent in 2000. In 2001, foreign direct investment climbed 26 per cent in France while falling by an average of 50 per cent in industrialized countries as a whole (Meunier 2003). Foreign firms, especially British and American, employ 15 per cent of the French labour force and produce 17 per cent of French GDP. Institutional investors, especially American, are the principal shareholders in the majority of large French firms. Their assets amounted to 83 per cent of French GDP in 1996, compared to Germany’s 50 per cent and the United States’ 181 per cent (OECD 1998). The institutional investor accounted for 10 per cent of CAC 40 capital in 1985, 35 per cent in 1999, and more than 50 per cent in 2002. As one would expect, the growing stake held by institutional investors has made hostile takeovers easier. Institutional investors sold 85 per cent of their shares when Société Générale launched its hostile bid to take over the Banque Nationale de Paris (BNP) (also a French bank), and 70 per cent of their shares in French oil producer ELF when it came under siege by Total, also a French oil producer. The number of mergers and acquisitions climbed from 284 in 1986 to 1,774 in 1990, and from a total value of $85 billion in 1991 to $558 billion in 1998. ‘French firms by the early 1990s came to rival the British and German in size, scope, and foreign direct investments. Although French firms could not outdo the Germans in shares in world exports, they remained ahead of the British. And many of the larger French firms became as export-oriented as German firms’ (Schmidt 2002: 189). Institutional investors brought about important changes in French corporate governance. Under their influence, CAC 40 firms increased the proportion

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of independent (or ‘outsider’) board of director members from 3 per cent in 1988 to 28 per cent in 1998 (Hancke and Amable 2001). Eighteen of the CAC 40 firms have established specialized committees to oversee auditing, remuneration, and nomination of new directors. German and Japanese firms have resisted the creation of such committees. Thirty-eight of the CAC 40 firms, unlike those of other European countries, have made use of stock options, especially for independent directors and board members sitting on specialized committees. The use of stock options is rare elsewhere in Europe. In Germany, one encounters their use in only four firms: Daimler-Chrysler, Deutsche Telekom, Hoechst, and Lufthansa (Hancke and Amable 2001). And yet it is not apparent that this evolution threatens the survival of developmentalist culture in French economic life. Corporate governance in France has not aligned on American norms. For the proponents of the ‘varieties of capitalism’ thesis, there is no strong reason to expect such convergence: ‘very different institutional arrangements can be imagined to solve the same economic challenge’ (Boyer, 58). The French system continues to endow its executives with considerable power and autonomy. ‘Autonomy . . . is one of the keys to understanding the continuing differences between evolving French capitalism and [British-American] market capitalism’ while ‘the interpersonal competitiveness of the elite, which also has its roots in the statebased elite educational system, provides for more individualism, inter-firm competition, and potential takeover fights than in managed capitalist Germany, where the emphasis on achieving consensus and cooperation has been much greater’ (Schmidt 2002: 195–6).12 The French system facilitates the accumulation of board positions, making the true ‘outsider’ a rare commodity in French capitalism. Such accumulation reflects the enduring omnipresence of the Grands corps elite in business. ‘The retreat of the state by way of privatization and cross-shareholdings led to the further colonization of business by state-trained, former civil servants in an extension of the old pattern of dominance of business by the interpenetrating political-financialindustrial elite’ (Schmidt 2002: 195). Liberalization has eased competition to enter ENA and directed many talented young Frenchmen to US-style MBA programmes, but liberalization cannot undo the fact that the elite is supremely well connected, and thus enduringly attractive to firms. The most prestigious American-style business schools cannot duplicate that advantage. The Grands Corps and grandes écoles conspire to produce a kind of ‘crony capitalism’ that works, even in the framework of a legal system that has become the purveyor of transnationally generated law. (It is estimated that about 80 per cent of French law today has been written in Brussels or Luxembourg, site of the European Court of Justice.) As for foreign investors, they remain underrepresented on the boards of French firms, despite the importance of foreign capital. Factors other than institutional share in promoting the survival of a style of governance that resists subjugation to ‘shareholder value’ à l’américaine as

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the chief moniker of success. The structural feature of state strength and bank weakness engendered a privatizing process that produced strong, competitive firms. In contrast to Great Britain, the French state, as shown above, used privatization to restructure industry and improve its position on international markets. Inversely, because French financial companies did not match German ones in size and experience, industrialists relied more on selffinancing than on bank borrowing, thus enhancing industrial autonomy. The unravelling of the cross-shareholdings of the noyaux durs actually enhanced that autonomy, with the result that the ‘French CEO . . . now has even more autonomy than before’ (Schmidt 2002: 197; and passim 190–8). That autonomy is further enhanced by the fact that shares held by institutional investors, though an important percentage of the total stock of individual firms, are nevertheless dispersed among many shareholders. The combined ownership of the top three foreign institutional investors surpasses 5 per cent in the case of only six CAC 40 firms. French capital, inversely, remains highly concentrated. Among all French firms, the principal stockholder possesses, on average, 66 per cent of the firm’s capital. For quoted enterprises that figure falls only to about 50 per cent. For the 120 largest firms, the five principal shareholders control almost half the capital.13 There are, in addition, significant family holdings. Though it is debatable whether family capital has the political and cultural importance in France that it has in South Korea and elsewhere in East Asia, it represents nevertheless 50 per cent of the capital of French firms, and 12 per cent for quoted firms. As for the institutional investors, it would not appear that they are ill at ease with French-style governance. French management has learned to lobby them and to convince them of the promise of their strategic plans. There is no reason to dismiss a priori the possibility that cultural prejudice for developmental strategy informs the conversation. Institutional investors themselves (particularly retirement funds) have long-range concerns that are not a priori insensitive to strategic vision. Moreover, institutional investors are not only answerable to their shareholders, but are also potentially answerable in some way to public opinion, as evidenced by the multiplication of ‘social responsibility’ and ‘environmental’ savings plans that they make available. They are not the anonymous private stockholders of capitalist myth, if only because they are potentially ‘too big to walk’. Exit is not viewed in all circles as a legitimate option, as made plain by the financial crisis in East Asia. One speculates that in the future we will see a kind of dialogue between large firms and large investors that could well come to resemble the cooperative discourse that occurs between firms and banks in closed bank systems. Elsewhere I characterized this discourse as a kind of ‘capitalism of voice’ (Loriaux 2002). Two other factors should inform speculation regarding the survival of France’s developmentalist culture. The first is the rather high volume of long-term savings in France. Currently, collective investment programmes

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draw on such savings, the value of which exceeds French gross national product (GNP). But these programmes invest only 10 per cent of their assets in stocks. Life insurance plans now manage about 22 per cent of household financial capital, but place up to 75 per cent of their funds in fixed return assets (especially government bonds), and only about 15 per cent in stocks. Fiscal measures stimulate household investment in stocks, but in a way that favours the medium (5 to 8 years) term. It is not unreasonable to predict that the French will look for ways to channel household savings toward longterm investment, possibly through reforms in pension financing. But one can also expect that such efforts will assume the form of charters and regulations that discourage speculation and complicate acquisition by foreign, especially non-European firms. Finally, the construction of the EU affects the evolution of corporate governance in France. European integration has engendered networks linking French firms to firms in other EU countries. Already ‘there are more formal EU governance-related networks and associational linkages that recreate a European sphere of activity separate from the global . . . The sheer density of these European networks has ensured that the European level is more privileged in most business sectors except the most internationalized . . .’ (Schmidt 2002: 56). The emergence of a European model of corporate governance could occur simply through the integration of European non-nationals in management and cross-ownerships through such networks. Finally, the sheer economic size of the EU, and its relatively low level of trade dependence (7 to 8 per cent) render it potentially invulnerable to US pressure to conform to a certain model. For this reason, European integration may provide developmental culture with yet another set of structures and institutions that favour its survival in a more global economy. In conclusion, changes in the structure of French capital, as in the institutions and norms of corporate governance, have not produced change in firm strategy since the period of public ownership. The strategy of core competence and foreign direct investment, in evidence during the period of state ownership and promoted by state planners, has not been affected by either privatization or the decline of the hard cores (Loriaux 1999). The concentrated ownership structure of French firms protect them from foreign takeover and diminish the risk of direct investment in foreign markets. The absence of Anglo-Saxon monitoring systems shelter ambitious strategists from secondguessing by shareholders. The power and autonomy of management, infused with grande école and Grand Corps self-confidence, facilitates bold moves. This management style inserts itself, with some creative tension, in an economic environment that is still characterized by the state’s voluminous presence. ‘While very real, the withering of the French state should not be exaggerated, and French leaders of both the Left and the Right are determined to see that it not go too far’ (Gordon and Meunier, 99). Government spending continues to consume half or more of GDP, a proportion that is among the highest in

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the world. Welfare expenditures, at 30 per cent of GDP, are third highest in the world, after Sweden and Denmark. France’s very effective health care system consumes 10 per cent of GDP. Vivien Schmidt suggests that the French political economy has evolved from a model of state-led capitalism to one of ‘state-enhanced’ capitalism. That characterization may overestimate the involvement of the state in investment decisions in our day, but it is true that one observes the survival of habits of thought, of a kind of economic culture, protected by the institutions of elite formation and selection, that continues to reflect and prolong France’s developmental heritage.

Notes 1 The Single European Act eliminated most non-tariff barriers to EU trade. 2 For the best account of the politics of finance in developmental East Asia, see Woo (1991). 3 The most important and most relevant of these Grands Corps are the Inspection des finances, the Corps diplomatique, the Cours des comptes, the Conseil d’état, and the Corps prefectoral. The works of Ezra Suleiman remain authoritative regarding the French elite. 4 The attractiveness of the high civil service has diminished under globalization. The number of students vying to enter the Ecole nationale d’administration (ENA) has dropped by about half, as bright students look to other opportunities, notably American-style business schools such as INSEAD. Nevertheless, the number of students postulating for a spot in ENA is still a significant multiple, say tento-one, of those who are admitted. 5 Note that trade dependence is much higher in France than in any of the developmentalist states of northeast Asia. 6 For technical reasons, ‘fine-tuning’ the currency, or targeting optimal exchange rates that sustained exports while limiting the inflationary impact of exchange rate-insensitive imported goods, proved impossible. See Loriaux (1991). 7 Critics of this structural interpretation of liberalization in France (for example, Levy 1999: 30) contend that it does not account for the timing of the reforms, overemphasizes the constraints on French policy, and does not explain why the reforms were as radical as they were. I would reply that this interpretation accounts admirably well for the timing of reforms by locating the decisive shift to a policy of currency strength in the year 1974, when global currency crisis sank the Bretton Woods system. The crisis revealed the need to strengthen the franc, first through the system of encadrement du crédit, the inadequacy of which begat the liberalizing reforms of 1983–7. It is customary, but erroneous, to locate the beginning of the franc fort in the reforms of 1983–4 (see, for example, Schmidt 2002: 78). Second, I explain the allegedly exaggerated character of the reforms with reference to the need to rid the political economy of the moral hazard that characterized the overdraft economy. Reform sought to alter economic expectations regarding the availability of state-sponsored credit. The need to replace inflationary financing with foreign investment and the supplementary impact of Reaganomics provide further explanations of the radical nature of French liberalization. The last objection, that policy leeway remained considerable, simply ignores France’s reasoned commitment to currency strength and the need to alter monetary and financial expectations. See Boltho (1996: 97) who also traces a

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8

9 10

11 12

13

‘fairly steady progression away from dirigisme and toward market-oriented prices’ to the oil and monetary crises of the 1970s. Boltho concurs that ‘The main impact of depreciation, in the uncertain world of floating, seemed to be higher inflation and larger oil import bills.’ Moreover (Boltho 100) ‘depreciations had uncertain effects on competitiveness as currencies had become more flexible and nonprice factors more important because instruments that had earlier been successful now seemed impotent, France had to embrace orthodoxy.’ The first one was composed of the Lyonnaise des Eaux, the Banque Suez, the Banque Nationale de Paris (BNP), and the Union des Assurances de Paris (UAP). The other brought together the Generale des Eaux, Banque Paribas, the Credit Lyonnais, the Société Générale and the insurance company Assurances Générales de France. See also Wade (1996: 85) on ‘national systems of innovation’. The French calculate unemployment by simply tabulating the number of people drawing unemployment benefits. In the United States, unemployment is calculated by surveying the population. The American method seeks to estimate the level of demand for employment. If the French were to adopt the American approach, the figure for unemployment in France would probably fall by several percentage points. Figures cited appear in Les Échos, 8 December 1998. See Philippe d’Iribarne, La logique de l’honneur: Gestion des entreprises et traditions nationales (Paris: Seuil, 1989), for whom France is characterized by a ‘cult of honour’ that produces a different business style than that found in America, one in which duty is associated with privilege and group identity. See Wade (1996: 79). In general, ‘top management and governance rest in home country hands’.

References Berger, Suzanne (1981) ‘Lame Ducks and National Champions: Industrial Policy in the Fifth Republic’. In William Andrews and Stanley Hoffman (eds), The Fifth Republic at Twenty (Albany, NY: State University of New York Press). Berger, Suzanne and Ronald Dore (1996) Diversity and Global Capitalism (Ithaca, NY: Cornell University Press). Boltho, Andrea (1996) ‘Has France Converged on Germany? Policies and Institutions since 1958’. In Suzanne Berger and Ronald Dore, Diversity and Global Capitalism (Ithaca, NY: Cornell University Press). Boyer, Robert (1996) ‘The Convergence Hypothesis Revisited: Globalization but Still the Century of Nations?’. In Suzanne Berger and Ronald Dore, Diversity and Global Capitalism (Ithaca, NY: Cornell University Press). Caron, François (1979) Economic History of Modern France (New York: Columbia University Press). Gordon, Philip and Sophie Meunier (2001) The French Challenge: Adapting to Globalization (Washington, DC: Brookings Institution Press). Hall, Peter (1986) Governing the Economy: The Politics of State Intervention in Britain and France (New York: Oxford University Press). Hancke, Bob and Bruno Amable (2001) ‘Innovation and Industrial Renewal in France in Comparative Perspective’, Industry and Innovation, 8, 113–34. Hayward, Jack (1986) The State and the Market Economy: Industrial Patriotism and Economic Intervention in France (New York: New York University Press, 1986).

Michael Loriaux 141 d’Iribarne, Philippe (1989) La Logique de l’honneur: Gestion des entreprises et traditions nationales (Paris: Seuil). Levy, Jonah (1999) Tocqueville’s Revenge: State, Society, and Economy in Contemporary France (Cambridge, MA: Harvard University Press). Loriaux, Michael (2002) ‘France: A New “Capitalism of Voice”?’. In Linda Weiss (ed.), States in the Global Economy (Cambridge, UK: Cambridge University Press). Loriaux, Michel (1999) ‘Myth and Moral Ambition: France as a Developmental State’. In Meredith Woo-Cumings (ed.), The Developmental State (Ithaca, NY: Cornell University Press). Loriaux, Michel (1991), France after Hegemony: International Change and Domestic Reform (Ithaca, NY: Cornell University Press). McArthur, John H. and Bruce R. Scott (1969) Industrial Planning in France (Boston: Division of Research, Graduate School of Business Administration, Harvard University). Meunier, Sophie (2003) ‘La France face à ses contradictions’, Le Figaro, 31 May–1 June. Patat, Jean-Pierre and Michel Lutfalla (1986) Histoire monétaire de la France au XXe siècle (Paris: Economica). Perez, Sofia (1998) Banking on Privilege: The Politics of Spanish Financial Reform (Ithaca, NY: Cornell University Press). Rosanvallon, Pierre (1990) L’État en France de 1789 à nos jours (Paris: Seuil). Schmidt, Vivien (2002) The Futures of European Capitalism (Oxford: Oxford University Press). Schmidt, Vivien (1996) From State to the Market: The Transformation of French Business under Mitterrand (Cambridge, UK: Cambridge University Press). Suleiman, Ezra (1978) Elites in French Society (Princeton: Princeton University Press). Suleiman, Ezra (1974) Politics, Power, and Bureaucracy in France: The Administrative Elite (Princeton: Princeton University Press). Wade, Robert (1996) ‘Globalization and its Limits: Reports of the Death of the National Economy are Greatly Exaggerated’. In Suzanne Berger and Ronald Dore, Diversity and Global Capitalism (Ithaca, NY: Cornell University Press). Whitley, R. (1992) Business Systems in East Asia: Firms, Markets, and Societies (New York: Sage Publications). Woo, Jung-En (1991) Race to the Swift: State and Finance in Korean Industrialization (Columbia University Press). Woo-Cumings, Meredith (1999) The Developmental State (Ithaca, NY: Cornell University Press, 1999).

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Part III Labour

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6 Asian Regimes and the Labour Contract Juhana Vartiainen

6.1

Introduction

Wage bargaining institutions and the institutional framework of the employer–labour relationship have been a classical issue of politics and political theory, and they have preserved their position on the political and economic agenda of modern capitalism. In crude terms, many United States (US) and European commentators distinguish between a European corporatist model in which the terms of employment are mostly regulated by collective agreements, and an Anglo-Saxon–US model where labour contracts are concluded individually and in a decentralized, market-driven fashion. Despite its crudeness, this dichotomy contains an important element of truth, as is shown by studies of stylized facts of the labour market (Holmlund and Zetterberg 1991; Teulings and Hartog 1998). The opposition between these two models is also political, and correlates, at least imperfectly, with the classical political divide between Left and Right. The Japanese way of running a modern economy, well depicted in analyses like those of Dore (1987) and Aoki (1988), represents the third stylized economic model. The peculiarity of the labour market aspect of this model is found in long-term loyalty relationships, low labour mobility and sophisticated ranking hierarchies within large firms. In a way, the large firm (that is, a genuine ‘corporation’) and enterprise-level unionism in Japan have replaced the role of corporatist organizations in European labour markets. To various degrees, commentators often find specific Asian values that sustain such economic behaviour. Similar characteristics are found in other Asian economies like that of Korea. Outside academia, there is a general predisposition to see the future as belonging to the Anglo-Saxon–US model of capitalism. Although this is not a view shared by a majority of labour economists, most politicians seem to accept – some half-heartedly, some enthusiastically – this general Zeitgeist according to which most non-market arrangements and collectivist institutions will erode. As to the political opposition between the US and European 145

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models, the lacklustre employment performance of large European countries in the 1990s did contribute to this attitude. This chapter argues that there is ample room even in today’s globalized capitalism for differentiated labour market institutions – and, to be more accurate, not only room but a need. One overarching theme of this chapter is to argue that European corporatist arrangements can best be interpreted as functional solutions to genuine economic challenges that arise in volatile, small and open economies. Thus, we see European and especially Nordic corporatism as an institution driven by the functional pursuit of efficiency. There is a general tendency among social scientists to ascribe Nordic-type corporatism to an inherent will to intervene in the economy, based on solidaristic preferences. This bias goes hand in hand with the error of generalizing the peculiar Swedish experience of the 1970s to be representative of Sweden and even Scandinavia at large. Against this biased received wisdom, this chapter sets out a functional explanation of Nordic labour market corporatism, and then uses this view to interpret some experiences and stylized facts of Asian countries like Japan and Korea. By considering the historical conditions of the labour market in countries like Japan and Korea, we argue that an institutional trajectory towards a more European-style corporatism is not ruled out and may even appear as a likely successor to the authoritarian developmental state. In particular, the chapter draws on the similarities between Korea and some small European economies, which have been analysed elsewhere with a broader focus on developmental strategies (Vartiainen 1999). Drawing on Kume (1998) and Koo (2001), we argue that the history of industrial relations in Japan and Korea provides quite a few parallels with that of European and Nordic corporatism. The chapter is organized as follows. Section 6.2 presents the theoretical background of corporatist labour markets. It draws heavily on modern ideas of asymmetric information and incomplete contracts, which lie at the heart of the theory of corporatist institutions. Section 6.3 uses this theoretical framework to characterize and classify the labour market institutions into three types: the Anglo-Saxon–US, the Nordic-European and the Japanese. Section 6.4 is the key empirical section of the chapter. It considers different possible trajectories of industrial relations in countries like Korea and Japan in light of the experiences of small European economies. The chapter concludes that a transition into a more European or even Nordic-type system of corporatist industrial relations, while distant at present, is not ruled out, particularly in Korea. The Appendix exposes a mathematical version of the model of section 6.2. The role of the Appendix is to build a closer link between the argument of the chapter and the mainstream economics literature. It can be skipped by a reader not interested in the fine print of formal economic models.

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6.2 6.2.1

The uniqueness of labour markets The fundamental contradiction

Labour markets are unique in the sense that they are riddled with problems and peculiarities that do not normally appear in markets like those for shoes and oranges. In economic jargon, these problems are mainly due to two factors: (i) the incompleteness and temporal inconsistency of contracts; and (ii) the asymmetry of information. These factors give rise to externalities that imply that long-term wage contracts are often a good (at least second-best) arrangement, in contrast to Walrasian spot markets in which competition constantly updates prices and reshuffles existing business partnerships. This, however, contradicts the need for wage flexibility in the face of economic shocks. Thus, seen from one angle, long-term and rigid wage contracts are a blessing; and from another point of view, they are a burden. Following Teulings and Hartog (1998), this trade-off between long-term stability and flexibility is called the fundamental contradiction of the labour relationship. In crude terms, the European model, the Anglo-Saxon–US model and the Japanese model each tackle this fundamental contradiction in different ways. They all represent different ways of sustaining economic efficiency. The next two subsections present the economic arguments related to these contractual inefficiencies in an intuitive form. 6.2.2

Match-specific investment and the hold-up problem

An employer–employee relationship can be viewed as a bilateral monopoly in which the parties work together to produce some valuable output. Once the output has been produced, the ‘cake’ must be partitioned between the two parties. The size of the cake, however, is usually not a given exogenous constant. Instead, it is a function of how much both parties have invested into the mutual relationship. A substantial part of such investment is matchspecific, so that the return on the investment is of very limited value if the current match dissolves. ‘Investment’ should in this context be understood in a very wide sense. It includes purchases of new equipment, education and training of personnel or creation of networks and friendships within the organization. Such investments can be undertaken by both parties: even an employee can use the time and energy to improve the organization of production or establish networks beneficial to the firm. The return on investment by definition takes time and does not accrue simultaneously with the original expenditure of money, time and effort. This in turn implies that incentives for these mutual investments are not necessarily at a level that would correspond to the first-best economic efficiency. The reason for this is that the division of returns – and the bargaining that determines this division – takes place after the resources for investment have

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been spent. Such a set-up implies that wage contracts will be renegotiated after the costs of investment have been sunk. Consider the following example. A firm considers investing in a new and expensive machine. Suppose that the cost of this investment would correspond to a continuous annual expenditure of $1 million. Suppose also that the yearly return on this investment is $1.2 million, so that the net revenue is $0.2 million for each year henceforth. This implies that it is efficient to undertake this investment. The private incentive of the firm does not necessarily dictate that the firm carries out the investment, however. Whether this is the case depends on the parameters of the wage bargaining set-up. Suppose that the firm bargains about the wage with a local union and that the bargaining power parameters imply that the outcome is a 50–50 division of the spoils. Then the workers will be able, each year, to expropriate half of the return on investment ($0.6 million), once the new machine has been irreversibly bolted to the factory floor. This leaves $0.6 million for the firm, so that the return on investment does not match the cost. Anticipating this ex post reneging of the original wage contract, the firm abstains from the investment. This problem is known in economic theory as the ‘hold-up’ problem or the problem of temporal inconsistency of contracts. It has been extensively analysed by such authors as Lancaster (1973), Grout (1984) and Macleod and Malcomson (1993); the macroeconomic implications are analysed by Caballero and Hammour (1998). The above example might suggest that the problem is only related to excessive worker militancy. Yet an analogous argument can be made for many investments that the worker might be able to carry out. Suppose that the worker could use his energy to improve the shopfloor production process and make it less straining. Suppose also that wages are continuously updated in a bilateral bargain (say, this set-up is represented with a Nash bargaining solution). If the job becomes less straining for workers, the mechanics of the Nash bargaining solution imply that the firm appropriates a part of this improvement to itself – after all, a lower remuneration is sufficient for a less stressful job. Thus, the worker’s wage or piece rate is adjusted downwards after the improvement is made. The worker, foreseeing this, might abstain from his innovative effort in the first place. In what ways could one alleviate the hold-up problem? This is really a question of the design of institutions.1 Intuition suggests that a contract that covers both investment and wages would be a way of implementing a firstbest solution, and economic models confirm this intuition. Thus, if it were possible to conclude contracts that would simultaneously determine the investment behaviour of both parties and the division of the spoils, a firstbest outcome could be sustained. It is generally agreed, however, that such institutions and contract forms are not easy to establish and sustain. A realistic second-best solution is to use

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long-term wage agreements. Suppose that the wage paid to the workers had been agreed in advance for many years, or that the principles of remuneration had been agreed in a collective agreement that binds both the union and the firm. Such a long-term contract, if it were binding, would cut the link between the wage and investment and would thereby remove the disincentive associated with extra investment. The appendix contains a slightly more complex formulation of this argument, with a stochastic element associated with the value of output.

6.2.3

Asymmetric information

A different theoretical story that also vindicates the idea of local wage rigidity is based on the informational problems of the workplace, or, in economic jargon, the asymmetry of information. This set-up has been analysed by Hall and Lazear (1984). An intuitive version of this theory would go as follows. Suppose again that the worker and a firm can produce some output by working together. This time, however, we suppose that the value of the output is a stochastic variable (say, because the price of the output is subject to shocks). Moreover, only the firm is able to observe this stochastic variable accurately. It is realistic to assume, however, that there are other variables of which the worker is better informed of than the firm. More specifically, the worker receives other job offers of which the firm cannot know. Thus, the worker does not know for sure the value of his output for the firm, whereas the firm does not know for sure about the alternative wage offers the worker may have received. In such a situation, it is in general impossible to implement efficient solutions as to the optimality of quits and layoffs, or in other words, efficient continuations and separations. If the informational problem did not exist and both parties were informed of both parameters, efficient continuation–separation choices would be easy to implement. They would only have to check whether the sum of their utilities is greater under separation or under continuation and act accordingly. They could then just bargain about the division of this surplus and the outcome of the bargain could be characterized by the Nash bargaining solution. When the parties do no know the payoffs of the other party, the problem cannot in general be easily characterized as a well-defined bargaining situation, and there is no theory that would predict a specific outcome, let alone an efficient outcome. If one wants more specific theoretical predictions on such set-ups, one must specify the wage determination procedure in more detail. One realistic set-up is monopsonistic wage setting, in which the firm sets the wage unilaterally. That case has been analysed by Hall and Lazear (1984); see also Teulings and Hartog (1998: ch. 2). If the firm only knows the distribution of the alternative wage offers that come to the worker, the firm offers a wage that induces too many separations when compared to the first-best outcome.

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In more concrete terms, the wage offers of the firm sometimes induce the worker to quit for a less productive job. One might think that normal market arbitrage would lead to efficient quits, but this is not the case. Suppose that the firm observes a particularly low product price for its good and tries to talk down the wage of the worker (and avoid dismissing the worker) by appealing to (genuinely) low profitability. The worker has no reason to believe the firm or accept a wage reduction, since, if he did, the firm would appeal to poor profitability even at times when profitability is good. By the same token, suppose that the worker gets a wage offer that exceeds the wage paid by his current employer. It might still be the case that it would be efficient for the current firm–worker pair to stay together (because the worker is more productive in the current job than in the alternative job). This would require that the firm raise the current wage to keep the worker from quitting. That outcome is not likely, however, because the firm has no incentive to take the worker seriously if he appeals to the higher wage offer. If the firm did go along and increased the wage, the worker would appeal to higher wage offers even if there were none. Thus, informational asymmetries lead to excess quits and layoffs. With realistic parametrizations of this model, it has been shown that a fixed wage contract can even in this case be a good second-best arrangement (see Hall and Lazear 1984). Thus, if the wage has been agreed in advance in a longterm wage contract and is completely insensitive to the price-wage shocks, the number of inefficient separations can be reduced. It cannot be avoided, but a rigid nominal wage contract might still be better than a completely flexible arrangement according to which the firm adjusts the wage at will after learning about economic shocks. 6.2.4

Nominal wage contracts as a second-best arrangement

The upshot of the discussion of the two previous subsections is that it is often advantageous to conclude fairly rigid, long-term wage agreements. Such contracts, the very point of which is to be insensitive to local shocks and local strategic behaviour, can be Pareto improvements over continuous short-term wage contracts. The point of these contracts is not that they always are at some optimal level – which they are not – but that they are not easily changed and that they cannot be easily manipulated by the parties. Thus, rigidity can be good for the local, ‘micro’ relationship. If that were the entire story, however, corporatist institutions would hardly ever have arisen. Now think of the above argument in the context of small or medium-sized economies that are heavily dependent on a few export markets. Such small and open economies are volatile: they are subject to large, economywide and industry-wide shocks, because global markets are volatile and these economies are often quite sensitive to the volatility of a few export markets. To tackle this volatility, an economy must be flexible and able to adjust wages and prices. If there is a major downturn in an important export market, it might

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be the case that almost all firms in a given industry or in the economy would be in a better shape if a general, encompassing wage freeze or wage cut took place. Yet, if all individual wages in all firms were renegotiated each time the economy is hit by a general shock, the very point of the long-term contracts would evaporate. Thus, there seems to be a contradiction between the needs of macro- or mesoeconomic flexibility and the need for local stability and long-termness. Reconsider the above story from section 6.2.2 and the fundamental economic issue at stake.2 Suppose you were a Pareto dictator in charge of investment and wage decisions. How would you approach the problem of determining investment and wages? You would certainly want to impose first-best investment, so that the next year (supposing the investment takes a year to complete) distribution issue would not affect the amount invested today. Yet you would also probably want to adjust the next period wage according to economic circumstances – say, having ex ante imposed some wage, you would want to increase the wage according to some rule of fairness if the profitability of the firm turns out exceptionally high – or, say, extending the model a little bit and letting employment be endogenous, if profitability turns out very low and employment would suffer, you would want to adjust the wage downwards. In other words, your distributional judgement should be flexible to circumstances, but you would not want to let investment depend on anticipation of future negotiations. Thus, there seems to be a trade-off between the advantages of long-term contracts and those of flexibility. Long-term contracts are good for efficiency since the investing party gets the proceeds of investment – but economic shocks might warrant realignment of wages. Yet the very anticipation of such eventual realignments might be enough to distort, ex ante, the incentives for investment. Suppose now that there are many firms like this and that there are higherlevel organizations in the economy: an employers’ federation and an industrial trade union. Suppose also that the individual (local) parties have delegated a possible readjustment of the wages to these corporatist parties: if the product price is very high so that the workers in each firm would break the contract, let the trade union and the industry federation re-bargain a general, encompassing upward adjustment of the wage, perhaps to the level implied by the Nash bargaining solution. Thus, instead of the shop union in each firm breaking the agreement, the corporatist organizations can negotiate a general wage increase. This might at first glance seem just like a replica of the firm-level outcome, but it is not: in this case, the ex post wage adjustment is independent of the individual firm’s investment. This is the rational basis of collective arrangements: they can sometimes help to adjust wages across the board without requiring that all individual, local contracts be reneged. Thus, this interpretation of corporatism and Nordic trade unions is that they are simply an indexing device. Such an interpretation may seem extreme

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or even shocking in the face of much of the conventional economic theory of unions, but it is the most realistic and convincing interpretation, in our view, of modern corporatism in the small European economies like the Nordic, the Dutch and the Austrian ones. We show in section 6.4.2 that the institutional fine print of Nordic collective agreements is strongly supportive of this ‘unions-as-indexing-devices’ view. The Appendix makes the theoretical argument more precise. There is a further twist to this argument, having to do with the asymmetry of information at the local level. Consider the story of asymmetric information, in which it was advantageous to fix the wage in order to prevent inefficient quits or dismissals. Suppose a negative economic shock hits the entire industry. Then it might be efficient to adjust all wages downwards. If each firm initiates a purely local discussion on the need for wage cuts, the workers cannot know whether the firm is bluffing. They might consequently refuse to let their wages be cut and be rather dismissed instead. Thus, a rational adjustment of the industry to adverse circumstances would be hampered. On the other hand, a general wage cut agreed by higher-level organizations – which are better equipped to detect overall economic shocks – might then be an efficient way of tackling the situation. This argument is presented in more detail in Teulings and Hartog (1998: ch. 2). 6.2.5

Corporatism as insurance

Although the distinction between corporatist and market-driven labour markets is often explained by political values, it is useful to note that certain structural factors of the economy seem to explain a large part of country differences in corporatist indices. Put simply, smaller economies, and more open economies in particular, tend to be more corporatist (see Agell 1999, 2000). The underlying argument is that the more open the economies are, the more they are exposed to economic shocks and the volatility of global export markets; corporatist arrangements and many other characteristics associated with rigid labour markets are clearly more prevalent in open economies. Put in a correlation plot with a corporatism index on one axis and a measure of economic openness on the other axis, neither the US or Japan looks like an outlier; they are simply fairly closed economies (see Agell 1999). Agell (2000) presents a nice economic argument that shows how wage compression sought by the unions can be interpreted as a rational arrangement for insuring against uncertainty associated with either human capital, economic shocks or the interplay of both. Agell’s preliminary regressions also indicate that linguistic and political homogeneity play a role in explaining the emergence of corporatist arrangements.3 6.2.6

Summing up: the functional explanation of corporatism

We have argued that the presence of strong trade unions which coordinate their actions on the industry level or national level can be explained by efficiency arguments. They represent a solution to the twin challenges of microeconomic

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long-term-ness and macroeconomic flexibility. According to this view, centralized wage bargaining can be interpreted as a macroeconomic indexing device. The main job of encompassing labour unions is to set the pace of wage increases so that the individual firm–employer pairs can continue their productive activities, without having to engage in disruptive local wage bargains. The institutional assumption that fits this ‘technical’ picture of corporatism is that centralized unions bargain primarily about wage increases and not wage levels. In traditional economic models of trade unions, such a distinction does not even arise: if the union is informed about the current wage, it is immaterial whether the new wage contract is formally defined as a new wage level or as an increase on top of the old level. In the real world, it is a very relevant distinction, however. Most Nordic unions are neither interested in nor capable of steering local wages, which are anyway almost always negotiated individually. Instead, and in cooperation with their employer counterparts, unions try to establish set a recommendatory wage increases, or ‘indexing updatings’ that are to be applied to all wages, regardless of their original level. According to this view, the commonplace way of regarding ‘decentralized’ and ‘centralized’ wage setting as two competing and mutually exclusive mechanisms is misleading. Instead, one should see them as complements: relative wages are determined locally and individually, but general wage increases enter the picture every now and then, and their magnitude reflects macroeconomic coordination between corporatist organizations. As we shall argue in more detail in section 6.4, this is precisely the content of modern centralized wage setting. Such a neat division of tasks between local and higher-level decisionmakers is surely not the only solution to the contradiction that we sketched above. Another one may be just to make labour’s bargaining hand so weak that the holdup problem does not even arise. Another solution might be to tie together investments and wages in an encompassing long-term contract at the local level. As the reader might guess, it is in these directions that we are going to look for interpretations for the Anglo-Saxon and Japanese labour contract institutions.

6.3

The labour contract in three economic cultures

In crude terms, the ‘Anglo-Saxon–US’, the ‘European-Nordic’ and the ‘Japanese’ economic cultures deal with these information-incentive problems in different ways. With some generosity of mind, one can distinguish between the following three sets of institutions. 6.3.1

The Anglo-Saxon–US institutions

The Anglo-Saxon–US solution to the above tradeoff between local longterm-ness and macroeconomic flexibility relies mostly on local arrangements. Any collective organizations outside the public sector are weak. There are no

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corporatist organizations, but wage contracts are often fairly long term ones. There is substantial evidence of the hold-up problem in firms with a unionized workforce. For example, Hirsch (1992) presents strong evidence that investment, physical capital and R&D are lower in the presence of unions. According to Teulings and Hartog (op. cit.), there are also strong indications that the incidence of firm-specific training is low in the United States as compared to other Organisation for Economic Co-operation and Development (OECD) countries. Thus, there is no attempt to tackle the dynamic externality in any collectivist or corporatist way. On the other hand, in terms of the above model, the US variant of capitalism represents an attempt to alleviate the hold-up problem by rendering the workers’ bargaining power as weak as possible. Recall that the Nash bargaining wage of the example in section 6.2.2 was derived by assuming a symmetric bargaining power for both parties. If trade unions are weak and strike activity is costly because of a political environment hostile to organized labour, then the bargaining power of labour is weak and the firm can count on a fixed or quasi-fixed wage even in the second period. In the extreme case of cut-throat competitive labour markets, the firm would simply dismiss the workers who want to renege the contract and hire other workers. In such an economic environment, few relationship–specific investments are made and a competitive wage ensures that the incentives for investment remain appropriate. As a caricature of US industrial relations, this is oversimplifying but not completely misleading.4 Turnover rates are relatively high in the United States, the majority of employment contracts are easily discontinued, and the bargaining power of labour is weak. Because of long-term wage contracts, nominal wage rigidity is also fairly high. When firms get into difficulties, workers leave and look for other jobs. The weakness of labour’s bargaining hand is simply a reflection of the weakness of unions and the weakness of employment protection. Recall the above intuitive economic model of the disruptive role of local negotiations. The hold-up argument relied on the assumption that the labour party could effectively renege on the old contract. Now, if the typical bargain is indeed one between the firm and an individual worker, that assumption will not hold. In such circumstances, it is easy to believe that the holdup problem is probably not very severe. Theoretical considerations also suggest that this is the case (see Malcomson 1997). The implication of effective workplace unionism is that the workers are able to commit to strategic actions like a strike that worsen the worker’s position in the short run. With individual negotiations, this is hardly an option. Hart and Moore (1988), Macleod and Malcomson (1993) as well as Malcomson (1997) show that in such a case the holdup problem never arises as long as it is only the firm that undertakes investment. That assertion relies heavily on the following ‘chain-store paradox’ argument. Suppose that a worker’s existing wage contract stipulates a very low wage

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and suppose that the firm’s product price goes up sharply, so that the firm and the worker now know that the value of the worker’s output exceeds the wage. Will he be able to claim a higher wage? The answer, according to this literature, is ‘no’. To see this, suppose that the relevant activity period is one year. Suppose also that the worker can on the morning of each day of the year ask for a higher wage contract, and then, after having learned the firm’s answer (‘yes’ or ‘no’), decide whether to work or not to work on this particular day. Then the firm will never answer ‘yes’ as long as the worker is better off by working than not working. Why? Suppose it is the last day of the year and, upon arrival in the office, the worker asks for a wage increase. The firm understands that the worker is better off working than not working, and since this is the last day of the year, the firm knows that the worker will just resign to working under this last day. But if this is the outcome of the last day, then exactly the same logic implies that the firm can say ‘no’ on the day before the last day, and so on, until today. Thus, according to this literature, the existence of some contract, however low in relation to the worker’s productivity, will compel the worker to work as long as the worker is better off working than being idle and without income. Thus, the only way the worker can get a wage increase is by appealing to better outside offers. If another firm makes him a better wage offer, the current firm is of course compelled to match that offer to keep him, and even willing to do so as long as the new wage remains below the worker’s current productivity. This eventuality, however, does not generate any hold-up problem, since the expected level of an outside offer is completely independent of the current firm’s investments. Thus, with contract wages low enough and enterprise unions weak enough, the firm has optimal investment incentives. The crucial difference of this stylized ‘US-Anglo-Saxon’ set-up vis-à-vis more unionized economies is that strong local unions can effectively commit the workers to a strike that is upheld as long as the firm has not yielded to the union’s demands. If that is the case, the backward induction argument does not apply, and some equilibria of the game indeed imply that the wage reacts to improved productivity. 6.3.2

The Nordic-European-corporatist institutions

The Nordic-European-corporatist solution is our second institutional caricature. Consider now a typical heavily unionized economy like a Nordic one. In this corporatist world, unions are strong enough to commit to strategic action at the workplace. This means that the hold-up problem is potentially severe, just according to the theoretical story that we outlined in section 6.2.2. When that is the case, the individual unions and firms must find a solution that constrains such harmful behaviour. Long-term contracts are the most immediate answer, but we argued above that they create a conflict with the need for flexibility. The corporatist solution is to delegate a part of the wage-setting process to higher-level organizations like unions and employer associations.

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These organizations function as indexing devices that increase flexibility without disrupting local contracts. Their task is to conclude collective adjustments of wages that apply to entire industries or even to entire economies without breaking local, long-term arrangements. This is the main point of Teulings and Hartog (1998) and it is only recently that their argument has been appreciated among economists. Recalling the above theoretical framework, consider once again the ideal mechanism for European-Nordic corporatism. Suppose that negative shocks, such as a crisis of a main export market, often hit some sectors of the corporatist economy. Suppose also that individual wage contracts and wage schedules (say, according to seniority and performance) in each firm have been concluded on a long-term basis, so that investment incentives are appropriate. In the face of an adverse shock, it might be necessary for employment’s sake to adjust everybody’s wage downwards. However, if each individual wage contract must be opened, the benefits of long-term contracts are lost: as everybody knows that the contracts are often opened, nobody can be sure of the returns on their investment efforts. The corporatist organizations, however, can deliver precisely the extra flexibility: in times of an economic slump, they might agree on shrinking everybody’s real wage mechanically by the same amount, so that the individual contracts need not be disrupted. Similarly, if macroeconomic policy fails and the economy suffers an extra bout of inflation, it might be efficient, from the point of view of the supply of labour, to increase everybody’s wage by some extra amount. If that outcome is to be achieved locally, it would presumably imply that the local union in each firm terminates the current wage agreement. This would mean disruptive local conflicts in many firms, and the very anticipation of such conflicts makes the firm ex ante suspicious of investment. The corporatist organizations, by contrast, can deliver just such an encompassing adjustment without disrupting individual contracts at the micro level. The main objective of corporatism is thus to avoid disruptive local bargains. Contrary to popular perceptions among economists and other social scientists, corporatist wage bargaining does not imply that individual wage levels be centrally determined. In general, when a new employment relationship is established so that an individual is matched with a job opening, the local parties are largely free to set the initial wage. The subsequent adjustments of the wage in the face of economic shocks, however, are largely regulated by corporatist organizations. Thus, ideally, the point of corporatism is precisely to enhance wage flexibility. This ideal view of corporatism presupposes that the labour unions be comprehensively organized and take into account economy-wide variables. If powerful unions are motivated by mutual envy and compete against each other, the corporatist solution might lead to an overall wage level that is so high that it is not compatible with full employment.

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The corporatist solution also presupposes that the corporatist organizations can effectively control the behaviour of their members (firms and shop unions). Work legislation is of importance here, because it affects the ability of local unions to challenge the firm’s wage offer by striking. In European corporatist countries, the acceptance of a collective wage agreement by an industrial union implies that the union accepts an industrial peace clause, which effectively prohibits striking by its local shop unions. Being able to control their local enterprise unions has always been one main task of strong European unions. This has often meant that Nordic unions have been favourable to legislation that imposes sizable fines on local wildcat strikes. This is entirely in line with the logic of corporatism: if the higher-level organizations are not able to control their members, they lose their very raison d’être. The higher-level organizations function as indexing mechanisms, but a part of the deal is that they effectively prevent the local enterprise unions from expropriating firms’ profits to themselves. This crucial starting point is duly reflected in the juridical form of collective agreements, most clearly in the Nordic countries. When an industrial union and its employer counterpart sign a new collective agreement, the agreements typically stipulate a general wage increase like ‘2 per cent more for everybody’. In some agreements, there is some freedom as to how this general increase is assigned locally, so that the agreement might be of the type ‘wages at the firm will increase by 2.5 per cent on average, and each individual will get at least 1 per cent’. There are many variations on this theme, but there is one common element to all of them: the local unions have by entering the collective agreement relinquished their right to undertake local industrial action. Thus, the local unions that are bound by the collective agreement cannot strike for higher wages. They can ask for higher wages, but all such local bargains must be conducted under a peace clause and normal work routines. The collectively agreed increase is a two-way street: the workers get at least something, and the firm can count on industrial peace. The increases stipulated in the collective agreement are often not even binding, nor need they be. If the local parties can agree on increasing wages by 100 per cent or cutting wages by 10 per cent, they are free to do so. What matters, however, is the fact that the collective agreement prevents either of the local parties from initiating a conflict.5 6.3.3

The Japanese enterprise unionism solution

The Japanese solution is our third caricature. In terms of the above model of investment and hold-up, the Japanese ideal solution probably comes nearest to the local Pareto efficient solution of contracting on both wages and investment. This interpretation rests on the fact that the role of management in a Japanese firm is not to unilaterally maximize the value of the shareholders, but to act as a kind of arbiter between the interests of the personnel and the stockholders (see Aoki 1988: esp. chs 4 and 5). The plausible economic interpretation of this stylized fact is precisely to think that the management can maximize a measure of overall welfare by taking a simultaneous decision about wages and investment.

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There is no better way of illuminating the Japanese way of tackling the hold-up problem than to cite Aoki (1988: 147): If all other resources of the firm, other than equity capital, can be mobilized from competitive markets and priced there, share price maximization against market-determined costs will ensure internal efficiency. However, if human resources of the firm have come to be internalized, . . . the wellbeing of the quasi-permanent employee will also depend on various corporate policies such as investment, employment and the like, which would affect their career opportunities and job security. In this situation, choosing strategic business policy to maximize share price subject to the pay of the quasi-permanent employees . . . would not lead to internationally efficient decision making. Thus, the management of Japanese firms takes a long-term view on investment and is not willing to let the shareholders exploit any short-term or opportunistic disadvantage of the workers. Excessive worker militancy, however, is also carefully controlled. Wages are set long in advance through the establishment of wage schedules, and the incentives for productive improvements are maintained through sophisticated promotion systems that rank people according to criteria that are set beforehand. Thus, the investment parameters and the distribution parameters are remarkably long-term, and short-term opportunism by any party is strongly discouraged.6 Worker effort is encouraged through ranking schemes that are not subject to market shocks.7 Compared to Europe, Japanese labour has been politically weak at the macro-political level. This characteristic has often been interpreted as a sign of the fundamental weakness of Japan’s unions. In his analysis of Japan’s trade unions, however, Kume (1998) shows that this interpretation rests on a rather mechanic transposition of European union traditions to bear on Japan. Kume argues convincingly that enterprise unionism is not a dead end and Japanese enterprise unions have steadily institutionalized their participation within the political economy, using the enterprise unionism structure as their firmament. In the light of our discussion, it is most appropriate to say that Japanese industrial relations display a different power structure than the European or Nordic ones, but we see all the necessary elements in place: local arrangements that limit harmful rent seeking, plus some nationwide bargaining routines – that will be described shortly – that enable the economy to adjust to macroeconomic circumstances. It should then be of no surprise that Japanese firms have traditionally sustained higher investment rates than US or European firms in similar circumstances (Aoki 1988). Thus, there is no question of the long-term-ness of the labour relationship of large Japanese corporations. Recall, however, that above story of the hold-up

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model as well as the virtues of European corporatism rest on the fact that a good labour market model has to combine the virtues of microeconomic steadiness with macroeconomic flexibility. How does the Japanese firm cope with macroeconomic and sector-specific shocks and how does it constrain the militancy of local unions? The answer is fourfold. Firstly, there is the celebrated bonus system of large corporations, which clearly constitutes a limited, but nevertheless one element of wage flexibility. Secondly, there is the large size of the ideal Japanese firm. A large firm can weather economic downturns and slumps in profitability and need not cut wages dramatically if demand drops temporarily.8 This fact is enhanced by the third aspect, namely, the attitude of the firm’s financiers: the banks and other financiers of the Japanese firms have traditionally been willing to sustain losses that would, in the US context, have led to more draconian shareholder measures. And fourthly, there is even an element of ‘European’ corporatism in Japan, namely the shunto or Spring offensive. The job of shunto is precisely to adjust wages in an economy-wide way, without disrupting individual firms’ wage schedules and patterns of remuneration. It has been econometrically well documented that the shunto mechanism has indeed contributed to wage flexibility in Japan (see Taylor 1989). Furthermore, as shown by Kume (1998), the history of Japanese industrial relations displays many episodes of coordinated macroeconomic control of wages that are completely analogous to the incomes policy phases of many European and Nordic countries. The introduction of the Shunto bargain in the 1950s implied a nationalization of bargaining on wage increases, completely comparable to similar developments in many European countries. The importance of the Shunto has varied from year to year, but it remains an essential element of the bargaining framework. We have cast our main argument in terms of long-term efficiency and macroeconomic flexibility. In section 6.2.4, however, we sketched another motivation for labour market corporatism, namely the demand for insurance against individual and idiosyncratic risks. Unsurprisingly, comparisons of wage differentials of the above labour market regimes reveal that they are clearly lower in European economies than in the US economy (see Holmlund and Zetterberg 1991). This holds true both for gross wage differentials and for unexplained differentials adjusted for productivity-related factors such as education and experience.

6.4 Trajectories of corporatism: small European countries, Korea and Japan 6.4.1

Taking stock

Let us start by summarizing the argument so far. We have argued that one crucial job of the wage bargaining framework is to sustain investment incentives whilst keeping the economy flexible to business cycles. This presents

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the local parties with a challenge: limit local rent seeking that destroys investment incentives, but design ways to make the economy flexible. Theory suggests at least three ways to do this: (i) keep the local union so weak that no surplus sharing ever arises (US–Anglo-Saxon solution); (ii) delegate the bargains on general wage increases to higher-level organizations like industrial unions, central organizations and the employer counterparts (the Nordic-European solution); or (iii) seek an encompassing contract on wages and investment at the enterprise level (the Japanese solution). The first solution comes closest to the assumptions of the competitive market. The latter two solutions presuppose strong unions at the workplace, and these solutions thus cannot function unless there are some macroeconomic mechanisms that adjust the wage structure to macroeconomic or sectoral shocks. In the Nordic countries, such macroeconomic institutions are quite prominent, whereas they play a lesser role in Japan. This is hardly surprising since Japan is a much larger economy, and our argument was that the corporatist delegation was particularly vital for small and open economies, because of their volatility. 6.4.2

Stylized facts of European corporatism

The three types of labour contracts and industrial relations all represent viable and interesting alternative institutions. This section will now turn to the historical preconditions of European and Nordic corporatism and relate them to such Asian cases as Korea and Japan. The tentative hypothesis is that the preconditions for a more European-type corporatism could well be available in some Asian countries. Suggesting any precise forecast about the evolution of Asian institutions would be naïve. However, the main argument here is that the common perception of all sets of industrial relations moving towards an Anglo-Saxon direction may be as premature as any other forecast. The above theory on investment and hold-up is of course an extremely streamlined picture of reality. In this section, we augment the theory with other considerations. The hold-up model, in our view, shows that there is a functional ‘social demand’ for unions that are able to control their members and impose macroeconomically sound pay increases. For corporatism to emerge, many other conditions have to be met. We argue below that smallness, nationalism and geopolitical vulnerability may have played a catalytic role as well. Consider the preconditions for labour market corporatism in the European countries. The following interrelated characteristics have been typical for many European corporatist economies: • Small or moderate size and relative openness of the economy. Most European corporatist economies have based their growth strategies on a bold exploitation of world markets. Indeed, it has been shown that labour market corporatism is associated with a high degree of openness (see Agell 2000). At least two interrelated theoretical arguments can be convincingly associated with this observation. Firstly, open economies tend to be dependent

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on volatile export markets, which entails greater income uncertainty. Corporatist labour market institutions, together with a large welfare state, can be seen as insurance arrangements that mitigate this uncertainty, both via taxation and income redistribution (see Rodrik 1998) and via a compressed wage structure (see Agell 2000; Agell and Lommerud 1992). Small size, openness and volatility go together, since large economies are less dependent on the world economy and tend to have a more varied production structure. Secondly, openness and volatility imply that that wage flexibility must be high if employment is to be stable. If wages are to be flexible without extreme income uncertainty at the individual level, it is useful to establish coordinated wage bargaining institutions that can carry out comprehensive wage adjustments in the face of adverse shocks (cf. sections 6.2–6.3 above). • A relatively homogeneous linguistic and political culture and egalitarian political preferences. As shown by Agell (2000), a culturally and linguistically homogeneous labour force tends to reinforce the likelihood of corporatist labour market institutions. This may be due to ease of establishing representative organizations as well as the enhanced solidarity that goes with cultural and linguistic affinity. Many corporatist countries are also associated with relatively egalitarian political preferences, although it is difficult to determine whether these are the cause or the consequence of a large welfare state and solidaristic wage bargaining. • An organized and politicized labour market. In the European corporatist countries, labour markets have been one main forum on which political contradictions have been articulated. Although corporatist bargains between the state and the labour market organizations have become quite peaceful, industrial relations have, at some historical phases, been very confrontational or even violent. Thus, it is incorrect to view corporatism as an expression of some type of social harmony; instead, corporatism has evolved as a way of dealing with turbulence. The formative years of corporatism were also times in which large industrial corporations played the main role in promoting corporatist industrial relations. • Partnership between the state and labour market organizations. In the case of late industrializers such as Austria and Finland, labour market organizations have been a partner of the developmental state. As described in Vartiainen (1999), the developmental regime can be interpreted as a bargain between state, labour and capital, according to which labour abstains from full exploitation of its bargaining power in return for a rapid investment programme. The emergence of corporatism is often associated with a period of economic and political nationalism, although this characteristic was less pronounced in Sweden. The above characteristics are important for the understanding of the traditional corporatist regimes in Northern and Central Europe. Countries like the Nordic ones, Austria, Switzerland and the Netherlands are the

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most obvious examples of this modus vivendi. However, even some more recent observations on the industrial relations of these countries are relevant: • The new macroeconomic policy environment. It is noteworthy that, during the 1990s, there was a proliferation of social pacts in various European countries in which the tradition for such arrangements has been quite weak; or as Martin Rhodes puts it in his survey (Rhodes 2000), ‘there are countries where new social pacts have grown on an apparently arid ground’: Italy, Portugal and Spain. Other, less surprising cases of reinforced corporatism include Ireland and the Netherlands. In most of these cases, the origin of corporatist concertation is to be found both in structural policies and macroeconomic endeavours. As to the former, the adverse economic conditions of the 1990s encouraged unions and policy makers to look for ways of enhancing the effective functioning of the labour market. This has included a controlled relaxation of labour market regulation as well as other reforms including pension restructuring. As to the macroeconomic imperative, the need to adapt to low inflation and a common monetary policy meant that any direct way of influencing wage costs by coordinated incomes policy became very valuable for any government.9 The recent theoretical literature on the interplay between monetary policy and wage bargaining suggests that the adoption of a single currency will increase the need for a centralized control of the wage level in the Economic and Monetary Union (EMU) member countries. The reason for this lies in the interplay between trade unions and the national monetary authority. A national central bank is able to discipline the wage setters, so that unemployment stays low. When the national monetary authority disappears, the disciplining effect has to be internalized by increased coordination between the unions. This intuition has turned out to be quite robust; it comes out of the analyses of Coricelli et al. (2001) as well as Holden (2001).10 Thus, both monetary policy concerns as well as the need for fiscal discipline have, in the European context, led to an increased cooperation between the state and the social partners. That this would be the case for Nordic countries is perhaps not surprising. It is more remarkable that this has been such an encompassing phenomenon in other European Union (EU) countries. • The Nordic convergence. As to the Nordic countries which perhaps most clearly exemplify the functional interpretation of corporatism outlined above, it is remarkable that all of them have steadily converged towards a rather similar model of wage determination. In all Nordic countries, wage determination is mostly local. When a firm hires an employee, it can agree on any wage or salary as long as it stays above the minimum tariff levels enumerated in the sector’s collective agreement.11 These local bargains live their own life and the firms are mostly free to operate their own wage policies. However, every second or third year, a general wage bargaining

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round is conducted, and it is in this phase that the ‘corporatism’ weighs in. The employers’ organizations and the trade unions bargain on some kind of ‘wage increase norm’, that is, a recommendation about how much pay can increase. There is a lot of variation between countries as to how much is left for local discussions and how much is guaranteed for each individual, but the general style is the same: relative wage differentials are determined at the firm, but corporatist organizations affect the speed of wage increases. One remarkable characteristic of these bargaining regimes is also that all the countries have established similar functional institutions that help and assist in the coordination process. Such committees gather data on wage indices in different parts of the economy and then issue recommendations on the appropriate level of wage increases. In Sweden, this task is carried out by a new Mediation Office;12 in Finland, there is a more low-key committee hosted by the Ministry of Finance;13 in Norway and Denmark, there are similar working groups. There is also some variation as to the explicit role of the state, as well as to the formal role of the central organizations. In all of these countries, the mechanics are pretty much the same: corporatist organizations coordinate their action and generate a general national guideline for pay increases. This functional description of Nordic pay policies cuts through such formalistic notions as ‘centralized’ or ‘decentralized’ pay bargaining. The fine print of the bargaining procedure can be transparent or opaque, coordination can be formal or informal, but the basic mechanism is pretty much the same.14,15 6.4.3

Asia and the European matrix

This section will attempt to fit Asian cases such as Korea and Japan into the European corporatist matrix. The argument is in two parts. First, we suggest that the same general economic logic that has reinforced corporatist arrangements in some European countries can be fully operative in Asian countries such as Korea and Japan. Secondly, the case of Finland and Korea will be closely examined since these two cases are bound together by a pedigree of a strong developmental state. General economic arguments The main story of section 6.2 involved the interplay of local efficiency and macroeconomic flexibility. That economic argument is quite general and will continue to make intelligible other labour market arrangements than a purely competitive Anglo-Saxon–US model. Mainstream economists are, by now, quite well aware of the merits of peaceful industrial relations based on a partnership between firms and unions. Thus, OECD’s (2000) economic survey of Korea (OECD 2000), while commending the country for its flexible and decentralized wage determination, also notes that

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Korea has made progress in bringing its industrial relations framework more into line with internationally-accepted standards since becoming a member of the OECD. First, the legalization of teachers’ unions paved the way for the recognition of the Korean Confederation of Trade Unions, the second national labor organization with about half a million members. Second, the number of jailed trade unionists has been greatly reduced and the government has announced a plan to minimize the use of imprisonment in cases of labor-law violations. Third, the principle of trade union pluralism has been accepted at the national level and will be introduced at the firm level in 2002. Fourth, the Tripartite Commission, consisting of representatives of labor, management and the government, has been strengthened and continues to function despite the ‘empty chair’ strategy periodically employed by the social partners. Furthermore, several other factors might sustain or even reinforce the tendencies for more regulated labour market practices in the East Asian countries: Globalization and individual insecurity. Economic globalization will increase the demand for social security and insurance-like arrangements for wage earners. That may be reflected either in the growth of universalistic welfare state arrangements or in corporatist solutions like unemployment benefits run by the unions. In a similar vein, Gills and Gills (1999) argue that globalization combines contradictory tendencies: on the one hand, it fosters increased competition, fragmentation and destabilization. On the other hand, these very same forces stimulate an opposite sociopolitical response, one which emphasizes social stability and cohesion as well as democracy and welfare state provision. Urbanization and nuclearization of families. Although many Asian countries have traditionally relied on the family to supply the social insurance functions, urbanization and nuclearization of families will reinforce the effects of globalization. Pascha (1998) argues that this effect can at least partly explain the undeniable if yet very timid progress of the Korean welfare state. For Huck-ju Kwon (2000), the recent Employment Insurance Act, while modest by European standards, is quite extraordinary by Korean ones. Korean labour market programmes have indeed been considerably expanded since the late 1990s.16 With more economic integration, even large (like the Japanese) or mediumsized economies (like that of Korea) will increasingly look like the textbook model of a small open economy. Then the economic challenge of being competitive remains a main point of the political agenda. That kind of national challenge has, at least in the past, invariably prompted political and corporatist interventions into the labour market. In Korea, for example, the government in the latter half of the 1960s forcefully promoted a kind of incomes policy based on productivity norms (Inagami 2000). In Japan, the

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same logic has repeatedly led to wage coordination across firms, as a way of limiting wage cost increases and promoting national competitiveness (Koshiro 1983; Inagami 2000; Manow 2000). In an era of free financial markets and monetary conservatism, a low inflation rate has become the general norm for monetary policy. This new-found discipline of monetary policy makes it very risky for labour market policy not to succeed. If wage costs increase more than what is compatible with low unemployment, the resulting unemployment cannot be dealt with an extra bout of inflation. On the contrary, once domestic unit costs increase too much, a prolonged period of deflation and unemployment is necessary to restore competitiveness. This makes it riskier for governments not to try to influence wage costs by direct incomes policies, be it by authoritarian means or cooperation with firm and union representatives. To anticipate the argument of the next section, Finnish corporatism was reinforced by the project of EMU accession, since the labour market parties had to imperatively agree on the means of limiting wage expansion. Parallel paths in Japan and Scandinavia Bearing in mind the functional needs of the wage bargaining system, both local stability and macroeconomic coordination, it is easy to see many quite parallel paths in Japan and Nordic incomes policies. Both local unionism and higher-level delegation have played a role, but there has been a perennial difference in their relative importance. In Japan, enterprise unionism is the heart of unionism and economywide ‘Shunto’ consultation the auxiliary and transitory element. In Scandinavia, unions have been more prominent at the national level. Notwithstanding this difference, many historical experiences are quite parallel. ‘Incomes policy’, that is, a macroeconomic regulation of wages became topical in the 1950s both in Scandinavia and in Japan. In Sweden, it gave rise to the famous Rehn–Meidner model. In Japan, a similar wage norm based on productivity was effectively operative from the 1950s through the early 1980s (Kume 1998: 15–16). During that period, Japanese labour unions became in many ways a part of the political power structure. By these means, union could also influence legislation on employment protection and many other aspects of the employment relationship (Kume 1998). The ‘Shunto’ bargain was introduced in the 1950s and it provides a very close parallel with Nordic incomes policies and centralized pay bargaining. It has been much more informal in its nature, however. Even in the heyday of the Shunto, major employers in Japan avoided the institutionalization of the collective wage setting mechanism. But even the workers organizations were more interested in maintaining their enterprise level muscle than extending it to national policy making.17 In many other respects, Japanese pay bargains have been very reminiscent of Scandinavia. As in Finland, the state has at times sponsored collective wage settlements by specific tax concessions (Lee 2004).

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The functional perspective even helps to interpret the recent difficulties of the Shunto. Since the recession of the 1990s, the Shunto pay initiative has been on the wane and it is unclear whether it will regain its influence. The Japanese labour movement has become weaker and firms have increased their freedom to set the parameters of the labour relation (see Weathers 1997). In 2004 and 2005, the Shunto seems to be reduced to a general discussion forum between the labour market parties,18 and employers have recently refused to participate in a unified wage settlement (Weathers 2003; Lee 2004). If one sees the Shunto primarily as an exercise of trade union power, it is indeed much weaker than what was the case in the 1980s. According to the alternative functional view that we have been pleading for, the Shunto represents a coordination mechanism that is used when it is needed, especially in strong economic booms when buoyant profits threaten the stability of wage setting. The real power of Japan’s labour is at the enterprise level, as argued by Kume (1998), and it is hardly affected by the ups and downs in the role of the Shunto. When the labour market is weak and the employers have the upper hand in pay bargaining, the employers are hardly in need of a mechanism that restrains labour militancy. Such a situation will not last forever, and a time will probably come when firms’ perceptions of the Shunto will change again. The current weakness of collectivism may thus be a reflection of the current economic crisis and may turn out less important for the underlying economic structures. Labour relations in Japan are undergoing change, but the fundamental institutions may turn out to be remarkably resilient (Kume 1998; see also Crump 1999). The underlying political values The discussion in section 6.4.2 summarized the typical characteristics of traditional social-democratic corporatism: openness, a strong labour movement and Social Democratic policies. The last two preconditions are obviously not there in East Asia, nor is their emergence likely. The discussion also emphasized, however, the more general social demand for corporatism, associated with openness, globalization, macroeconomic shocks and the demand for social insurance. As the dependence of almost all economies on the global economy increases, that demand for corporatist institutions is likely to grow, provided the underlying political culture is able to generate the necessary arrangements. From this point of view, it is intriguing to ask whether the emphasis on the Social Democratic pedigree of European corporatism is misleading. What may be more important is an underlying political culture according to which the oikos should always be subordinated to the polis; or, in other words, a reluctance to let the political be subordinated to the market. In that sense, there might be a deeper affinity between some conservative Asian regimes and European social democratic regimes than what is generally appreciated. What might be more relevant and also more general is society’s collective endeavour to find the arrangements that make the flexibility exigencies of the global marketplace palatable to society. Economists and social and political

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scientists, those with a European bias in particular, are perhaps too prone to think that collective solutions to this challenge must always be sought under the red banners of European-type social democracy. This is the point of view from which the study of Asian economies is so intriguing for social scientists whose instincts have been shaped by the political opposition between markets and intervention. The Asian developmental regimes of Japan, Taiwan and Korea, while conservative in many respects, have never abstained from vigorous state intervention into the economy. In that sense, Asian political attitudes towards collectivistic intervention could even support European-style corporatist labour markets and corporatism in the sense of cooperation between a strong state and organized economic agents. The thick fabric between state and society, typical for these countries, could in principle be also a factor that would limit the scope of decentralized market relationships in the labour market. Nor is this deep politicization of the economy showing any signs of unravelling. As Woo-Cumings and Loriaux (1999) emphasize, the ability and willingness of the state to intervene in the Korean economy remains very much alive, although the precise content of this intervention is less clear than what it used to be in the heyday of the authoritarian developmental state. Similarly, a closer look at the re-engineering of the Taiwanese developmental state reveals that the active role of the state shows no signs of withering away (see Chu 1999). For the traditional developmental regimes of semi-authoritarian states like Korea and Taiwan of the Cold War period, the threat of military defeat and national annihilation provided one powerful motivation for sacrificing present consumption for tomorrow’s productive capacity and economic growth. As Meredith Woo-Cumings (2000: 37) notes in her discussion on the Asian regimes: ‘The genius of the states in South Korea and Taiwan was in harnessing very real fears of war and instability toward a remarkable developmental energy, which in turn could become an abiding agent for growth.’ In the global marketplace of the new millennium, the threat of military annihilation must be replaced by the necessity of surviving and thriving in the global economy, but it is unlikely that this nationalistic political challenge would vanish altogether. Thus, global instability replaces the threat of military annihilation but the national economic question is hardly purged out of the political agenda. Finally, another factor that makes one suspicious of a laissez-faire trajectory for labour markets like those of Korea is the role of egalitarian political preferences and an even distribution of income. Although the basic motivation for non-competitive labour market arrangements is perfectly compatible with individual rationality, it is also true that Nordic and European labour market institutions have probably been reinforced by political attitudes that favour small income differentials. For Korea, at least, many commentators have emphasized the relatively even distribution of income as a factor conducive to growth (Benabou 1996) and as a trait of national culture.

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According to Pascha (1998), that same aversion for inequality can explain much of the adversarial bitterness that is felt by Korean trade unions; but, also, a strong longing for equality seems almost a trait of the national character (Pascha 1998). 6.4.4

Korea and Finland – more than superficial parallels?

This section concludes the chapter by pointing out some intriguing parallels between Korea and Finland. As argued by this author elsewhere (Vartiainen 1999), the étatist late-industrialization developmental strategies of these two countries have exhibited surprisingly similar characteristics. This might seem odd to many, since Finland is often associated with Nordic and social democratic political regimes whereas Korea has been categorized as an authoritarian developmental state. Yet a similar corporatist-étatist logic has been at work in both regimes, and a closer look reveals other similarities. Starting with differences, however, there is one aspect of Korea that, at least according to conventional views, is quite opposite to Finland; the legalistic tradition and the overall respect of formal legal procedures. While the commonplace view of ‘Asian cronyism’ is clearly biased (see the contribution of Ohnesorge in this volume), it is a legitimate concern – expressed inter alia by Pascha (1998) – that the potential dangers of social corporatism in Korea have much to do with the difficulty of containing vested interests. This might be especially true in a country where mutual distrust of the various political actors has traditionally been deemed high. Finland’s political culture, by contrast, is a very legalistic one, since the law and country’s own constitution has always been seen as one pillar of independence. As to the political centre of gravity, Finland is not that far from Korea: the political Left has been weak and occurrences of leftist parliamentary majorities are limited to two since the country’s independence (1918– ). Economic policy was, for a long time, dominated by a conservative state – big business coalition, which aimed at rapid industrialization and the establishment of an economic base that would make it possible for the nation to survive in a contested international position. The country also faced the Communist challenge and the expansionist endeavours of the Soviet Union. It was only in the 1960s – and partly as a way of neutralizing the Communist challenge – that the political Left became more acceptable. At that time, the trade union movement also assumed its place as a more equal third partner in the management of the Finnish economy. Thus, the conservative growth regime of the 1930s through the 1960s has since then given way to a more Nordic-type labour market corporatism in which the social partners and the state de facto share the responsibility for macroeconomic management. This regime is not without strains nor does it rest on established and explicit constitutional rules. In sum, even Finland has moved from a political system characterized by at least partial exclusion of labour and a business-dominated oligopolistic development state (especially in the 1930s) towards a mature

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democracy and a more level playing field between the state and the economy’s organized agents. As to the developmental regime, the management of the economy has gradually shifted away from the intensive fostering of tangible capital investment – typical for the 1950s – towards a more modern emphasis on human capital formation. Even here, there is a parallel between the economics of Korean and Finnish development. By the 1990s, it was generally acknowledged in Korea that the chaebols’ investment strategies had been ambitious but reckless and not compatible with sound revenue maximization. Partly because of domestic criticism by economists and opposition politicians and partly because of US demands for greater economic liberalization, president Kim Young Sam (whose administration was inaugurated in February 1993) took the first steps to break the hegemony of the chaebol. As described below, that first attempt was not altogether successful. The interesting point is the similarity of the Finnish structural economic debate of the 1990s, in which it was generally acknowledged that the main forest and metal industries had got used to an unnecessarily advantageous supply of credit and had consequently over-invested into unproductive capacity. That criticism was most forcefully advanced by the economist Matti Pohjola (1996). Looking at the later Korean experiences through this Finnish prism, other parallels emerge. To put the argument compactly, we would like to suggest that the Korean industrial relations-welfare state-regime could be on a somewhat similar trajectory to that of Finland. The main differences are that of a time lag (that is not exactly constant for all policy areas) and, perhaps, a political ‘constant term’ which implies that Korean policies have a more right-wing ring in general. More specifically, we would like to look at the changing configuration of state–capital–labour relationships as Korea transits from a developmental regime to a mature capitalism and from an authoritarian political regime to a more democratic state. It should be borne in mind that the outcome of this process is far from certain and contingent on the uncertainties of class politics. There are two underlying forces at work. There is the changing global economy, which requires constant updating and recreation of developmental strategies. As argued above, the forces unleashed by this process do not necessarily push a medium-sized economy into a neoliberal mould. The other engine of social and political change is found in the arena of domestic class politics in which the main actors – the state, big and small business and labour – try to form coalitions and improve the economic resources of their constituencies. In the case of Korea, the old, authoritarian and chaebol-dominated developmental model had, by the 1990s, become weaker at both fronts. It was hardly compatible with an emphasis on a liberal economy, nor was it compatible with increasing popular pressure for more democracy. The first strike at the power of the chaebol was taken by President Kim Young Sam. As a way of adapting Korea to the increasingly globalized world economy, his policy aimed at curtailing their power and introducing more competition into the

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economy (see Gills and Gills 1999). The policy also attempted to root out endemic corruption. These measures provoked a conservative backlash against reform, and Kim Young Sam concluded that he could not conduct his economic policy without the cooperation of the chaebol. This meant turning away from the idea of a decisive break in the government–chaebol alliance. The ensuing political programme of adapting Korea to globalization (segyehwa) got a definitely Conservative bias, in particular a stern resistance to progressive labour reform sought by the unions. The social safety net was not much improved, and the rising unemployment of 1997–98 left many workers badly exposed (Gills and Gills 1999). This contributed to the political failure of Kim Young Sam. In short, Kim Young Sam’s first attempt to discipline the chaebols failed because he had no political power base; his openings alienated both business and labour. Labour market reform was one key arena of political discord. The original set-up was badly biased to the disadvantage of labour, and the unions had developed long-standing grievances against such restrictive elements of the law as the prohibition on plural unionism, third party intervention, public sector unions and union participation in politics. In the 1990s, the chaebol sought to increase flexibility and discipline labour, whereas unions pushed for a democratization and modernization of labour practices. One altogether more positive impetus for reforms in authoritarian labour market practices was Korea’s endeavour to become a part of international organizations like the OECD and the International Labour Organization (ILO). This boosted the unions’ proposals for a democratization of labour law. From the point of view of political power, it seemed typical for the Korea of the 1990s that no element of the triad of state–capital–labour appeared (nor does any appear as of now) to be strong enough to impose its will onto others. This is a characteristic similar to that observed in Finland, in which the basic corporatist class compromise has not, since the 1950s, expressed a clear hegemony of one part of the triad.19 Such a situation creates political uncertainty, but opportunities as well. This became manifest in the first window of opportunity for reform under the presidency of Kim Dae Jung. The conservative and authoritarian approach to globalization under the presidency of Kim Young Sam had led to a major and nation-wide confrontation with organized labour, led by the Korean Confederation of Trade Unions (KCTU). The other main trade union federation, the Federation of Korean Trade Unions, or FKTU, subsequently joined the strike, and the trade unions’ campaign could even muster substantial popular support (Gills and Gills 1999). This strike became a watershed in the Korean trade unions’ self-assurance and paved the way for a more equal social and political partnership between business, the state and the unions.20 The main outcome of the strike was a compromise on the reform of the labour law. It smacked already much of the typical Nordic compromises: in some respects, it increased the managers’ scope for flexible redundancy dismissals,

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but it improved union rights and established a basis for a more participatory and cooperative industrial relations system through reform of rules on collective bargaining and intermediation on industrial disputes. That general political orientation was much reinforced under the presidency of Kim Dae Jung, the first opposition party candidate to be elected president since the founding of the Republic in 1948. According to Gills and Gills (1999), Kim Dae Jung’s administration used globalization as a motivation for building a new political coalition which would ‘alter the state–capital relationship and move towards an inclusion of organized labour into state policy-making’. This new orientation was thus a mixture of neoliberal, social-democratic and corporatist elements, a mixture that does not look too unfamiliar to a Nordic or Finnish observer. It led to a modest expansion of the social safety net (see Kwon 2000) as well as the founding of the first Tripartite Commission, an embryo of a typically social-corporatist institution (see Lee 1997). In January 1998, the Commission was institutionalized as a presidential advisory body. In February 1998, the new Commission was able to forge a first ‘social pact’ according to which employment protection would be weakened, but this concession to employers would be met by an expansion of the social safety net (Lee 2004). In parallel with these developments, trade unions had in the name of national competitiveness engaged in concession bargaining which entailed a pay freeze (Lee 2004). The subsequent performance of this social concertation effort has been anything but smooth. Yet these episodes show that steps towards a more ‘Nordic’ social pact model are clearly possible even in a country that has been traditionally classified as an authoritarian developmental state, a weak and divided labour movement21 and a fiercely outward economic orientation. For a Finnish observer, such political openings are reminiscent of much earlier historical instances, but they have an altogether familiar ring. It is perhaps not a coincidence that recent years have also seen the proliferation of academic and political papers and articles that have examined the relevance of Nordic and German models for Korea and Japan (see Pascha 1998; Manow 2000; Ho-Jin 1997). This probing period has for Korean industrial relations has continued since the election of the pro-labour candidate Roh Moo-Hyun to the presidency in 2002 (Roh was inaugurated in February 2003). At the beginning of his administration’s term of office, Roh explicitly endorsed a multi-level collective bargaining system that would empower industrial unions as key agents for wage contracts (Lee 2004). Seen against the background of our analytical perspective, it was highly significant that one of President Roh’s early priorities was to prevent illegal strikes. Furthermore, the Tripartite Commission was charged with designing a blueprint for a new industrial relations system that would incorporate effective arbitration mechanisms. A second ‘social pact’ was forged in December 2003. It aimed at stabilizing wages over the next two years, and business representatives agreed to caution in employment cuts.

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Seen against our discussion on the Nordic regimes, these openings obey a very familiar logic and display familiar elements. There is a ‘trilateral commission’ (compare with the various coordinating bodies in Scandinavia), illegal strikes are perceived as a problem (recall the corporatist necessity of controlling local militancy), and a more institutionalized collective bargaining mechanism is being discussed. In our view, however, it is the last element which is the most important, and in this respect the Korean version of social corporatism is still unstable and unclear.22 The next logical step to be taken in Korea would the establishment of more regular wage bargaining procedures that transcend the individual firm. Whether that is possible against the historical background of the enterprise union system remains to be seen; at present, a more institutionalized collective wage bargain is viewed with distrust by both workers and the employers. To a Finnish observer, even such attitudes are fascinatingly familiar, although with a transposed timing. Throughout the 1970s and 1980s even many Finnish rank-and-file union members were thoroughly suspicious of ‘incomes policy’ concessions, and it is only more recently that such a corporatist strategy has gained a stronger acceptance within the labour movement. The employers’ attitudes have been similarly multifarious and they have even undergone various positive and negative phases. Time and again, Finnish employers’ representatives have declared that the coordinated wage increases model is obsolete, only to change their mind when faced with the obvious truth that low pay increases guaranteed by such incomes policy settlements will even in the future guarantee a fairly predictable wage development, high profitability in the most innovative sectors and a relatively low incidence of conflicts. It remains to be seen, both in Finland and in Korea, whether that same magic will still be operative in the global economy of the new millennium.

Appendix: A Model of Bargaining and Investment under Uncertainty Consider a firm and an employee that can together produce something valuable. After producing, they bargain on the division of the product. Output is enhanced if the firm invests in new machinery or trains its employee. Suppose the relationship lasts for two periods. In both periods, output is produced and wages are paid. In the first period, the firm also has to decide how much it invests into new machinery that will be available in the next period. Suppose that first period output has already been produced and first period wages have been agreed upon. Thus, the first period variables other than investment need not preoccupy us. What do the two parties’ payoffs look like? Denoting the firm’s payoff by
we can write (1)
  C(I)  [pF(I)  W],

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where I is investment, C(I) the cost of investment, F(I) is next period output, p is output price tomorrow, W is the wage next period and  is a discount factor for one period ahead. Following convention, we assume that C is a convex function and F is a concave function. Price p is a random variable that will be observed at the beginning of the second period. Only the probability distribution of p is known as of today. As to the workers, having had their wages agreed upon this year, their remaining payoff  is simply their discounted next period wage: (2)   W. This simple set-up generates the hold-up problem. Assume risk-neutral agents, so that both parties value their returns linearly (assuming concave utility functions would not change the set-up), and set   1 to simplify. A Pareto planner would equate the marginal cost of extra investment to expected marginal return. With linear utilities, the expected marginal return would simply be the sum of the two parties’ payoffs. Thus, denoting the expected value of p by E(p), the Pareto planner would choose I to maximize E( 
)  C(I)  E(p)F(I)  W  W. The first order condition is (3) C’(I)  F’(I)E(p). Thus, the marginal cost of extra investment must equal the marginal product of that investment times the expected market value of that product. What would happen in the real world? Consider first a benchmark flexible bargaining set-up, in which the parties bargain about the wage in the beginning of each period. Thus, once today’s investment has been carried out and next period p is revealed, the parties start a bargain. Suppose that the bargaining procedure is such that the Nash bargaining solution (NBS) is the appropriate solution concept. The NBS is found by maximizing the joint product of the parties’ returns from cooperation: (4) max [F(I)p  W]aW(1  a), where a and (1  a) are indices of bargaining power. For simplicity, let a  1/2 so that bargaining powers are equal. The solution is (5) W  pF(I)/2, so that each party gets a half of the surplus. Anticipating this, the firm’s manager chooses investment I in the first period to maximize the expected return (6) E(
)   C(I)  E(p)F(I)  (E(p)F(I)/2)  C(I)  (1/2)E(p)F(I).

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Maximizing (6) with respect to I yields the first order condition (7) C’(I)  (1/2)F’(I)E(p), which implies that investment is lower (recall that C’’  0) than in the Pareto case of equation (3). Thus, anticipating that the workers will step up their wage claim after productive capacity has increased, the firm abstains from the optimal amount of investment. Which institutions can remedy this? One solution is a long-term wage contract that would set a constant wage, thus breaking the connection between wage and investment. This is seldom feasible, however. Even if the workers were willing in the first period to commit themselves to a fixed wage, what would prevent them from reneging on this contract? To illustrate the argument, suppose indeed that the workers and the firm could agree, in period 1, on the wage W that is to be paid in period 2. Suppose that the legal content of that contract is such that the workers must pay a fine of B if they breach the contract and strike in period 2. In that case, after paying the fine, the outcome will correspond to the Nash bargaining case of equation (5). Under which circumstances will the workers break the contract and opt for a renewed Nash bargain? In the beginning of period 2, the price p is revealed. By breaking the contract and initiating a Nash bargain, they get the revenue B  pF(I)/2, that is, the Nash wage minus the fine. By sticking to the contract, they get W. They break the agreement if pF(I)/2  W, or (8) p  2(W  B)/F(I)  T(I). Thus, a sufficiently high realization of the price variable leads to a strike. To make notation simpler, denote the threshold value 2(W  B)/F(I) by T and note that it depends both on the fine as well as on I. Thus, we can write it as a function of I: T  T(I) and note that T’(I)  0: the more the firm invests, the lower is the price threshold for workers to break the contract. Anticipating this, how will the firm invest? Its expected return is now a probability-weighted sum of the expected return in the two cases ‘contract broken’ and ‘contract honoured’. The expected payoff as evaluated in period 1 is (9) E(V)  Prob(broken)(1/2)F(I)E(p|broken)  Prob(honoured) [F(I)E(p|honoured)  W]  C(I). The first term of (9) is the payoff in the case in which the workers break the contract; in this case the firm keeps the value of the output less the Nash wage (1/2)F(I); the value of output is given by F(I) times the conditional expectation of p, given that p was high enough for the workers to break the contract. The second term is the payoff in the case in which the workers keep the contract (that is, value of output less the contract wage W); the value of this event is weighted by its probability. The firm chooses I to maximize (9); omitting the details, the first order condition is

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(10) C’(I)  (1/2)F’(I)E(p)  (1/2)F’(I)Prob(honoured)E(p|honoured)  g(T(I))T’(I)[(1/2)F(I)T(I)  W], in which g( ) is the density function of the price p. Expression (10) permits a comparison with expressions (3) and (7) (recall that the higher is C’(I), the more the firm will invest, since C is convex). The first term at the right-hand side of (10) is the same as in (7); thus, whether investment in this contract case is higher than in the Nash bargaining case depends on the last two terms. The first of the two is positive and it reflects the possibility that the contract will be honoured. The last term is negative and it reflects the marginal effect of extra investment on the probability that the workers default on the contract. Speaking loosely, g(T(I)) is a measure of the probability of p hitting the threshold value T(I), T’(I) is the marginal effect of investment on the threshold value and (1/2)F(I)T(I)  W is the loss in profits at the threshold value: the contract wage W is replaced by the Nash bargaining wage (1/2)F(I) and the difference in square brackets is the ensuing loss for the firm. Without going into details, it can be shown that there are contract wages W that are ex-ante beneficial for both parties. Thus, a plausible scenario is that the parties will indeed in period 1 agree on some wage W that enhances the expected utility of both parties. Even that arrangement would not in general correspond to the first-best investment solution given by (3), but, with plausible parameter values, contracts W exist that make expression (10) larger than expression (7) so that the firm invests more in the long-term contract case. Thus, long-term wage contracts plus fines may offer one way of alleviating the dynamic inefficiency due to temporally inconsistent contracts. Indexing the wage may be even better. Suppose that there are many identical firms like this and suppose that there are higher-level organizations: an employers’ federation and an industrial trade union. Suppose that the local parties have delegated a possible readjustment of the wages to these corporatist parties: if the price becomes so high that the workers in each firm would break the contract, they let the trade union and the industry federation rebargain a general, encompassing upward adjustment of the wage, to the level implied by the Nash bargaining solution. Thus, instead of the shop union in each firm breaking the agreement, the corporatist organizations negotiate a general wage increase. This might at first glance seem just like a replica of the Nash outcome (10), but it is not: in this case, the ex post wage adjustment is independent of the individual firm’s investment. Consequently, in (10), T’(I)  0 and the third term drops out: the firm has no reason to restrain investment in order to decrease the probability of default by the workers. Thus, investment in the corporatist case is even higher than in the local fixed wage contract case (10): (11) C’(I)  (1/2)F’(I)E(p)  (1/2)F’(I)Prob(honored)E(p|honoured)

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To sum up, the corporatist organizations provide an indexing technology: they take care of negotiations so that local strikes or lockouts can be avoided. The above model is cast in terms of firm investment, but a remarkably similar story could be told for work effort or learning by the worker.

Notes 1 Economists speak of the ‘design’ of contract forms and other institutions, but the main institutions of capitalism are of course not in general freely designable. 2 The formulation of the next argument draws heavily on Teulings and Hartog (1998). 3 A related argument has been suggested by Rodrik (1998), who shows that the share of public sector expenditure exhibits a significant positive correlation with economic volatility. 4 Malcomson (1997) presents a sophisticated analysis of US labour contract forms in the light of game theory and contract theory. 5 This simple fact is strikingly absent from the mainstream economic models of trade unions. Most labour economics text simply assume that ‘unions set wages’ and treat the collective agreement as a constraint on a local bargain. 6 Note also the sophisticated point made by Milgrom and Roberts in a mimeo and iterated by Aoki (op. cit.: 32): it is a typical characteristic of the Japanese firm to keep shuffling people between job assignments, so that everybody can be useful in many tasks. While this may leave some economies of specialization unexploited, it also alleviates the hold-up problem because no group of workers can then command a position in which just its task and expertise is crucial and no other group of workers can be substituted to its place. This generalization of productive expertise clearly makes rent seeking more difficult, and thus alleviates the hold-up problem. 7 See Carmichael (1979) and Macleod and Malcomson (1988) for analyses of such ranking schemes and their optimality properties. 8 The relationship of size to the holdup problem is analysed in Vartiainen (1992). 9 Rhodes (2000) predicts that ‘Rather than disrupting these forms of concertation and fragmenting governance in the European labour market, the completion of the single market and movement to full EMU is likely to lock the bargaining partners even more closely together’. 10 See also the survey by Cukierman (2002). 11 In most industries, these minimum tariff wages are so low that they do not constrain the local wage bargain. 12 ‘Medlingsinstitutet’. 13 ‘Tulopoliittinen selvitystoimikunta’. 14 These bargaining institutions do not much constrain the evolution of relative wages. Thus, an increase in interfirm wage differentials has been observed in all Nordic countries since the early 1990s, and this increase has been accommodated within the present bargaining system. 15 It is astonishing how little these obvious realities of Nordic pay bargaining have influenced the mainstream economic theories of the unions. Almost all economic models of unions start from the simplistic and erroneous assumption that ‘unions set wages’ for their members. Furthermore, wage compression by solidaristic wage policies is almost invariably regarded as ‘the’ defining characteristic of Nordic unionism. As we argued above and in the previous endnote, Nordic unions have not been able to steer relative wage differentials. The flagrant exception to this

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16 17 18 19

20 21

22

was the ambitious solidarism of the 1970s in Sweden, but that phase has somehow become ‘the’ internationally representative specimen of what Nordic unions are. That policy experiment was transitory, however, and resulted in complete failure (see Vartiainen 1998). In other Nordic countries, such an ambitious solidarism was never even attempted. Finnish unions, for example, have always been happy to let most of the action in wage setting happen at the workplace. Yet much of the economics and social policy literature has extrapolated the Sweden of the 1970s to represent the entire Scandinavian experience. See OECD (2000) Pushing Ahead with Reform in Korea: Labor Market and Social Safety-net Policies (Paris: OECD). ‘The Japanese unionized workers displayed a far stronger enterprise consciousness than class consciousness’ (Lee 2004). ‘Shunto enters new era’, Japanese Foreign Press Center, Japan Brief No. 0370, 2 April 2004. This is again a clear difference vis-à-vis neighbouring Sweden, in which Social Democracy from early on commanded a hegemonic position. That may explain why labor market corporatism and formal social partnership between the state and the labour market partners never evolved very far in Sweden – after all, Swedish Social Democrats never felt the need to share their political power base with any other societal actor. See Sohn (1998) for a union-side statement on the significance of the strike. To a Finnish observer, even the division of the Korean trade union movement into a more radical KCTU and a more conciliatory FKTU is quite familiar; it corresponds to the traditional division of Finnish trade unions and has not proved incompatible with an effective tripartite cooperation. Joohee Lee (2004) takes a similar view: ‘Without some institutionalized bargaining coordination at the meso- or industry-level, Korean experiments with tripartism will most likely end in futility’.

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178 Labour Crump, John (1999) Where Is the Japanese Variety of Capitalism Now?. Paper presented at the conference Where Are National Capitalisms Now?, Political Economy Research Centre, University of Sheffield, 15–17 July. Cukierman, Alex (2002) Monetary Institutions, Monetary Union and Unionized Labour Markets – Some Recent Developments. In R. Beetsma, C. Favero, A. Missale, V.A. Muscatelli, P. Natale and P. Tirelli (eds), Monetary Policy, Fiscal Policies and Labour Markets: Key Aspects of Macroeconomic Policymaking in EMU (Cambridge: Cambridge University Press). Dore, R. (1987) Taking Japan Seriously (London: Athlone Press). Gills, Barry K and Dong-Sook Gills (1999) Globalization and ‘National Capitalism’ in South Korea: Reconfiguring State-Capital-Labour Relations. Paper presented at the conference Where Are National Capitalisms Now?, Political Economy Research Centre, University of Sheffield, 15–17 July. Grout, Paul (1984) ‘Investment and Wages in the Absence of Binding Contracts: A Nash Bargain Approach’, Econometrica, 52. Hall, R.E. and E.P. Lazear (1984) ‘The Excess Sensitivity of Layoffs and Quits to Demand’, Journal of Labor Economics, 2, 233–57. Hart, Oliver D. and John Moore (1988) ‘Incomplete Contracts and Renegotiation’, Econometrica, 56(4) (July), 755–85. Hirsch, B.T. (1992) ‘Firm Investment Behavior and Collective Bargaining Strategy’, Industrial Relations, 31. Ho-Jin, Kim (1997) Labor Relations in New Millennium, KOILAF commentary papers, quoted from Korea Times (1997). Holden, S. (2001) Monetary Regimes and the Co-ordination of Wage Setting. Mimeo, Department of Economics, University of Oslo, 2 February. Holmlund, B. and J. Zetterberg (1991) ‘Insider Effects in Wage Determination: Evidence from Five Countries’, European Economic Review, 35. Inagami, Takeshi (2000) Labor Market Policies in Asian countries: Diversity and Similarity among Singapore, Malaysia, the Republic of Korea and Japan, ILO Employment and Training Papers 34. Koshiro, K. (1983) ‘Development of Collective Bargaining in Postwar Japan’. In Taishiro Sh (ed.), Contemporary Industrial Relations in Japan (University of Wisconsin Press, 1983). Kwon, Huck-ju (2000) East Asian Social Policy in Global Context: The Korean Case. Paper presented at the Conference on Neoliberalism and Institutional Change in East Asia, Bangkok, 12–13 May. Lancaster, Kelvin (1973) ‘The Dynamic Inefficiency of Capitalism’, Journal of Political Economy, 81. Lee, Byoung-Hoon (1997) The Third Tripartite Commission and the Prospects for Its Activities, KOILAF commentary. Lee, Joohee (2004) A Comparative Analysis of Corporatist Policymaking Coordination in Japan and Korea. Paper presented at the IIRA 5th Asian Regional Congress, March. Loriaux, Michel and Meredith Woo-Cumings (1999) Neoliberalism and Institutional Reform in Korea and France. Paper presented for the Conference on Neoliberalism and Institutional Change in East Asia, Bangkok, 12–13 May. Macleod, W.B. and J.M. Malcomson (1993) ‘Investment, Holdups and the Form of Market Contracts’, American Economic Review, 83. Macleod, W.B. and J.M. Malcomson (1988) ‘Reputation and Hierarchy in Dynamic Models of Employment’, Journal of Political Economy, 96(4) (August) 832–54. Malcomson, James M. (1997) ‘Contracts, Hold-Up and Labor Markets’, Journal of Economic Literature, 35 (December) 1916–57.

Juhana Vartiainen 179 Manow, Philip (2000) Wage Coordination and the Welfare State: Germany and Japan Compared, Max-Planck-Institut fur Gesellschaftsforschung, Working Paper 00/7, December. OECD (2000) (Organization for Economic Co-operation and Development), Economic Surveys: Korea (Paris: OECD). Pascha, Werner (1998) On the Relevance of the German Concept of ‘Social Market Economy’ for Korea, Duisburger Arbeitspapiere Ostasienwissenschaften No. 9, GerhardMercator-Universität Duisburg, Institut für Ostasienwissenschaften. Pohjola, Matti, (1996) Tehoton pääoma (Helsinki: WSOY Yrityskirjat). Rhodes, Martin (2000) ‘The Political Economy of Social Pacts: “Competitive Corporatism” and European Welfare Reform’. In Paul Pierson (ed.), The New Politics of the Welfare State (Oxford: Oxford University Press). Sohn, Hochul (1998) Late Blooming of South Korea Labor Movements, KILSP paper, 9 February. Taylor, John B. (1989) Synchronized Wage Determination and Macroeconomic Performance in Japan, MITI/RI Discussion Paper 89-DOF-3, January. Teulings, Coen and Joop Hartog (1998) Corporatism or Competition? (Cambridge: Cambridge University Press). Vartiainen, Juhana (1999) ‘The Economics of Successful State Intervention in Industrial Transformation’. In Meredith Woo-Cumings (ed.), The Developmental State (Ithaca: Cornell University Press). Vartiainen, Juhana (1998) ‘Understanding Swedish Social Democracy’, Oxford Review of Economic Policy 14(1), Spring. Vartiainen, Juhana (1992) Capital Accumulation in a Corporatist Economy (Berlin: Springer-Verlag, 1992). Weathers, Charles (1997) Japan’s Fading Labor Movement, Japan Policy Research Institute (JPRI), Working Paper 35 (July). Weathers, Charles (2003) ‘The Decentralization of Japan’s Wage Setting System in Comparative Perspective’, Industrial Relations Journal, 34(2). Woo-Cumings, Meredith (2000) Ideology and Economic Development in Northeast Asia: Nationalism, Security, and Asian Values. Paper presented at the Conference on Neoliberalism and Institutional Change in East Asia, Bangkok, 12–13 May 2000.

7 Continuity and Change in Welfare State and Production Regimes in Advanced Industrial Societies Evelyne Huber and John D. Stephens

The neoliberal view of the world holds that globalization signifies the triumph of the market and exerts pressures on states to withdraw from regulation and redistribution in economic and social life. Essentially, in order to prosper societies will have to approximate the American model of a liberal market economy and a minimalist – or residual – welfare state. Governments who refuse to accept this model endanger the welfare of their citizens. In this chapter, we provide evidence from an analysis of advanced industrial societies which contradicts this view. We focus primarily on welfare state regimes, but also explore the important linkages of welfare state to production regimes, particularly their labour market components; in other words, we analyse the linkages between institutions that shape social and economic policy. We make the following six arguments: (1) Generous welfare state regimes and coordinated production regimes performed better on indicators of poverty and inequality than residual welfare state regimes and liberal production regimes in the Golden Age of post-Second World War capitalism, and they have continued to do so under the more difficult conditions since the 1970s while performing at least as well in terms of economic growth. (2) For the most part, significant retrenchment in welfare states was a response to rising levels of unemployment. (3) Welfare state regime shifts have been rare, and where they have occurred, they have been associated with increasing poverty and inequality. (4) Overall activity rates are important for the maintenance of generous welfare state regimes, and female labour force participation is one important component of such high activity rates. (5) Globalization, other secular changes, and conjunctural factors have put pressures on coordinated production regimes that have made the successful pursuit of full employment policies more difficult. (6) Different welfare state and production regimes remain differentially able to promote and sustain high labour force participation and thus generous welfare states. We shall first develop our arguments by discussing different types of welfare state and production regimes and their relationships to one another. Then we shall examine their effects on poverty and inequality. Next we turn 180

Evelyne Huber and John D. Stephens 181

to an analysis of welfare state retrenchment, which began in some countries in the late 1970s, spread to most others in the 1980s, and reached the remainder in the 1990s. We discuss its extent, its causes – as well as the causes of differential resilience of welfare state regimes – its linkages to changes in the production regimes, and its consequences for poverty and inequality. In discussing its causes and its linkages to changes in the production regimes, we pay particular attention to the effects of globalization. We then identify the characteristics of welfare state and production regimes that are essential for the maintenance of low rates of poverty and inequality and offer some policy prescriptions. Finally, we pose the question of transferability of welfare state and production regimes, and of the identity of their political carriers. Throughout our analysis, we emphasize the importance of political institutions, power distributions, and choices in constructing and maintaining generous welfare states. We demonstrate that welfare states are politically constructed and reflect the commitments and power bases of incumbents. Room for political choice was clearly greatest in the period of high growth during the first three decades after the Second World War, but even in the more constrained economic environment since the mid-1970s partisan incumbency has continued to matter. Political institutions are important because they shape the degree of power concentration and thus the ease with which the preferences of incumbents can be translated into policy. Power dispersion slowed down the construction of generous welfare states, but it has also slowed down retrenchment. We also show that globalization does not impose a uniform set of policy choices, but has clearly shifted power in favour of capital and away from governments and union movements. On the other hand, generous welfare states have very strong support constituencies beyond the groups that were decisive for their construction, which presents opportunities for incumbents committed to the maintenance of these welfare state regimes to build political coalitions for an adaptation of welfare state and production regimes to the new economic context. We finally pose the question of the relevance of our analysis for East Asia. Of obvious relevance is our conclusion that globalization leaves room for political choice and does not make the neoliberal model the only realistic option, contrary to the prescriptions of the international financial institutions (IFIs). This is true for welfare state programmes proper and also for associated production regimes, especially their labour market aspects. Since welfare state regimes are political creations, the key question becomes how strong political support coalitions for generous welfare state regimes and coordinated production regimes can be formed. Clearly, the central actors in such a support coalition have to be strong political parties and labour movements, but they have to come to an accommodation with employers. Such an accommodation requires considerable capacity for collective action on both sides, that is, both labour and employers have to be able to act authoritatively on behalf of their constituents. The pursuit of the common goal of a

182 Labour

productive and competitive economy, based on strong human capital, opens room for compromises on issues such as wage setting and employment creation. Strong labour movements are more inclined to make concessions on such issues if they can rely on the party in power to promote adequate taxation and expenditures for comprehensive welfare state programmes.

Welfare states and production regimes Our conceptualization of social policy regimes builds on the path-breaking work of Esping-Andersen (1990) who distinguished three worlds of welfare capitalism: a social democratic, a conservative/corporativistic and a liberal world. Though it is difficult to show empirically that advanced industrial countries cluster neatly into these three worlds of welfare capitalism, we find his typology to be a highly useful heuristic explanatory device. We take it as our starting point and introduce the following modifications. First, following Castles and Mitchell (1993), we distinguish an Antipodean type of welfare state called wage earner welfare state (Table 7.1). Secondly, we label Esping-Andersen’s conservative/corporativistic group Christian democratic for two reasons. First, the Christian democratic label is parallel to the liberal and social democratic labels because it refers to the political constellation underlying the construction of these welfare states. More important, EspingAndersen’s label and interpretation suggest that the ‘conservative’ welfare states of continental Europe reinforce inequalities created in the market, which runs counter to our findings. The essential features of the four types of welfare states will become clear in more detail in the course of our discussion, but we begin by characterizing them briefly.1 The social democratic welfare state is comprehensive (offering protection from all kinds of risks), universalistic (covering the entire population with the same kinds of programmes), generous (offering a combination of basic and high earnings-related benefits), service-oriented (providing a wide array of social services), emphasizing active labour market policy, and – at least as of the 1990s – gender-egalitarian (providing benefits to women on their own, not through their husbands, and facilitating the combination of work and family). The Christian democratic welfare state is also comprehensive, but fragmented (having different programmes for different social groups), generous mainly for those connected to the labour market (no or few basic benefits, mainly high earnings-related ones), transfer-oriented (funding but not providing social services), emphasizing passive labour market policy, and gender-inegalitarian (providing benefits to women mainly as wives and mothers, not facilitating the combination of work and family). The liberal welfare state is a residual welfare state, aimed mainly at those who cannot protect themselves through the market. It is partial in its coverage (offering protection from few risks), emphasizes income or needs testing, provides benefits with moderate or low income replacement rates, provides or funds very few

Table 7.1

Welfare state regimes, circa 1980 1

2

3

4

5

6

7

8

9

10

Left Christian Social Transfer Total Public HEW Health Spending Decommodification Support for mothers Cabinet Democratic security payments taxes employment expenditure on non- index (% public) aged employment years Cabinet years expenditure Social Democratic welfare states Sweden Norway Denmark Finland

30 28 25 14

0 1 0 0

31 20 26 17

18 14 17 9

56 53 52 36

20 15 18 9

92 98 85 79

12.7 8.5 11.5 10.5

39 38 38 29

62 43 64 66

Mean

24.3

0.3

23.6

14.5

49.4

15.5

88.5

10.8

36.2

58.8

15 19 22 16 4 30 10

21 21 27 23 25 20 13

19 21 26 17 19 14 13

46 43 53 45 45 33 33

4 6 4 4 7 5 5

69 82 76 79 79 84 68

4.1 10.2 12.6 8.0 7.5 3.4

31 32 32 28 28 24 30

59 34 36 53 36

16.4

21.6

18.4

42.4

5.0

76.7

7.6

29.3

43.6

0 0 0 0

13 19 17 12

10 13 12 11

36 39 40 31

7

5.7 6.8 9.2 4.5

22 23 23 14

35

8 5

75 92 90 42

22 14

0

15.2

11.5

36.5

6.7

74.8

6.6

20.6

23.7

7 10

0 0

11 16

8 10

31

7

62 84

2.8 3.1

13 17

22

0

0

10

10

28

3

71

2.4

27

Christian Democratic welfare states Austria Belgium Netherlands Germany France Italy Switzerland Mean

20 14 8 11 3 3 9 9.6

Liberal welfare states Canada Ireland UK USA Mean

0 3 16 0 4.7

‘Wage earner’ welfare states

Japan

183

Australia New Zealand

184 Labour

services outside of education and basic health services, and is passive in labour market policy and in gender and family policies. The wage earner welfare state is (or was, since it has undergone many changes since the 1980s) a system of social protection based on wages and benefits delivered through the arbitration system. The formal welfare state provided complementary benefits with partial programme coverage only, significant reliance on income testing but with relatively high income limits, moderate to low replacement rates in transfer programmes, few publicly delivered services outside of education and few publicly funded services outside of health and education, and it pursued a passive labour market policy and strongly reinforced the male breadwinner family pattern. We argue that advanced industrial societies also vary systematically in their production regimes. The concept of production regime denotes a configuration of institutions and policies, in a parallel manner to the concept of welfare state regime. The key institutions that make up production regimes are private and public enterprises (industrial and financial), associations of capital interests (business associations and employer organizations) and of labour, along with labour market institutions and governmental agencies involved in economic policy making. The key policies are labour market policy, macroeconomic policy, trade policy, industrial policy, and financial regulation. In Soskice’s (1999) terminology, these institutions constitute national frameworks of incentives and constraints that shape the behaviour of actors and are relatively impervious to short-run political manipulation. Our analysis puts primary emphasis on labour market institutions and policies, but we will also investigate other aspects, particularly financial institutions and policies. As noted, we do not claim that the different groups of welfare state and production regimes constitute sharply distinct categories. Nevertheless, as groups they show systematic differences. Moreover, the characteristics of the welfare state regimes within these groups are associated with characteristics of different types of production regimes in a mutually supportive relationship. The groups themselves vary in their homogeneity. The Nordic social democratic group is the most homogenous and the continental Christian democratic group is the most heterogeneous. These differences in heterogeneity are reinforced if one adds production regimes to the analysis. To take account of internal heterogeneity, we have divided the Christian democratic group into three subgroups. We want to emphasize here that these groupings are based on welfare state types, not on measures of predominance of different political tendencies. The data in Table 7.1 outline the basic differences between the institutional make-up and the policy patterns of the different groups of welfare states.2 Japan does not fit into any group and is being treated as a case apart. The economy is a group coordinated market economy (Soskice 1999) and the welfare state comes closest to a residual model, with very low benefits through the public programmes in pensions and health care. The pillars of the system of social provision are private programmes in the large corporations, from which only

Evelyne Huber and John D. Stephens 185

a minority of the labour force benefits, and the family (Pempel 1997). All data are for 1980 or the closest possible year; thus, they reflect by and large the situation at the end of the Golden Age, as retrenchment had begun in a few cases only. Columns 1 and 2 document the history of political incumbency; the missing non-social democratic, non-Christian democratic category is secular centre and right incumbency, incumbency being measured by share of cabinet seats. The table makes it clear that the Nordic countries have the longest histories of social democratic incumbency and the continental European countries, with the notable exception of France, of Christian democratic incumbency. Actually, Austria had more social democratic participation in government than Finland. Up to the mid-1960s Finland had been governed by an agrarian party, but then a coalition, led by the social democrats and including the communists, came to power, and labour unified its organization and reached a corporatist pact with employers, all of which initiated a process of catch-up to the Nordic neighbours in terms of the construction of a generous social democratic welfare state (Stephens 1996; Huber and Stephens 1998). In Austria, a Grand Coalition between social democrats and Christian democrats governed during the first two decades after the Second World War, when the essential groundwork for the welfare state was constructed on the basis of an essentially conservative/corporatist heritage, and even after that there was no decisive shift in the political power distribution which would have made a major transformation possible. Among the countries with liberal welfare states, only Britain had significant periods of left incumbency, and they did leave their mark, particularly in the form of the national health service, which added some social democratic traits to the welfare state. None of the countries outside of Europe had any Christian democratic participation in government. Comparing the welfare state characteristics across the groups, one is struck by the significantly greater generosity of both the social democratic and Christian democratic welfare states (columns 3–5). If we consider transfers only, the Christian democratic welfare states appear even more generous than the social democratic welfare states. This is mainly a result of the fact that the clientele for transfer benefits, the elderly and the unemployed, was larger in the continental than the Nordic countries, which in turn is related to the labour market orientation of the two types of welfare states. The Christian democratic welfare states used to rely mainly on passive labour market measures; that is, the response to rising unemployment was to reduce the labour supply through measures such as early pensions or easy access to disability pensions. Esping-Andersen’s decommodification index (column 9) is a much better indicator of the generosity of transfer systems; it is a composite measure of the characteristics of three income transfer programmes (pensions, sick pay, and unemployment compensation), composed of various measures of qualifying conditions and benefit duration and income replacements for two categories of workers, a ‘standard production worker’ and those qualifying for only minimum benefits (Esping-Andersen

186 Labour

1990: 49, 54). This index shows the social democratic welfare states to be clearly the most generous. Where social democratic and Christian democratic welfare states differ most sharply is in the public provision of social services. The best indicator for public provision of social services is public health, education, and welfare employment as a percentage of the working age population (column 6). This percentage is on average three times greater in the social democratic than in the Christian democratic welfare states. The low public employment in social services is consistent with the Christian democratic principle of subsidiarity, that is, the principle that the state should only provide what the family or community – with the help of religious institutions – cannot provide (van Kersbergen 1995). When we look at the figures for the share of public health expenditures in total health expenditures, we see that most of the Christian democratic welfare states are heavily involved in financing health care, though not in delivering it. In this group, only Italy had a national health service, established comparatively late, in 1978. Perhaps the most striking figure in this column is the extremely low public share in health expenditures in the United States. The other countries in the liberal group have much higher shares; the high share in Britain, of course, is due to the public health service which was instituted by the Labour government in the early post-Second World War period. The provision of social services outside of health and education is one of the crucial factors that make social democratic welfare states women-friendly, or gender-egalitarian. Other such factors are maternal and parental leave programmes and separate taxation. These social services include, above all, child care, but also elderly care, two types of care services usually provided by women to family members. Availability of these services on a subsidized basis makes it possible for women to combine having a family with doing paid work outside the home. The last column of Table 7.1 provides a further measure of provisions that facilitate the participation of mothers with young children in the labour force. Again, the social democratic welfare states are way above any others on this measure, and, as we shall see, women’s labour force participation is indeed the highest in this group. Spending on transfers to the non-aged as a percentage of gross domestic product (GDP) (column 8) captures financial support for families of working age, but also support for people during periods of education and training or retraining. Thus, it is a partial indicator of investment in human capital and in labour mobilization. As noted above, there is a mutually supportive relationship between welfare state and production regimes. We adopt Soskice’s (1999) terminology, though our conceptualization is wider than his, as we include the relations between labour and employers and a more explicit treatment of the role of the state. Soskice emphasizes employer organization and relationships between companies and financial institutions as defining characteristics of production regimes. He distinguishes three types: (1) coordination at the industry or subindustry level, as in Germany and in most Northern Continental European

Evelyne Huber and John D. Stephens 187

and Nordic economies (industry-coordinated market economies); (2) coordination among groups of companies across industries in Japan and Korea (group coordinated market economies); or (3) absence of coordination in the deregulated systems of the Anglo-American countries (uncoordinated market economies).3 Coordination refers to cooperation in training the labour force, sharing technology, providing export marketing services and advice for research and development (R&D) and for product innovation, setting product standards, and bargaining with employees. High coordination of bargaining with employees, of course, requires a bargaining agent for labour as well, and where the labour movement is strong and centralized, coordination of bargaining often occurs above the industry level. Good indicators of strength are union density and union contract coverage (Table 7.2, columns 1 and 2). Density measures union membership as a percentage of total wage and salary earners, and contract coverage measures the percentage of total wage and salary earners that are covered by negotiated contracts, be it because they work in unionized enterprises or because collective contracts are extended to all workers in a given industry, either legally or by agreement between employers and unions. Union density is by far the highest in the Nordic countries, but the Northern continental European countries and Australia and New Zealand have high contract coverage also, in stark contrast to the Anglo-American countries. Wage bargaining as of 1980 was most centralized in the Nordic coordinated market economies, and most decentralized in the uncoordinated Anglo-American market economies, with the Continental European coordinated market economies in the middle. However, at least in Germany and in Austria, informal coordination of wage bargaining at the national level was prevalent (Traxler 1998; Streeck 1997). The advantage of highly coordinated wage bargaining is that it facilitates wage restraint and thus successful competition in open world markets. Successful competition also requires a high skill level on the part of the labour force. In the coordinated Nordic and Northern European market economies, unions and employers cooperate in labour training, often with additional cooperation from public schools. Unions typically are also involved in organizing working conditions within companies. In contrast, in uncoordinated market economies, there is no general and generally recognized system of labour training. To the extent that there is, it tends to be restricted to craft unions and lacks employer cooperation. Industrial unions are weaker, have no formal role in organizing working conditions within enterprises, and generally have more antagonistic relations to employers than unions in coordinated market economies. Competitiveness in world markets requires not only a highly qualified labour force, but also secure sources of financing. In the coordinated market economies of Europe, this has typically been ensured by close ties between industries and banks as suppliers of preferential sources of long-term credit, or by the state playing a major role in bank ownership and in preferential

188 Labour

credit provision for industry. In uncoordinated market economies, bank–industry ties are weak and industries must rely on competitive markets to raise capital. This dependence on competitive financial markets in turn forces them to orient decisions towards short-term profitability. Strong labour movements in highly open economies and systems of highly coordinated bargaining were generally willing and able to accept wage restraint, in exchange for the mostly implicit governmental commitment to an expansion of the welfare state and the maintenance of full employment. We refer to a mostly implicit commitment, because our comparative-historical research on welfare state formation showed extremely few instances of an explicit bargain between unions, employers, and the government that involved any major welfare state legislation, though social policy and tax adjustment to secure wage restraint occurred frequently (Huber and Stephens 2001). Governmental commitments to the maintenance of full employment were by and large strong in these coordinated market economies, though stronger in the Nordic countries than on the continent, and governments relied on fiscal and monetary policies that depended in part on capital controls in their efforts to promote employment-generating investment. Among the coordinated market economies of Europe, one can draw a further distinction based on the degree of centralization of bargaining and the extent of state involvement in capital and labour markets (Kitschelt et al. 1999). This distinction sets the Nordic countries apart from their Northern continental counterparts. In the former, labour movements and bargaining were centralized at the national level, in the latter bargaining was carried out at the industry level, though in the cases of Germany and Austria, there was coordination at the national level. Furthermore, in the former the state took generally a stronger role in economic management than in the latter.4 Governments in the Nordic countries pursued consistent supply-side policies to stimulate productive investment. Central among these policies were an active labour market policy, regional policies, and industrial policies. Direct subsidies and tax incentives were provided for selected areas and industries, and in addition tax and credit policies favoured productive investment over consumption. Tax policies also heavily promoted reinvestment of profits rather than distribution. The governments also used credit rationing, state supply of cheap credit, and public sector surpluses to keep interest rates low. Though fiscal and monetary policies were generally counter-cyclical – with the exception of Finland, where they tended to be pro-cyclical – fiscal policy across cycles was generally austere, resulting in budget surpluses. The results of expansionary monetary and fiscal policies were in part neutralized through occasional devaluations. Clearly, this entire approach to macroeconomic management was predicated on controls of capital markets. The Austrian production regime shows strong similarities to that of the Nordic countries in terms of union density, contract coverage, and bargaining centralization. In addition, it is similar to Norway’s in terms of the strong

Evelyne Huber and John D. Stephens 189

role of state enterprises and banks. In other aspects, such as monetary, fiscal, and labour market policy, it is closer to the Northern continental European countries. Austria pegged the currency to the German mark in the 1960s already, and it only put into operation an active labour market policy in the 1970s. As column 5 in Table 7.2 demonstrates, as of 1980 its active labour market policy remained similar to that of the other Northern continental production regimes and very underdeveloped compared to that of the Nordic production regimes. On the other hand, Austrian governments also exercised considerable control over capital markets and used this control to stimulate domestic investment. A final crucial aspect of the welfare state/production regime configurations that we need to discuss here is the level of women’s labour force participation and thus of total labour force participation rates. By 1980, the Nordic countries already differed greatly from all others in the extent of women’s labour force participation. Twenty years earlier, only Finland had shown markedly higher female labour force participation than the continental countries. In the 1960s, the two sets of countries took different paths to deal with the emerging labour shortages (Huber and Stephens 2000a). In the Nordic countries, immigration of non-Nordic labour was highly restricted, and women began to enter the labour force in larger numbers. This meant that women became more mobilized and began to articulate demands for women-friendly policies, such as parental leave provisions and public social services, above all day care. They were able to find allies in the social democratic parties and governments, which effected a rapid expansion of the public social service sector. The expansion of this sector in turn created more jobs, jobs that were disproportionately filled by women. In contrast, the continental countries imported foreign labour and persisted in their preference for the male breadwinner model. As a result, they failed to expand their public social service sector. In addition, the strength of unions and the extent of union contract coverage in these countries also prevented the emergence of a dual labour market and of a low-wage private service sector. Thus, women’s labour force participation remained the lowest of our four groups. The growth of a low-wage private service sector facilitated the increase of women’s labour force participation in the liberal welfare state and production regimes (Esping-Andersen 1990). Those women towards the lower end of the skill pyramid found jobs in this sector, and those toward the upper end could purchase the services that made it possible for them to pursue a career while raising a family. Neither the Nordic nor the Northern European continental production regimes, then, developed a low-wage labour market, in contrast to the Anglo-American liberal production regimes. This labour market structure stands in a mutually supportive relationship to the welfare state regime. High wages make it possible to fund generous welfare state benefits, and generous welfare state benefits in turn make it possible for workers and their

190 Labour

families to develop and maintain high skill levels. A high-wage/high-skill labour force in turn makes it possible to compete on world markets with high-quality products, by taking the ‘high road’. This ‘high road’ economic strategy is further supported by coordination among the government, employers, and labour in labour training, R&D, wage setting, and investment promotion. In other words, the structure of the production regime facilitates a high wage/high social wage strategy, which in turn provides the resources for a welfare regime that invests in human capital and labour mobilization.

The impact of welfare state and production regimes on poverty and inequality The different welfare state and production regimes have had a profound impact on levels of poverty and inequality. High union density and contract coverage, and high bargaining centralization result in lower degrees of wage dispersion (Table 7.2, column 4). This means that essentially there is no problem of the working poor, of people with full-time jobs who are nevertheless below the poverty line, in the Nordic and Northern Continental European countries. Since these countries also have generous welfare states, the tax and transfer systems further reduce poverty rates among those who cannot hold full-time jobs, because of sickness, disability, old age, or other reasons. Table 7.3 shows that poverty rates are markedly lower among the working-age population, the elderly, and single mothers – a particularly vulnerable group – in the social democratic and Christian democratic than in the liberal welfare states. The data come from the Luxembourg Income Surveys (LIS); the first dates are as close to 1980 as possible, and the second in the early to mid-1990s. In this initial discussion, we focus on the earlier data and then discuss the trends below. Poverty is defined by an income level of less than 50 per cent of the median income in a given country. Table 7.3 also shows systematically lower poverty rates for all groups in the social democratic than in the Christian democratic group as a whole, though the Northern continental Christian democratic welfare states are closer to the social democratic group than is the group as a whole. Inequality, measured by the Gini index for income distribution, shows the same consistent pattern. The social democratic welfare states have the lowest inequality and the liberal welfare states the highest, Australia the second highest, and the Christian democratic group is between Australia and the social democratic group. Within the Christian democratic group, the Northern continental countries again have lower levels of inequality than France, Italy and Switzerland. Since the Gini index is based on income distribution, it does not capture the redistributive effect of free or subsidized welfare state services. Welfare state services are in general more redistributive than transfers, because the large transfer programmes are typically earnings-related,

Evelyne Huber and John D. Stephens 191 Table 7.2

Labour market regimes, circa 1980 1

2

3

4

5

Bargaining centralization

Wage dispersion1

Active labour market policy spending/ unemployment

95

0.58 0.63 0.59 0.45

2.0 2.0 2.1 2.5

75 26 20 18

84.3

Union Union coverage density (%)

Social Democratic welfare states Sweden 82 Norway 59 Denmark 70 Finland 73 Mean

71.1

83 75

0.56

2.2

35

Christian Democratic welfare states Austria 66 71 Belgium 72 90 Netherlands 38 60 Germany 40 76 France 28 92 Italy 51 Switzerland 35

0.44 0.27 0.35 0.34 0.10 0.22

3.5 2.4 2.5 2.7 3.3 2.6 2.7

8 10 10 10 7 4 23

Mean

77.8

0.29

2.8

10

47.0

Liberal welfare states Canada 31 Ireland 68 UK 48 USA 25

38

0.07

4.0

47 18

0.27 0.07

2.8 4.8

6 9 6 4

Mean

34.3

0.14

3.9

6

‘Wage earner’ welfare states Australia 51 New Zealand 59

43.0

80 67

0.57

2.8 2.9

5 20

Japan

21

0.23

3.0

6

31

Note: 1 Mid-1980s data for Belgium, Netherlands and New Zealand; 1991 for Switzerland.

whereas free or subsidized services are equally available to all and lowerincome groups are more likely to use these services than upper-income groups (Saunders 1991). We saw above that the social democratic welfare states are much more service oriented than any others, which means that they are even more redistributive than Table 7.3 indicates. The reasons for the outstanding performance of the social democratic welfare state and production regimes in reducing both poverty and inequality are multiple. In addition to the low wage dispersion, the low levels of unemployment were favourable for low poverty and inequality in the primary income distribution. The effectiveness of the tax and transfer system in redistributing

192 Labour Table 7.3

Inequality and poverty 1

2

3

4

Post tax transfer Gini

5

6

7

8

% of group in poverty

25–59

Aged

Single mothers

Circa Early to Circa Early to Circa Early to Circa Early to 1980 mid-1990s 1980 mid-1990s 1980 mid-1990s 1980 mid-1990s Social Democratic welfare states Sweden 0.20 0.22 Norway 0.22 0.24 Denmark1 0.26 0.24 Finland1 0.21 0.23

4.8 3.7 4.8 3.0

3.1 3.4 3.7 2.9

0.3 4.7 9.2 3.0

1.9 1.1 4.6 3.4

7.7 12.1 4.5 4.8

2.7 8.4 6.3 3.7

Mean

4.1

3.3

4.3

2.8

7.3

5.3

3.9 5.2 11.5 7.8 15.7

6.0 6.0 3.9 10.0 10.3 8.3 15.2

8.2 3.5 8.8 9.8 6.8

13.3 14.2 6.6 6.0 22.8 17.5 22.4

7.3 16.1 36.4 24.6 38.7

0.22

0.23

Christian Democratic welfare states Austria 0.23 2.3 Belgium1 0.23 0.23 4.4 Netherlands 0.28 0.27 6.7 Germany 0.25 0.30 4.2 France 0.30 0.29 9.5 Italy1 0.31 0.35 10.5 Switzerland 0.32 6.1 Mean

0.27

0.29

6.2

8.8

8.5

7.4

14.7

24.6

0.29

12.3

3.0 6.9 15.4

42.0 15.4 10.8 42.3

31.9

10.9 15.0

9.3 4.9 4.8 21.8

28.1 48.8

Liberal welfare states Canada 0.29 Ireland1 0.33 UK 0.27 USA 0.31

0.35 0.38

10.3 10.9 5.5 11.9

Mean

0.34

9.7

12.7

10.2

8.4

27.6

36.3

‘Wage earner’ welfare states Australia 0.29 0.32

9.3

9.4

5.3

15.3

44.8

29.8

0.30

Note: 1 First date is mid-1980s.

income stems from the combination of basic security and income security components, that is, transfers with flat rate benefits and transfers with earnings related benefits. Korpi and Palme (1998) have shown that this combination, which characterized the Nordic pension system along with most other transfer programmes, is most redistributive. Transfer programmes that lack the basic security component are less redistributive, because those without or with only spotty participation in the labour market fail to qualify for benefits and have to rely on means-tested social assistance. Such social assistance is typically less generous than the basic benefits in universalistic transfer programmes, principally because its political support base is weaker. Nevertheless,

Evelyne Huber and John D. Stephens 193

the generosity of social assistance also varies considerably among welfare state types. In general, it is higher in those welfare states with generous universalistic transfer programmes, if only because the discrepancy between benefit levels would appear much wider than in liberal welfare states with overall low transfer benefits. One category of people for whom minimum benefits are crucial to stay out of poverty is the category of low-skilled unemployed. This applies both to the minimum benefit level in unemployment insurance and in social assistance, as unemployment insurance benefits are limited in duration and the long-term unemployed then have to rely on social assistance. As the data in Table 7.3 show, levels of poverty among single mothers vary widely, not only between, but also within welfare state types. Here we have to insert a note of caution. Typically, the subsamples on which these data are based are rather small, so the margin of error is not insubstantial. Nevertheless, the differences between the welfare state types are large enough to be taken seriously. Certainly, the high labour force participation rate of single mothers, facilitated by the availability of day care and parental leave, is one important reason for the low poverty rate among this group in social democratic welfare states. Generous child allowances are another. These child allowances are the main policy measures that reduce poverty rates among this group in the Northern continental Christian democratic welfare states. Child allowances are also an important policy tool that keeps low income families out of poverty. It is well known, of course, that the welfare state has been under pressure for the past two decades, for reasons that we will discuss in the next section. What we would like to discuss here is the extent of retrenchment that has taken place, and its impact on poverty and inequality.5 Retrenchment has been pervasive, but generally moderate and driven by budget pressures resulting from rising unemployment, not by ideological zeal. Table 7.4 traces the rise in unemployment from the 1970s on. The countries where unemployment rose early (Denmark and the Netherlands) began to cut welfare state benefits in the 1970s, the countries where it rose late (Sweden and Norway) did not institute major cuts until the 1990s. Similarly, the countries where unemployment remained at a high level for extended periods of time (Denmark, Belgium, the Netherlands, Australia, and New Zealand) undertook deeper cuts than the countries where it fell back to more moderate levels. For the most part, these cuts took the form of reducing benefit levels, increasing waiting days for benefits, shortening the periods for which benefits are available, tightening eligibility conditions, raising co-payments for services, and making part or all of the benefits taxable. Rarely was a programme abolished or its character radically altered. The exceptions were cases where a clear consensus had formed that the programme had been widely abused and its original intent perverted, such as the Dutch disability pensions which had become an early retirement programme. Often, the severity of cuts was kept in check by increases in contributions or other taxes designed to fund the programmes. The most typical result of all these cuts was simply to keep welfare

Table 7.4

Unemployment, female labour force participation and dependency rates

1960–73

Female labour force participation

1974–79

1980–89

1990–94

1995–98

1960

1980

50 36 44 66

77 66 74 73

48.9

Ratio of working population to nonworking population

1994

1960

1989

76 71 78 70

0.92 0.67 0.81 0.92

1.11 0.94 1.06 1.01

72.3

73.7

0.83

1.03

52 36 26 49 47 40 51

50 49 40 52 54 40 54

59 54 56 61 59 43 58

0.87 0.64 0.57 0.89 0.76 0.74 1.00

0.78 0.61 0.71 0.81 0.65 0.60 1.10

43.0

48.5

55.6

0.78

0.75

34 35 46 43

60 38 57 62

65 41 65 69

0.53 0.59 0.86 0.61

0.92 0.45 0.88 0.93

Social Democratic welfare states Sweden Norway Denmark Finland

1.9 1.0 1.4 2.0

1.9 1.8 6.0 4.6

2.4 2.7 8.1 5.1

5.2 5.6 10.9 12.3

7.6 4.3 6.3 14.2

Mean

1.6

3.6

4.6

8.5

8.1

Christian Democratic welfare states Austria Belgium Netherlands Germany France Italy Switzerland

1.7 2.2 1.3 0.8 2.0 5.3 0.0

1.6 5.7 5.0 3.4 4.6 6.3 0.4

3.3 11.3 9.7 6.7 9.1 9.3 0.6

3.9 10.7 6.2 7.8 10.6 10.6 2.7

4.1 12.5 5.8 9.0 12.0 12.1 3.9

Mean

1.9

3.9

7.1

7.5

8.5

Canada Ireland UK USA

5.0 5.2 1.9 5.0

7.2 7.6 4.2 7.0

9.3 14.3 9.5 7.6

10.3 14.9 8.4 6.6

9.2 10.5 7.4 5.1

Mean

4.3

6.5

10.2

10.1

8.1

39.3

54.2

60.2

0.65

0.80

Liberal welfare states

‘Wage earner’ welfare states Australia New Zealand

2.0 0.2

5.1 0.8

7.5 4.4

9.6 9.2

8.4 6.6

34 31

53 46

62 63

0.66 0.58

0.86 0.78

Japan

1.3

1.8

2.4

2.3

3.5

60

57

62

0.91

0.99

Grand mean

2.2

4.2

6.9

8.2

7.9

43.3

55.6

61.8

0.80

0.80

Note: Unemployment figures are percentage of the labour force unemployed. Female labour force participation: % of females aged 15–64 in the labour force.

194

Unemployment

Evelyne Huber and John D. Stephens 195

state expenditures from rising further, in the face of a growing clientele. In some cases, though, such as in the Netherlands, expenditures that had greatly increased were brought back down to lower levels. In other cases, such as in Sweden in the late 1990s, benefits were partly restored to previous levels once unemployment came down. The reasons for this general moderation in retrenchment are political. The generous welfare states created large support constituencies, larger than the support constituencies that had been responsible for their original creation (Pierson 1996). Once people expected that welfare state programmes would be in place to enable them to sustain a decent standard of living, they became highly reluctant to give up this expectation. This kept most governments, regardless of their political persuasion, from attempting to pursue radical cuts. Where right-wing governments did seem willing to pay the political price and tried to push through substantial cuts in programmes that affected large numbers of people, unions and opposition parties were typically able to mobilize opposition to such cuts. With the exceptions noted in the next paragraph, deep cuts required a generalized perception of crisis and an agreement among the major political parties and the social partners on the types of changes to be made. Only in three cases can we identify clearly ideologically driven cuts; in Britain under Thatcher, in the United States under Reagan, and in New Zealand under the conservative National government – and only in Britain and New Zealand can we speak of a regime shift. In the United States, the budget pressures did not stem from rising unemployment but rather from Reagan’s large tax cuts. In Britain, Thatcher’s cuts went way beyond what was needed to adjust to higher unemployment levels, and they undermined the universalistic and basic income security features that the British welfare state had inherited from its early post-Second World War period of Labour government. Thus, what we mean by regime shift in this case is that the British welfare state under Thatcher became a purer type of liberal or residual welfare state. In New Zealand, the welfare state was transformed from a wage earner welfare state to a liberal one. Arguably, the transition from a heavily protected to an open economy made the wage earner welfare state model unviable. This model had been predicated on the ability of employers to shift a large part of the costs of the welfare state benefits they were responsible for to consumers behind high tariff walls. Once these walls came down, the structure of the welfare state had to change. However, as the example of Australia demonstrates, which underwent the same transition and suffered if anything even higher unemployment levels, the change did not have to go in the direction of a residual welfare state. The constellation that led to these radical cuts and regime shifts in Britain and New Zealand is the combination of right-wing incumbency, a unitary and parliamentary system of government that provides no veto points, and a single-member district electoral system that makes it possible to obtain a parliamentary majority without a popular majority.

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What is remarkable, then, is the general resilience of the generous welfare states in the face of economic adversity. This resilience is reflected in the figures on poverty and inequality in the 1990s, and their comparison to the figures for 1980. Inequality increased only marginally in the social democratic welfare states and the Christian democratic welfare states, with the exception of Germany. Poverty levels even declined among the working-age population, the elderly, and single mothers in the social democratic welfare states, despite the steep rise in unemployment in the early 1990s. The development of poverty levels in the Christian democratic welfare states is less uniform. In Germany, poverty clearly increased, except among the elderly. In Belgium and the Netherlands poverty declined slightly among the working-age population, and in the Netherlands also among the elderly, whereas it increased somewhat among the elderly in Belgium. Italy showed a considerable increase in poverty among the working-age population but a slight decline among the elderly. The average for the Christian democratic welfare states shows a moderate increase in poverty among the working-age population and a slight decline among the elderly. The average level of poverty among both the working age population and the elderly, though, remained clearly below that of the liberal welfare states. Equally remarkable are the profound effects that the welfare state cuts in Britain and labour market developments in the United States have had on poverty and inequality in these two countries. Britain shows a steep increase in inequality, followed closely by the United States. The increase in Britain was 0.08 in the Gini index, and in the United States 0.07; the next highest increase was 0.05 in Germany – an increase that was at least in part due to the economic crisis in the former East Germany following unification. Poverty increased in Britain among all three groups, and it doubled among the workingage population (Table 7.3). In the United States, only the elderly were spared from an increase in poverty, precisely because social security pensions were not affected by the cuts. Unfortunately, there are no LIS data for New Zealand in the 1990s, but other data show a significant increase in poverty and inequality as well (Easton 1996).

Reasons for welfare state retrenchment and changes in production regimes We have argued that welfare state retrenchment was largely a response to rising levels of unemployment. Of course, there were a variety of other factors that put pressure on various aspects of the welfare state, such as the growth of the aged population on the pension systems. It is obvious that large increases in unemployment put pressure on the welfare state budget; there are fewer people who pay taxes at the same time that the claims for benefits increase, most prominently in unemployment insurance, but often also in the pension schemes for early pensions and disability pensions and in social

Evelyne Huber and John D. Stephens 197

assistance for support for the long-term unemployed. Thus, our search for the reasons of welfare state retrenchment has to focus both on direct effects on the welfare state and on indirect effects via rising unemployment and changes in the production regimes. These reasons are complex, and we can point to three sets of factors: globalization, secular changes in the structure of production and employment, and conjunctural factors. Before we delve into these factors, we should engage an argument frequently made by conservative critics of the welfare state – that the generous welfare states themselves are responsible for generating lower growth and higher unemployment. If this were the case, we would expect to see generally lower levels of growth and higher levels of unemployment in the countries with the more generous welfare states. We show elsewhere that this is not the case for growth rates (Huber and Stephens 2001), and Table 7.4 shows that it is not the case for unemployment rates either. Indeed, the Nordic countries as a group did much better than other countries until the 1990s. Moreover, the early 1990s were the depth of the economic crisis in the Nordic countries, and if the data were extended to the late 1990s, these figures would be clearly lower. Thus, we find no support for this argument at the macro level. For the micro level, there is no conclusive evidence either that taxes and social benefits constitute work disincentives, as a recent comprehensive review of the literature by Atkinson and Mogensen (1993) concludes. As we noted in the beginning, a favourite argument of neoliberals is that globalization, specifically the growth of international trade, has made generous welfare states simply uncompetitive because of excessive wage and non-wage costs. We refute this argument on the grounds that increases in trade in the countries with the most generous welfare states, the Nordic and Northern continental European countries, were only moderate. More important, the welfare states in these countries had been built up in the context of highly open economies, and they had been built with the interests of export sector workers and employers in mind. The successful pursuit of a highskill/high-quality export strategy had made it possible to sustain a high wage and a high social wage. In fact, the export sectors in Sweden and Germany were doing exceptionally well in the mid-1990s, and yet governments in these countries were cutting benefits at the same time (Huber and Stephens 1998; Pierson 2000; Manow and Seils 1998). Thus, we need to look at other components of globalization, namely the growing integration of international financial markets, growing internationalization of production, and increasing importance of international institutions, some of which have had negative effects on employment and the welfare state. The growing integration of financial markets motivated governments gradually to remove controls first on international capital flows and then also on domestic financial markets. This meant that governments could no longer control interest rates and exchange rates at the same time and thus lost room for manoeuvre in fiscal and monetary policy. In particular, fiscal

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stimulation could be very costly, as fiscal deficits are considered risky by financial markets and impose a risk premium on interest rates or put downward pressure on foreign exchange reserves. Financial deregulation also meant that governments lost policy instruments for the preferential allocation of credit and thus for the promotion of investment. In fact, the coordinated market economies where governments had relied on capital controls to promote investment did suffer a decline in gross fixed capital formation from the 1960s through the 1980s. In contrast, the liberal market economies suffered no such decline. Still, a comparison of the absolute levels of gross fixed capital formation shows that they remained higher in the coordinated than the liberal market economies (Huber and Stephens 2001). Financial internationalization also had a detrimental effect on the German system of investment financing, in so far as the ties between banks and enterprises that had guaranteed preferential treatment for the capital needs of these enterprises were weakened (Streeck 1997; Manow and Seils 1998). Internationalization of production had negative effects on the welfare state by shifting the political balance of power rather than by constituting a direct economic constraint on wage and tax levels. If wage and tax levels were decisive for the location of production, then all of German industry would have migrated to Portugal years ago. However, the growth of transnational enterprises heightened the ease with which management can shift production from one location to another and thus the credibility of exit threats by enterprises. As a consequence, capital has gained leverage vis-à-vis unions and governments to demand lower wages and taxes. Similarly, though as we have argued above export competitiveness is not a problem and thus a direct economic constraint forcing a downward adjustment of wages and welfare state benefits in the Nordic and Northern continental European countries, the argument about the danger to export competitiveness has been used rather effectively by the right and capital in political debates to legitimize cutbacks (Swank 1998). The growing importance of international institutions for domestic economic and social policies has been less manifest in advanced industrial than in developing economies. For instance, a comparison of pension reforms in Latin American and advanced industrial societies places into stark relief the importance of the agenda-setting activity of the IFIs in the former in terms of promoting fully private, individual, capitalized accounts, whereas the latter were free to design their own solutions (Huber and Stephens 2000b). Nevertheless, advanced industrial societies have been exposed to pressures also, in the form of persistent attempts on the part of the Organization for Economic Co-operation and Development (OECD) to persuade them to liberalize their labour markets in order to deal with unemployment (OECD 1994). Arguably, the most important international influence on social policy has been that of the European Union (EU) on its member states, but that influence has been rather indirect, operating through the macro economic

Evelyne Huber and John D. Stephens 199

effects of the EU’s monetary integration process (see below). The efforts at social policy harmonization have been aimed mainly at raising the floor rather than pushing down the generous welfare states, but, to date the social charter has largely been a dead letter except in the area of women’s rights in the labour market where EU directives have had a definitive egalitarian effect. Finally, the propagation of a neoliberal view of the world by the IFIs probably did have an intangible, but still rather important impact on the political debate and on the perceptions of many politicians of the kinds of constraints they were working under. Among the secular changes, the overall lower growth rates have certainly presented problems for the welfare state. Average annual Growth of GDP per capita fell from 3.8 per cent in the period 1960–73 to 2.6 per cent in the 1980s. It is politically much easier to couple redistribution with the distribution of a rapidly growing pie than to attempt redistribution in a context of stagnation. In other words, growth eases distributive conflicts. By easing distributive conflicts, as Rowthorn (1995) argues, it also eases inflationary pressures and thus allows the non-accelerating inflation rate of unemployment to stabilize at a lower level. Without attempting to answer the million-dollar question about the causes for lower growth in the last quarter century, we would point to two factors that arguably contributed to it; the decline in gross fixed capital formation mentioned above, and the sectoral shift from manufacturing to services, where presumably productivity increases are slower (Iversen 2000; Pierson 2000; see also Maier 1985). Contrary to what one might expect, however, the lower economic growth rates did not translate into lower rates of employment growth (Glyn 1995: 2). Thus, the advanced industrial economies produced more jobs for every one per cent of GDP growth in the post-1973 period than they had produced in the period 1960–73. The sectoral shift was responsible for this because of the greater labour intensity of services. Whereas the sectoral shift arguably had positive effects on employment creation, it did have other indirect negative effects on the welfare state via challenges to the production regimes. The shift in the sectoral composition of the labour force changed the balance of power within the labour movements and thus made the customary forms of coordination of wage bargaining more difficult to sustain. As union membership in the service sector grew, these unions came to constitute a counterweight to the manufacturing export workers and at times to contest the wage leadership of the latter. Particularly in the Nordic countries, the growth of the service sector was closely linked to the growth of female labour force participation, which added a gender dimension to the division between manufacturing and service sector workers. In addition, most services are in the sheltered sector and thus less directly exposed to the negative employment effects of excessive wage claims. We are not arguing here that sectoral and gender diversifications of the workforce and the union movement were the primary causes of the problems of centralized wage bargaining,

200 Labour

but simply that they were a contributing factor. Another factor was increasing employer interest in flexibility in wage setting at the enterprise level because of greater skill differentiation in manufacturing and the need to attract highly skilled labour. Moreover, in Sweden, where changes in the bargaining system have been most pronounced, the goal of employers to weaken the blue-collar union confederation politically was important (Huber and Stephens 2001: ch. 7). A partial answer for the rise in unemployment is to be found in rising participation rates. In the pre-1973 period the entry of women into the labour force was entirely offset by the exit of men from the labour force. Under full employment the exit of men was essentially voluntary, caused by longer periods spent in education and declining retirement ages. In the more recent period, the exit of men was predominantly forced by rising unemployment. At the same time, women entered the labour force at twice the rate of male exits. However, different countries obviously dealt with this increase in participation rates in very different ways. In the social democratic welfare states, the big increase in women’s labour force participation occurred while these countries maintained close to full employment. Women were absorbed at a fast rate into the expanding public social service sector. Governments presiding over the Christian democratic welfare states chose not to expand that sector and generally also neglected to pursue active labour market policies to train people for available jobs and to support the creation of jobs in the private sector. Turning now to conjunctural factors that have aggravated the unemployment problem and exerted pressures on the welfare state in the 1990s, we can point to the legacy of the debt accumulation in the 1970s, the development of the European Monetary System and then Monetary Union, the collapse of the Soviet Union, German unification, and a variety of policy mistakes, particularly in Sweden and Finland. We call these factors conjunctural to differentiate them from the irreversible secular changes in the economic and demographic structures discussed above. We do not mean to imply that they are simply transitory and will soon lose importance. However, they are more political in nature than the secular changes and can potentially be countered better by political action. In the 1970s, most governments regarded the economic difficulties as a cyclical problem and allowed expenditures to increase much faster than revenue (Huber and Stephens 1998). Though they changed course in the 1980s, they remained saddled by a large public debt which constituted a drain on resources. The combination of fixed exchange rates under the European Monetary System and deregulation of capital flows meant that financial markets and thus de facto the conservative German Bundesbank came to set interest rates for the member countries. In the wake of German unification, which imposed a tremendous financial burden on the country (Czada 1998), the Bundesbank countered wage demands and rising government expenditures with increases in interest rates. These increases were then passed on to

Evelyne Huber and John D. Stephens 201

other European countries. The criteria for fiscal policy contained in the Maastricht Accords further reinforced the pressures for austere macroeconomic policies (Hall 1998; Soskice 2000). The collapse of the Soviet Union and its economy presented considerable problems for countries that had provided a large volume of exports, particularly Finland. Finally, one can point to policy mistakes in Finland, Sweden and, to a lesser extent Norway, that were crucial contributors to the economic crises there. The governments of all three countries deregulated their financial markets in the 1980s, when the economies were strong. A great boom in consumer spending contributed to an overheating of the economy, inflationary wage pressures, and much speculative investment. The governments failed to intervene to slow the economies down, and ultimately the boom ended in a real crash. Property values fell precipitously, which caused bank insolvencies. Consumers’ confidence was badly shaken and they reacted by increasing their savings, which aggravated the recession. In both Sweden and Finland, the governments bailed out the banks, at a cost of 5 per cent and 7 per cent of GDP, respectively. Strong evidence for the importance of these policy mistakes and the cyclical nature of the crisis is the much improved economic performance of these countries in the second half of the 1990s. The wage earner welfare state and production regimes of Australia and New Zealand were special cases and underwent more dramatic changes than those of other countries. The viability of these regimes was predicated on the transfer of revenue from the primary export sector to a highly protected manufacturing sector. When the primary export earnings ceased to be sufficient to allow for adequate growth of manufacturing, the governments were forced to open their economies. Once employers had to compete on open markets, wages and benefits had to be adjusted to levels compatible with successful competition. The result was a transformation of the production regimes in a liberal direction. In addition, large parts of the public sector were marketized and rationalized (Castles et al. 1996; Schwartz 1994a, 1994b, 1998). All of these changes resulted in a significant rise in unemployment and an increased risk for workers of falling into poverty. However, the governments obviously had the capacity to intervene and assume more responsibility for welfare state programmes to mediate the adjustment shocks. The Labour government in Australia chose to do so, compensating those hit hardest with targeted programmes and introducing medical care and supplementary pensions on a universalistic basis. The conservative government in New Zealand, in contrast, not only deregulated the labour market but also made deep cuts in benefits, thus transforming both the production and the welfare state regime into a liberal one.

Future viability of different welfare state regimes The Nordic recovery and the positive unemployment performance of the Netherlands (see below) and Austria, as well as the conjunctural features of

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the European unemployment problem, put the viability of the generous welfare states in a very different light than that cast by the neoliberal critiques of the Northern European welfare states. There is no doubt that the opening of capital markets and the tremendous increase in cross-border capital flows has eliminated some tools which proved effective in stimulating investment, growth, and employment in those countries whose models were predicated on capital controls. Moreover, the new financial environment has made macroeconomic management more difficult for all countries. However, it is clear from the recent experience of the Nordic countries, the Netherlands and Austria that there is still sufficient policy autonomy at the national level for governments to restore budget balance (or even surplus), lower unemployment, raise labour force participation levels, and defend the generous welfare state. Indeed, restoration of previously cut entitlements is now on the agenda and the old partisan differences on welfare state expansion are reappearing, at least in some of these countries. This does not mean that adjustments do not need to be made to the old model to make it successful under the new conditions. It has been argued that the Christian democratic welfare states face the most serious challenge (Esping-Andersen 1999; Huber and Stephens 2001; Scharpf 2000). Most discussions of demographic challenges to the welfare state focus on the old age dependency ratio – that is, the ratio of the aged population to the working-age population. This is a misleading indicator if one is interested in the future viability of the welfare state. A better indicator is the ratio of those supporting the welfare state by working and paying taxes to those not working, including not only the aged but also the young, who are dependent on welfare state services, above all education but also day care and health care, and the nonworking population of working age, the unemployed and those out of the workforce, some of whom collect benefits and all of whom do not pay taxes. As one can see from the last two columns of Table 7.4, the Christian democratic welfare states not only are the lowest by this measure, they also do not display the favourable trends that the other welfare state groups show. From Table 7.4, one can see that the low working to non-working ratio in Christian democratic welfare states is partly a product of the low levels of women’s labour force participation. It is also a product of their response to unemployment, which was to decrease the supply of labour. Older workers were helped into early retirement or provided with disability pensions. For example, in the Netherlands labour force participation among male workers in the age group 60–64 fell from around 70 per cent to 22 per cent between 1973 and 1991 (Hemerijck and Kloosterman 1994). In the social democratic welfare states, in contrast, active labour market policies were used to keep up employment. Thus, in 1994 at the peak of the Nordic crisis, labour force participation among males aged 55–64, was at 64 per cent in the four Nordic countries compared to 42 per cent in five Christian democratic welfare states for which there is comparable data (OECD 1996b: 34).6

Evelyne Huber and John D. Stephens 203

The Netherlands is the one Christian democratic welfare state which has responded aggressively to this crisis. The new Dutch strategy, which can be dated from the Wassenaar agreement of 1982, combined a new approach to collective bargaining and welfare state reforms. After the failure of collective agreements as well as of government-imposed wage restraint in the 1970s, the loss of jobs and of union members finally induced employers and unions to arrive at a bipartite agreement in 1982 that set the precedent of moderation in wage demands in exchange for acceptance of the goal of a reduction in working hours (Hemerijck and van Kersbergen 1997). The revised system of centrally coordinated sectoral bargaining succeeded in delivering wage increases below the level of German wage increases, thus securing a competitive advantage for Dutch industry. The welfare state reforms focused on reducing the social assistance, sickness pay, and, above all, the disability pension systems with the goal of reducing the number of people on transfer payments and moving them back to work. The new legislation contained both disincentives and incentives for both employers and workers to reduce the inflow into the systems and increase active job seeking. Crucial for the reduction in unemployment and the increase in labour force participation rates were clearly the increase in part-time work and the efforts to improve the conditions of part-time work with regards to benefits. The share of parttime work in total employment increased from less than 15 per cent in 1975 to 35 per cent in 1994; 75 per cent of part-time jobs are held by women, which in turn meant a substantial increase in female labour force participation (Hemerijck and van Kersbergen 1997). By the late 1990s unemployment was under 5 per cent, far below the EU average. A first step for the other Christian democratic welfare states would be to follow the Dutch example and give labour market policy a more active profile along Nordic lines, reducing early and disability pensions and increasing women’s employment by increasing part-time work, increasing financial incentives to enter work, decreasing incentives to remain on transfers, and providing job training to match job seekers with available work. While the Dutch example shows that such policies will work, Dutch female labour force participation is still below the average for advanced industrial societies (see Table 7.4) and it would appear that a gradual movement towards the Nordic-style gender egalitarian policies which facilitate combining work and family is necessary. If raising the level of female labour force participation in order to lower the overall dependency ratio would seem to be reason enough for the expansion of women-friendly policies in the Christian democratic welfare states, the effect of such policies on fertility would appear to absolutely clinch the argument for movement in this direction. Fertility is very low in the Christian democratic welfare states, at 1.5 per woman of child-bearing age, and catastrophically low in the Mediterranean countries, at 1.3 per woman of childbearing age.7 This presents these countries with a future demographic time bomb as it will necessarily lead to large proportional increases of the aged

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population dependent on pensions and public health care as succeeding cohorts retire while the cohorts of working age shrink in relative terms. In the not so distant past, female labour force participation was negatively related to fertility, but in current post-industrial societies, this relationship has completely reversed (Esping-Andersen 1999: 68; Rindfuss, Benjamin and Morgan 2000). Apparently, women are entering the labour force regardless and in the absence of supportive policies (as in social democratic welfare states) or private alternatives (as in the liberal welfare states), have fewer or no children as a result (Esping-Andersen 1999: 67–70). We do not mean to say that the Nordic model can go or has gone on unaltered. All of the Nordic countries have strengthened the active profile of their labour market policy and adapted to the new international financial environment by reducing the role of the state in stimulating and/or directing investment, though the state’s role remains large in Norway. There has been some discussion of moving towards the Danish model in the other Nordic countries. The Danish model is singular in two ways, both of which can be seen as an adaptation to the Danish industrial structure, which is heavily weighted towards small and medium-sized business enterprises, and therefore congenial to the growth of the private service sector in which such enterprises are overrepresented. First, payroll taxes are extremely low in Denmark and thus the wage bills faced by employers are correspondingly lower. Denmark makes up for this difference in higher direct and indirect taxes. Second, though the other Nordic countries rate as only moderate on the OECD’s index of job protection, Denmark rates very low; it is very easy to lay off or fire workers. On the other hand, because unemployment benefits are extremely generous, losing one’s job in Denmark does not mean a great loss of income. With regard to employment protection, it is important to note that though the other Nordic countries rate in the middle of the OECD’s measure, extant protection in legislation does not pose a great barrier to enterprises downsizing their workforce. Moreover, though legislation specifies ‘first in, first out’, the companies can negotiate with the union to modify the rule and the unions have proven very flexible in letting the companies retain key personnel. In the Nordic model, employment security is general, not specific to a firm. That is, employment is treated as a right and, in case of layoff, it is the government’s role to place the person in a new job, providing any training and moving expenses and providing high income replacement rates during the unemployment spell. Thus, the layoffs that proved so traumatic recently in Korea would not have the same negative effects in the Nordic countries due to well-developed active labour market policy and the generous unemployment benefits. Moreover, layoffs are particularly traumatic where social protection is tied to employment in a particular enterprise. If it is true that new production methods such as flexible specialization, diversified quality production, and just-in-time production demand more labour force flexibility, then the Nordic model, particularly its Danish variant,

Evelyne Huber and John D. Stephens 205

is better adapted to these new methods than the Japanese or continental European model. At present, movement of the other Nordic countries towards the Danish model is a point of discussion and major actors, the unions and finance ministries (because of budgetary implications of significantly reducing payroll taxes), oppose such moves. More important for the retention of the Nordic model is that there is no serious discussion of the creation of low-wage markets or further cuts in the unemployment insurance systems, as recommended by the OECD in its periodic reports on member countries and in the Jobs Study in any of the Nordic economies, including in Denmark. The problems of liberal welfare states are obvious from Table 7.3: they generate a great deal of poverty and inequality. Moreover, in the most neoliberal of the liberal welfare states, the United States and the United Kingdom, these problems are growing. Of course, the neoliberal view is that although poverty may be an unfortunate by-product of inequality, inequality in itself is not a problem. Indeed, since, in their view, there is a trade off between inequality and growth, depressing inequality is bad policy even for the less fortunate in the long run. What this view ignores is the negative effect of inequality on the skill acquisition of the people at the bottom of the social hierarchy. As we show elsewhere, the skill level as measured by a recent OECD study of literacy levels (OECD/HRDC 1997) at the low end of the skill distribution is markedly lower in the liberal welfare states, particularly the United States (Huber and Stephens 2001). By contrast, the skill level at the lowest end is highest in egalitarian Sweden. These are not isolated cases, there is a strong negative correlation (⫺0.79) between inequality and the literacy level of the least literate. Seen in this light, egalitarianism is a positive investment in human capital, an asset of increasing value in the emerging knowledge and information economy.8 Correspondingly, high levels of inequality and poverty have an economic cost in the form of wasted human capital.

Concluding remarks In sum, while globalization has constrained the policy choice of national states, it does not impose neoliberal social policy on governments and the generous welfare states of Northern Europe remain very competitive in world markets. Moreover, as these governments manage to bring down budget deficits and even turn them into surpluses, they have recovered some options lost during the austerity period. Here we can draw out the implications of our analysis of social policy for policy choices governments do have in a globalized and increasingly information- and knowledge-based economy and therefore its relevance for the advanced economies of East Asia, particularly Korea and Taiwan. First, one should not lose sight of the fact that the main goal of social policy is to provide social protection; to provide income security in illness, periods of unemployment and old age, and to reduce poverty and social

206 Labour

exclusion. From the data in Table 7.3, one can see that both the social democratic welfare state and the Christian democratic welfare state, particularly its Northern European variant, do an excellent job of meeting this goal. Second, the pattern of social policy must be economically viable and in so far as possible make a positive contribution to the economy. As we have shown, the Christian democratic welfare state faces serious current and future economic problems due to the low level of labour force participation and low levels of fertility. The Nordic model which combines support for women’s employment and active labour market measures and incentives to promote high levels of labour force participation is clearly the preferred policy configuration. The Nordic models have strengthened this active profile and reduced work disincentives in the transfer systems over the past decade. While the jury is still out on this question, the other Nordic countries may be well advised to move closer to the Danish model of lower employer payroll taxes, especially for small and medium employers, and labour market flexibility with strong safety nets in order to promote employment in the private service sector. Finally, the optimal social policy pattern ought to promote the development of human capital through spending on health, education, training, active labour market policy and egalitarian social policies. We can also offer some observations about the implications of our analysis of recent changes in the production regimes for the optimal configuration of policies for coordinated market economies in a globalized economy. We limit our remarks to labour market institutions on which we have focused in this essay.9 In the European coordinated market economies (CMEs), employers face unions of moderate to great strength (with the possible exception of France) and in every case, unions are well organized in the critical export sector.10 Employers are also well organized in these economies and this opens up the opportunity for unions and employers to coordinate wage bargaining, either in centralized economy-wide bargaining or in coordinated industry-level bargaining, in order to ensure modest wage increases which maintain competitiveness with a country’s trading partners. Indeed, the periodic economic difficulties which these countries have experienced in the past two decades have most often been caused by external shocks or poor macro economic management which undermined bargaining outcomes or by breakdowns in the coordination of bargaining (Huber and Stephens 2001; Scharpf and Schmidt 2000). The implications of the European experience for East Asia are most obvious in the Korean case, where labour is already well organized and relatively militant. There the development of coordinated industry-level or centralized bargaining would appear to be high on the agenda of economic management. We have underlined that there is a ‘mutually enabling fit’ between production regimes and welfare states regimes, rather than a deterministic relationship. The CME form is compatible with such diverse welfare state regimes as the Nordic egalitarian regime, the clientelistic Italian variant of the Christian democratic regime, the Swiss regime with its combination of liberal and Christian democratic elements, and the Japanese regime of

Evelyne Huber and John D. Stephens 207

company-based welfare and liberal social policy. The choice between these paths is an essentially political one with the strength of unions and the left, the strength of Christian democracy, and the strength of the secular right being the most important determinants of the outcome. In our view, future welfare state trajectories in East Asia are most likely to be determined by politics, not by the supposed economic necessities of global markets. Korea, with its relatively strong unions and current centre-left government, has the greatest potential for developing in a Nordic direction. Despite the contentious relationship since, the recent government social policy concessions to unions are promising steps in that direction.

Notes 1 For a more detailed discussion and characterization, see Huber and Stephens (2001: ch. 4). 2 See appendix for data definitions and sources in all tables. 3 He treats France as a special case, where the state played the leading role in coordinating the production regime. 4 We discuss and document additional production regime characteristics elsewhere; see Huber and Stephens (2001: ch. 4, especially table 4.3). 5 For a more extensive discussion of retrenchment and ample empirical support for the assertions made here, see Huber and Stephens (forthcoming: chapters 6 and 7). 6 The corresponding figures for liberal welfare states is 64 per cent and for the Antipodes 62 per cent. Among the social democratic welfare states, Finland is the exception as only 43 per cent of men of the 55–64 age group are in the labour force. 7 Italy is included along with Spain, Portugal and Greece as Mediterranean countries in the figures and is not included in the figure for Christian democratic countries which otherwise include all of the countries included in that group in our tables. 8 Low levels of inequality did not appear to depress the literacy skill levels of the highly skilled. For instance, the 95th percentile in egalitarian Sweden scored higher than the same percentile in inegalitarian United States (OECD/HRDC 1997: 150). 9 For a more comprehensive review of the macroeconomic and investment policy implications, see Huber and Stephens (2001: Conclusion). 10 France is an exception in that unions’ ability to disrupt production has not depended on high union membership, but rather on the ability of an organized network of militants to mobilize non-members in work stoppages.

References Atkinson, A.B. and Gunnar Viby Mogensen (1993) Welfare and Work Incentives: A North European Perspective (Oxford: Clarendon Press). Atkinson, A.B., Lee Rainwater and Timothy M. Smeeding (1995) Income Distribution in OECD Countries (Paris: OECD). Castles, Francis and Deborah Mitchell (1993) ‘Three Worlds of Welfare Capitalism or Four?’. In Francis G. Castles (ed.), Families of Nations: Public Policy in Western Democracies (Brookfield, VT: Dartmouth).

208 Labour Castles, Francis G., Rolf Gerritsen and Jack Vowles (eds) (1996) The Great Experiment: Labour Parties and Public Policy Transformation in Australia and New Zealand (Sydney: Allen and Unwin). Czada, Roland (1998) ‘Vereinigungskrise und Standortdebatte: Der Beitrag der Wiedervereinigung zur Krise des westdeutschen Modells’, Leviathan, 26 Jahrgang, Heft 1. Easton, Brian (1996) ‘Income Distribution’. In Brian Silverstone, Alan Bullard and Ralph Lattimore (eds), A Study in Economic Reform: The Case of New Zealand (Amsterdam: Elsevier). Esping-Andersen, Gøsta (1999) Social Foundations of Postindustrial Economies (Oxford: Oxford University Press). Esping-Andersen, Gøsta (1990) The Three Worlds of Welfare Capitalism (Princeton: Princeton University Press). Glyn, Andrew (1995) ‘The Assessment: Unemployment and Inequality’, Oxford Review of Economic Policy 11(1), 1–25. Gornick, Janet, Marcia K. Meyers and Katherin E. Ross (1998) ‘Public Policies and the Employment of Mothers: A Cross-National Study’, Social Science Quarterly 79(1) (March), 35–54. Hall, Peter (1998) Organized Market Economies and Unemployment in Europe: Is It Finally Time to Accept the Liberal Orthodoxy? Paper delivered at the Eleventh International Conference of Europeanists, Baltimore, MD, 26–8 February. Hemerijck, Anton C. and Kees van Kersbergen (1997) A Miraculous Model? Explaining the New Politics of the Welfare State in the Netherlands. Mimeo. Hemerijck, Anton C. and Robert C. Kloosterman (1994) The Postindustrial Transition of Welfare Corporatism. Paper delivered at the Conference of Europeanists, Chicago, 31 March–2 April. Huber, Evelyne, Charles Ragin and John D. Stephens (1997) Comparative Welfare States Data Set (Northwestern University and University of North Carolina) (http://www. lis.ceps.lu/compwsp.htm). Huber, Evelyne and John D. Stephens (2001) Development and Crisis of the Welfare State: Parties and Policies in Global Markets (Chicago: University of Chicago Press). Huber, Evelyne and John D. Stephens (2000a) ‘Partisan Governance, Women’s Employment and the Social Democratic Service State’, American Sociological Review ( June). Huber, Evelyne and John D. Stephens (2000b) The Political Economy of Pension Reform: Latin America in Comparative Perspective, Geneva 2000 Occasional Paper No. 7 (Geneva: United Nations Research Institute for Social Development). Huber, Evelyne and John D. Stephens (1998) ‘Internationalization and the Social Democratic Model’, Comparative Political Studies 31(3) (June), 353–97. Iversen, Torben (2000) ‘The Dynamics of Welfare State Expansion: Trade Openness, Deindustrialization and Partisan Politics’. In Paul Pierson (ed.), The New Politics of the Welfare State (Oxford: Oxford University Press). Iversen, Torben (1998) ‘Wage Bargaining, Central Bank Independence and the Real Effects of Money’, International Organization 52(3). Kitschelt, Herbert, Peter Lange, Gary Marks and John D. Stephens (1999) ‘Convergence and Divergence in Advanced Capitalist Democracies’. In Herbert Kitschelt, Peter Lange, Gary Marks and John D. Stephens (eds), Continuity and Change in Contemporary Capitalism (New York: Cambridge University Press). Korpi, Walter and Joakim Palme (1998) ‘The Strategy of Equality and the Paradox of Redistribution’, American Sociological Review 63(5) (October), 661–87. Maier, Charles (1985) ‘Inflation and Stagnation as Politics and History’. In Leon Lindberg and Charles Maier (eds), The Politics of Inflation and Economic Stagnation (Washington: Brookings Institution).

Evelyne Huber and John D. Stephens 209 Manow, Philip and Eric Seils (1999) ‘Adjusting Badly’: The German Welfare State, Structural Change, and the Open Economy. Paper delivered at the conference on The Adjustment of National Employment and Social Policy to Economic Internationalization, Ringberg Castle, Germany, February, pp. 17–20. Mitchell, Deborah (1991) Income Transfers in Ten Welfare States (Brookfield, VT: Avebury). Myles, John, (1997) How to Design a ‘Liberal’ Welfare State: A Comparison of Canada and the United States. Paper prepared for the Conference on Models of Capitalism and Latin American Development, Chapel Hill, University of North Carolina, May. Nickell, Stephen (1997) ‘Unemployment and Labor Market Rigidities: Europe vs. North America’, Journal of Economic Perspectives 11(3), 55–74. OECD (1996a) (Organization for Economic Co-operation and Development), Employment Outlook, July (Paris: OECD). OECD (1996b) OECD Economies at a Glance: Structural Indicators (Paris: OECD). OECD (1994a) New Orientations for Social Policy (Paris: OECD). OECD (1994b) OECD Jobs Study: Evidence and Explanations (Paris: OECD). OECD/HRDC (Human Resources Development Canada) (1997) Literacy Skills for the Knowledge Society: Further Results from the International Adult Literacy Survey (Paris: OECD/HRDC). Pempel, T.J. (1997) Labor Exclusion and Privatized Welfare: Two Keys to Asian Capitalist Development. Paper prepared for the Conference on Models of Capitalism and Latin American Development, May (Chapel Hill: University of North Carolina, May). Pierson, Paul (2000) ‘Post-industrial Pressures on Mature Welfare States’. In Paul Pierson (ed.), The New Politics of the Welfare State (Oxford: Oxford University Press). Pierson, Paul (1996) ‘The New Politics of the Welfare State’, World Politics 48(2), 143–79. Rindfuss, Ronald R., Karen Benjamin and S. Philip Morgan (2000) The Changing Institutional Context of Low Fertility. Mimeo, Carolina Population Center, University of North Carolina. Rowthorn, Robert (1995) ‘Capital Formation and Unemployment’, Oxford Review of Economic Policy 11(1), 29–39. Saunders, Peter (1991) Noncash Income and Relative Poverty in Comparative Perspective: Evidence for the Luxembourg Income Study. Paper delivered at the conference on Comparative Studies of Welfare State Development, Helsinki, 29 August–1 September. Scharpf, Fritz W. (2000) ‘Economic Changes, Vulnerabilities, and Institutional Capabilities’. In Fritz W. Scharpf and Vivien A. Schmidt (eds), Welfare and Work in the Open Economy, Vol. I: From Vulnerability to Competitiveness (Oxford: Oxford University Press). Scharpf Fritz W. and Vivien A. Schmidt (eds) (2000) Welfare and Work in the Open Economy, Volume II: Diverse Responses to Common Challenges in Twelve Countries (Oxford: Oxford University Press). Schwartz, Herman (1998) ‘Social Democracy Going Down or Down Under: Institutions, Internationalized Capital and Indebted States’, Comparative Politics. Schwartz, Herman (1994a) ‘Public Choice Theory and Public Choices: Bureaucrats and State Reorganization in Australia, Denmark, New Zealand, Sweden in the 1980s’, Administration and Society, 26, 48–77. Schwartz, Herman (1994b) ‘Small States in Big Trouble: The Politics of State Organization in Australia, Denmark, New Zealand, and Sweden’, World Politics, 46. Soskice, David (2000) ‘Macroeconomic Analysis and the Political Economy of Unemployment’. In Torben Iversen, Jonas Pontusson, and David Soskice (eds), Unions, Employers and Central Banks: Wage Bargaining and Macroeconomic Regimes in an Integrating Europe (Cambridge: Cambridge University Press). Soskice, David (1999) ‘Divergent Production Regimes: Coordinated and Uncoordinated Market Economies in the 1980s and 1990s’. In Herbert Kitschelt, Peter Lange, Gary

210 Labour Marks and John D. Stephens (eds), Continuity and Change in Contemporary Capitalism (New York: Cambridge University Press). Stephens, John. D. (1996) ‘The Scandinavian Welfare States’. In Gøsta Esping-Andersen (ed.), Welfare States in Transition (London: Sage). Streeck, Wolfgang (1997) ‘German Capitalism: Does it Exist? Can it Survive?’. In Colin Crouch and Wolfgang Streeck (eds), Modern Capitalisms (London: Sage). Swank, Duane (1998) Globalization, Democracy, and the Welfare State: Why Institutions Are So Significant in Shaping the Domestic Response to Internationalization. Political Economy of European Integration Working Paper, University of California Center for German and European Studies-Harvard Center for International Affairs. Traxler, Franz (1998) ‘Austria: Still the Century of Corporatism.’ In Anthony Ferner and Richard Hyman (eds), Changing Industrial Relations in Europe (Oxford: Blackwell). Traxler, Franz (1994) ‘Collective Bargaining: Levels and Coverage’, OECD Employment Outlook ( July), 167–94. UN (United Nations) (1996) World Populations Prospects: The 1996 Revision (Population Division, Department of Economic and Social Affairs of the United Nations Secretariat. van Kersbergen, Kees (1995) Social Capitalism (London: Routledge). Visser, Jelle (1996) Unionization Trends: The OECD Countries Membership File (Amsterdam: University of Amsterdam, Centre for Research of European Societies and Labour Relations–CESAR). Visser, Jelle and Anton Hemerijck (1998) A Dutch Miracle: Job Growth, Welfare Reform and Corporatism in the Netherlands (Amsterdam: Amsterdam University Press).

Appendix: Tables: Data definitions and sources Table 7.1 (1) Left Cabinet: Scored 1 for each year when the left is in government alone, scored as a fraction of the left’s seats in parliament of all governing parties’ seats for coalition governments from 1946 to 1980 (Huber, Ragin and Stephens 1997; hereafter HRSa) (2) Christian Democratic Cabinet: Religious parties’ government share, coded as for left cabinet (HRS) (3) Social security benefit expenditure as a percentage of GDP (HRS, ILOb) (4) Social security transfers as a percentage of GDP (HRS, OECDc) (5) Total taxes as a percentage of GDP (HRS, OECD) (6) Public health, education, and welfare employment as a percentage of the working age population (WEEPd). Canadian figure provided by John Myles on the basis of Statistics Canada data (7) Public health expenditure as a percentage of total health expenditure (HRS, OECD) (8) Spending on the non-aged as a percentage of GDP (OECD 1996b: 107) (9) Decommodification index (Esping-Andersen 1990: 52) (10) Support for mothers’ employment (Gornick et al. 1998)

Evelyne Huber and John D. Stephens 211 Table 7.2 (1) Union density: Union membership as a percentage of total wage and salary earners (HRS, Visser 1996) (2) Union coverage: Union contract coverage as a percentage of total wage and salary earners (Traxler 1994) (3) Bargaining centralization (Iversen 1998) (4) Wage dispersion: 90–10 ratio: The wages of a full time employee at the 90th percentile of the wage distribution as a multiple of one at the 10th percentile (OECD 1996a). (5) Active labour market spending as percentage of GDP divided by the percentage of the labour force unemployed. Calculated according to Nickell (1997) by David Bradley.

Table 7.3 All data in Table 7.3 are from Luxembourg Income Surveys. The calculations were done by David Bradley with household adjustments and other definitions such that the figures are consistent with those in Mitchell (1991), Atkinson et al. (1995), and those periodically updated at the LIS website (http://www.lis.ceps.lu). (1, 2) Gini index for disposable household income (3, 4) Poverty – Age 25–59: Percentage of households in which the household head is between 24 and 60 with disposable incomes below 50 per cent of the average disposable household income (5, 6) Poverty – Aged: Percentage of households in which the household head is over 65 with disposable incomes below 50 per cent of the average disposable household income (7, 8) Poverty – single mothers: Percentage of single mothers with disposable incomes below 50 per cent of the average disposable (post tax and post transfer) household income

Table 7.4 Unemployment: Unemployment as a percentage of the total labour force (OECD, HRS) Female labour force participation: Percentage of women age 15 to 64 in the labour force (HRS, OECD) Ratio of working population to non-working population: employed population/unemployed and inactive population (all ages) (HRS, OECD) a

Data from the Huber, Ragin, and Stephens (1997) data set. Original data source is International Labour Office (ILO). Original data source is OECD. d Data from the Welfare State Exit Entry Project, Science Centre – Berlin. b c

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Part IV Governance of the Private Sector

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8 The Korean Corporate Governance System: Before and After the Crisis Sung Wook Joh

8.1

Introduction

Prior to 1997, people marvelled at the apparent success of Korea’s open, high-growth and moderate inflation economy. In particular, Korea’s large business groups (chaebols) were considered to contribute to high growth, enjoying such competitive advantages as (i) lower transaction costs through an internal capital market and product market;1 (ii) concentration of the country’s limited pool of talented workers; and (iii) consolidated technology, as Leff (1978) and S. Chang and Choi (1988) argued. After the surprising collapse of the Korean economy in 1997, people searched for its causes. There are at least three views on the causes of the Korean economic crisis. One view focuses on external factors, suggesting that the collapse of other economies in the region, such as those of Thailand and Indonesia, triggered a massive flight from the Korean currency market by investors and creditors despite the sound fundamentals of the Korean economy. However, accepting merely external factors as catalysts of the crisis does not explain why investors lost confidence in the Korean economy (but not in others such as Taiwan) and why it was so vulnerable to this loss of investor confidence. Another view emphasizes United States (US) policy makers’ contribution to the crisis. According to this argument, the Korean crisis could have been avoided if the US government had supported the Korean economy by continuing to extend loans to Korean banks. Paul Blustein (2003) describes how the US Treasury department refused the Korean government’s request for help at the onset of the crisis, and pressured the International Monetary Fund (IMF) to get concessions from the Korean government in exchange for assistance. These concessions included opening the Korean financial and commodities market to foreign firms. In this paper, I do not test the validity of this argument. Even if the US policy was hurting the existing Korean firms, opening these markets would benefit Korean consumers and improve the allocation efficiency of domestic resources. 215

216 Governance of the Private Sector

In the third view, internal factors, such as the intertwined structural problems of the financial and corporate sectors, reduced allocation efficiency and contributed to the vulnerability of the economy. The corporate sector relied heavily on debt for financing, reaching an average debt–equity ratio of almost 400 per cent in 1997. High debt alone does not cause a crisis if firms are sufficiently profitable. Joh (2003) showed that Korean firms’ average return on equity fell short of cost for many years before the crisis. Chiu and Joh (2003) showed that more than 20 per cent of firms had incomes smaller than their debt payments and that banks lent more money to these distressed firms than to sound firms. Because of chronic low performance, Korean firms failed to pay its high debt services. These corporate insolvencies in turn severely weakened related firms and financial institutions. Concerned about their investments and loans, foreign investors demanded immediate repayment of short-term loans, and foreign investors sold their Korean stocks. In short, corporate insolvencies provoked a domestic financial crisis and ultimately caused the external liquidity crisis. What caused such low levels of corporate performance? This chapter argues that Korea’s weak corporate governance system is one factor. It facilitated lackluster firm performance by failing to discipline controlling shareholders and managers to maximize firm value. Instead, they often diverted corporate resources to pursue their own private interests. In particular, a poor corporate governance system is considered to be a main cause of the ailing performance of chaebols. Because of their size and importance,2 the failure of these chaebols had a devastating impact on the economy, leading to a series of large-scale bankruptcies of related firms. This chapter documents: (i) the causes of the weak corporate governance system; (ii) its impact on firm performance; (iii) how poor firm performance led to the economic crisis; (iv) government reforms; and (v) preliminary results of those reforms. Repeated government intervention and lack of monitoring by financial institutions further undermined a weak corporate governance system that was limited by legal and institutional constraints. Weak corporate governance lowered overall corporate performance by exacerbating conflicts of interest among shareholders. Joh’s (2003) analysis of financial data and ownership information on more than 5,500 Korean firms during 1993–97 provides evidence of these effects. Low corporate performance, in turn, led to insolvencies and sparked the economic crisis. After the economic crisis, the Korean government instituted reforms to improve the corporate governance system. Analysis of daily stock market data of the 25 largest chaebols during the period 1996–99 shows how the market evaluated recent government polices on corporate governance. In particular, the analysis tests whether the corporate governance system has improved – specifically whether controlling shareholder influence has decreased, and hence their pursuit of private benefits.

Sung Wook Joh 217

8.2

Inadequate corporate governance infrastructure

According to Shleifer and Vishny (1997), corporate governance defines the ways in which the suppliers of finance to corporations are assured of getting a return on their investment in a firm. A firm includes management, capital suppliers (including debt holders, equity holders and their representatives – that is, boards of directors), and other stakeholders such as employees. By defining the firm’s rules, incentives and goals, these parties affect the mechanisms by which capital and resources are allocated, profits are distributed, and performance is monitored. In a corporate governance system that operates for the benefit of all shareholders,3 management pursues maximization of firm value. Korean firms did not. Factors that contributed to weak corporate governance in Korea included: (i) disparity between control and ownership; (ii) inadequate financial information; (iii) ineffective exit threat; and (iv) inadequate financial institution monitoring. 8.2.1

Disparity between control and ownership

The largest shareholder of a Korean firm usually controls and manages it, directly or indirectly – and is henceforth referred to as the controlling shareholder.4 (Even when a hired professional Chief Executive Officer (CEO) manages the firm, his/her decision-making power and scope is limited.5) However, the largest shareholder usually does not hold a majority of shares. Using various methods for gaining and keeping control of a firm, the controlling shareholder can exploit this control–ownership disparity for private gain at the expense of other shareholders. Most Korean firms are under the strong control of its founder and his/her family.6 Shin (1984) and Cho (1990) showed that children of founders inherit stock from their parents so that ownership stays within the family. Direct ownership by controlling family members is lower among public firms and chaebols (see Table 8.1). The average controlling shareholder family owns 14 per Table 8.1

Controlling shareholder ownership (per cent)

Type

Mean

Standard division

Weighted mean

Publicly traded firms Privately held firms Independent firms Business groups 1st–5th chaebols 1st–30th chaebols 1st–70th chaebols

32.46 51.22 52.54

28.13 34.92 32.96

13.82 40.27 43.69

11.64 12.67 27.83

22.14 22.26 32.15

6.19 10.56 24.92

Source: Joh (2003).

218 Governance of the Private Sector Table 8.2

In-group ownership trends of the 30 largest chaebols (percentage)

30 largest chaebols 5 largest chaebols

1989

1990

1991

1992

1993

1994

1995

1996 1997

31.5 35.7

31.7 36.3

33.0 38.4

33.5 38.6

33.1 37.2

33.0 35.0

32.8 n.a.

33.8 n.a.

34.5 36.6

Note: n.a. ⫽ not available. Source: Korea Fair Trade Commission (1999).

cent of public firms (weighted by assets), compared to 40 per cent of private firms. Likewise, it owns less than 25 per cent of chaebol firms (only 6 per cent for the top 5 chaebols!), compared to 44 per cent of independent firms.7 In international comparisons, Korea’s direct ownership by controlling family members is lower than most Asian countries.8,9 Despite low ownership, shareholders can control firms through: (i) crossholdings, (ii) direct participation in management, and (iii) legal constraints on small shareholders. First, cross-holdings or interlocking ownership protected the controlling shareholder from potential outside threats. Although direct circular interlocking ownership (firm A owns firm B, and B owns A) is illegal, more complex forms existed (for example, A owns B, B owns C, C owns A). In the 1990s, the average interlocking institutional ownership exceeded 33 per cent10 (see Table 8.2). Through cross-holdings, a controlling shareholder could prevent institutions from acting independently – even though institutional owners held more than 40 per cent of aggregate shares.11 Similarly, controlling families in chaebol firms retain control through cross-holdings among their subsidiaries.12 Secondly, a shareholder can control a firm by participating directly in executive management. Claessens et al. (1998) showed that 80 per cent of large Korean firms have at least one controlling family member as CEO, chair or vice-chair of the board of directors.13 Thirdly, legal constraints limited small shareholder activity and precluded their representation on the board of directors. Korean laws at the time required at least 5 per cent ownership for a shareholder to exercise most corporate rights. These included demanding a convocation; inspecting accounting books, affairs and company property; filing an injunction; filing a derivative suit; requesting removal of a director and requesting a new liquidation receiver.14 Nearly 97 per cent of shareholders held less than 1 per cent of a firm’s shares,15 so these laws effectively eliminated these shareholders from participating in corporate governance activities. Thus, firms could often ignore minority shareholders’ views with impunity. According to a survey in 1995, over 75 per cent of firms reported that they hardly considered the views of the minority shareholders when selecting a director or an auditor (see Table 8.3). Minority shareholders thus lacked representation on the board of directors as well. Because each board member was elected through separate majority votes, the controlling

Sung Wook Joh 219 Table 8.3 Degree of influence of minority shareholder opinion in selecting directors and auditors (per cent) Type of firm Owner-manager Hired manager

Always

Often

6.2 2.9

6.2 5.7

Sometimes 12.5 14.3

Rarely

Never

31.3 40.0

43.8 37.1

Source: Jun and Kong (1995).

shareholder picked all of them. In practice, they were accountable only to the controlling shareholders, as small shareholders with less than 5 per cent of ownership could not remove them. As minority shareholders had limited representation on the board of directors and few legal rights, a controlling shareholder could exploit the large disparity between control and ownership for private gain. Assume that a shareholder can exercise more control than his/her ownership warranted. If firm resources are diverted for private gain, benefit is roughly proportional to control, while cost is roughly proportional to ownership. Thus, when control exceeds ownership, benefits exceed costs. As the disparity between control and ownership increases, the incentive for diverting firm resources for private gain increases.16 Korean founders and their families control their firms despite low ownership, so they have an incentive to pursue their own private gains rather than maximizing firm value. With few legal rights or protections, minority shareholders could not stop them. 8.2.2

Inadequate financial information

Poor accounting standards, lack of transparency and government-created incentives for firms to exaggerate their size all contributed to inadequate financial information on Korean firms, especially chaebols. First, accounting standards in Korea did not meet accepted international standards. For example, capital losses were not properly reflected in financial statements, and important firm transactions that might significantly increase debt and risk levels were not fully reported. Consider, for example, how chaebols hid their risk level. Chaebol firms often guaranteed the debts of affiliated firms to reduce their loans’ interest rates. Lee (1998) argued that widespread debt payment guarantees allowed chaebol firms to borrow much more money than stand-alone firms, resulting in high debt levels. As shown in Table 8.4, the debt payment guarantees exceeded the level of equity. Moreover, the reported debt payment guarantees sometimes did not include guarantees for money borrowed abroad. Lacking adequate financial information hinders evaluation of firms, thereby skewing both internal firm decisions and outsiders’ decisions. Lack of transparency and proper auditing, especially among chaebols, facilitates the largest shareholder’s control. Reduced transparency hinders criticism and

220 Governance of the Private Sector Table 8.4

Debt payment guarantees of the 30 largest chaebols (trillion won) Amount of debt payment guarantee

Year 1993 1994 1995 1996 1997

Equity (A) Restriction (B) 3.52 4.28 5.07 6.29 7.04

12.06 7.25 4.83 3.52 3.36

No restriction (C) 4.49 3.82 3.38 3.23 3.13

Ratio (%)

Sum (B ⫹ C)

B/A

(B ⫹ C)/A

16.55 11.07 8.21 6.75 6.49

342.4 169.3 95.2 55.9 47.7

469.8 258.1 161.9 107.3 92.2

Source: Fair Trade Commission.

hence, potential challengers. Intra-group chaebol transactions especially reduced transparency.17 In general, a chaebol can arbitrarily price intra-group sales, loans and investments to enhance its overall image or to help a specific firm. The failure of the sale of Daewoo Motors to Ford Motor Company is related to the lack of transparency. Graham (2003) reports that the failure is largely due to the lack of transparency in Daewoo Motors. Ford withdrew its bid to Daewoo as due diligence revealed that Daewoo Motors had more debt and potential liabilities than previously reported. Past Korean governments also provided low-cost capital through banks loans to large firms undertaking large projects and to exporting firms. These loans conferred an important competitive advantage as non-government loans cost 2–9 times more in interest payments during 1960–91 (Cho and Kim 1997). Firms therefore had an incentive to exaggerate their true size and performance. As discussed earlier, chaebols can inflate their size through intra-group investments (cross-holdings). If firm A invests its assets in an affiliated firm B, the sum of the assets of firms A and B exceeds the group’s total assets. Thus, chaebols can increase their apparent size through circular equity investment. As seen in Table 8.5, the 30 largest chaebols’ average equity investment over equity ratio exceeded 20 per cent. Furthermore, if a firm can easily obtain debt financing, it has less incentive to provide financial transparency to attract and retain equity investors. Inadequate financial information hinders evaluation of firms, thereby skewing internal firm decisions as well as external government, investor and bank decisions. Inside the firm, inadequate information hinders management evaluation, obstructing both rewards for good managers and removal of bad managers. Governments awarded large projects to firms based partially on their size and performance. Thus, chaebols that inflated their size and performance had an unfair advantage in government projects. Likewise, investors lacked accurate firm information (profitability, debt, risk level, and so on) to make appropriate investment decisions.

Sung Wook Joh 221 Table 8.5

Equity investment of the 30 largest chaebols (trillion won)

Equity investment (A) Equity (B) Ratio (A/B)

1995

1996

1997

1.13 4.92 23.0

1.36 6.22 21.9

1.69 6.98 24.2

Source: Fair Trade Commission.

Table 8.6

Number of cases and duration of bankruptcy proceedings, 1993–95

⭐ 3 years Successful turnaround, conclusion Failure, termination

4–5 years

6–7 years

8–10 years

11–15 years

16–20 years

Total years

1

1

2

6

7

1

18

17

12

10

8

5

0

52

Source: Court Administration Agency, from Koo (1998).

Inadequate financial information also led to excessive loans by banks. Excessive loans increase the default risks for the borrowing firm, its guarantee provider and the lending bank. When assessing these firms’ risk levels, banks tended to underestimate them, allowing the firms to borrow excessively (Lee 1998). The cascade of bankruptcies during the 1997 crisis exemplified the dangers of excessive default risks. The inability of insolvent borrower firms to pay their debt led to the bankruptcy of certain guarantee providers, which in turn caused the failure of some banks. 8.2.3

Ineffective exit threats

Large Korean firms faced no exit threat due to: (a) lengthy formal insolvency procedures, (b) obstacles to mergers and acquisitions (M&As); and (c) previous government bailouts. Insolvency procedures favoured debtors over creditors. Korea had three formal bankruptcy procedures: liquidation, composition, and corporate reorganization (similar to Chapter 11 of the US bankruptcy code). Often lasting several years, these procedures invited stalling tactics by debtors (see Table 8.6) and were rarely used until 1997. In 1997, over 17,000 cases of insolvency were reported,18 but only 490 were filed in court. Of these, only 38 were liquidations.19 Most of the remaining firms (322 out of 490) applied for composition, available to firms owing less than 250 billion won. During composition, the debtor keeps his/her estate while negotiating with creditors. Composition assigns a minor role to the court and gives creditors few guarantees. The remaining firms applied for corporate reorganization, but their financial conditions often had deteriorated too far to restructure successfully.

222 Governance of the Private Sector

Koo (1998) showed that the average debt–equity ratio of these firms was 1,200 per cent. Government regulations on M&As and chaebol cross-holdings also weakened the exit mechanism. Government regulations only allowed friendly M&As of small firms, and the acquiring firm had to buy over 50 per cent of the target firms’ shares (mandatory tender offer). Also, foreign M&As involving over 2 trillion won in assets required government approval. Lastly, investors cannot purchase more than 10 per cent of a chaebol firm’s shares (chaebol equity investment ceiling). Chaebol cross-holdings also obstructed M&As. To acquire a chaebol-affiliated firm involved in extensive cross-holding, a person must obtain more voting shares than the incumbent controlling owners in each of the interlocking firms. The government also rescued financially distressed Korean firms (especially chaebols) during 1972, 1979–83, and 1984–88. During the debt crisis of 1972, the government froze their debts and provided them with bailout loans.20 During the depression of 1979–83, firms in the heavy and chemical industries sector suffered from insolvency and excess capacity.21 In response, the government gave financial subsidies and consolidated firms to create more concentrated markets. When debt-ridden firms became insolvent during 1984–88,22 the government gave creditor banks special interest rates on loans of between 3 per cent and 6 per cent (the general bank loan rate was about 12 per cent).23 The government also allowed them to write off bad debts, extend debt maturities, and replace existing debt with longer-term debt at a lower rate.24 In short, the government repeatedly rescued large firms in financial distress with packages provided by government-controlled banks. As a result, large-scale bankruptcy was almost nonexistent until the 1997 crisis.25 Why did the government prevent the bankruptcies of large firms (especially chaebols)? A large-firm bankruptcy could trigger additional bankruptcies as its liquidity problems cascade onto its subcontractors and debt-guaranteeing firms. By preventing these bankruptcies, the government avoids massive unemployment and financial instability. Thus, the government became insurers and underwriters, implicitly guaranteeing large firms’ investments and supporting the view that some firms are ‘too big to fail’.26 Lengthy insolvency proceedings, M&A obstacles, and a government safety net sharply reduced the exit threat to Korean firms (especially large chaebols). Insolvency proceedings favouring debtors protected them from creditors. Obstacles to M&As shielded them from other firms with more efficient plans. Finally, the government-controlled banks provided a safety net of financial subsidies. The lack of an effective exit threat in the market removed the incentive to maximize firm performance and resource allocation efficiency. As a result, diverting firm resources for private gain was less likely to force the firm to fail and exit.

Sung Wook Joh 223

8.2.4

Inadequate creditor monitoring

Korean firms rely heavily on debt financing, but financial institutions in Korea have not monitored them adequately. This inadequate monitoring stems from their past control by the government and their links with chaebols. In the 1980s once-nationalized commercial banks were privatized. However, the legacy of government control remained through interest rate regulation, credit policies and government-appointed bank executives.27 As a result, banks did not develop credit evaluation techniques, risk management skills or informed loan analysis processes. The linkage between chaebols and financial institutions created conflicts of interest. In particular, chaebols can pressure their affiliated financial institutions to support weak affiliated firms through unwarranted debt guarantees, loans, or resource transfers. Kim (1999) showed that chaebols controlling non-bank financial institutions had high debt–equity ratios and that chaebolaffiliated institutions had lower returns on assets. Banks did not monitor firms adequately. Chiu and Joh (2003) showed that Korean firms lent more money to financially distressed firms than to sound firms. Rather than rejecting loans for financing unprofitable projects, they supported them. Thus, they did not prevent the wasteful allocation of firm resources. In the same study, Chiu and Joh showed that financially distressed firms with higher borrowing growth rates were also more likely to face financial difficulties in the future. These results suggest that bank lending to financially distressed firms contributed to bank problems. In short, control-ownership disparity, inadequate financial information, ineffective exit threat and inadequate creditor monitoring all contributed to a weak corporate governance system. Thus, this system could not prevent controlling shareholders from pursuing private gain rather than maximizing firm value.

8.3 8.3.1

Weakness of the Korean corporate sector prior to the crisis Historic high debt-equity and low profits

Many have argued that the high debt levels in the Korean corporate sector contributed to the economy’s vulnerability.28 However, the debt–equity ratio was persistently high without any sharp increase in recent years (see Figure 8.1). The data imply that a sudden credit expansion and lending boom did not cause the 1997 crisis. The largest 30 chaebols also had very high debt–equity ratios. The average debt–equity ratio was 347.5 per cent in 1995, 386.5 per cent in 1996 and 519 per cent in 1997, thus consistently exceeding 300 per cent prior to the crisis. In 1997, the ratio was rather extreme because a steep devaluation of the currency during the period inflated the level of foreign debt. Firms with high debt–equity ratios can flourish if they yield high profitability on their equity. So, high debt alone does not necessarily cause a crisis.

224 Governance of the Private Sector 600

500

(%)

400

300

200

100

0 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 year Manufacturing

Figure 8.1

All industries

Debt to equity ratio of Korean firms

However, as Figure 8.2 shows, the average rate of return on equity was lower than its opportunity cost for 30 of the 38 years from 1960 to 1997. Likewise, chaebol profits fell short of interest rates for 12 of the 15 years from 1983 to 1997. As Choi and Chang (1988) showed, chaebols did not outperform other firms during the period 1974–85. In 1972 and from 1979 to 1988, chaebols suffered losses and were bailed out by the Korean government. The accumulation of higher debt and continuing low profitability persisted as the Korean corporate governance system failed to alleviate these problems. Minority shareholders’ rights were weak and the board of directors did not provide internal monitoring. Meanwhile, inadequate financial information, ineffective exit threats, and inadequate financial institution monitoring prevented action by outsiders. Inside the firm, a controlling shareholder’s incentive to pursue private gain (due to the control–ownership disparity) still existed as long as the company still had assets. With strong control by the controlling shareholder and management, the internal monitoring system did not function properly. Opposition by other shareholders or the board of directors was prevented. The former lacked the necessary corporate rights, as they need at least 5 per cent of shares to exercise shareholder rights. Meanwhile, the directors did not have incentives to oppose management decisions as they were usually selected by the controlling shareholders. Outside the firm, inadequate levels of financial information hid the firm’s weaknesses. Even if outsiders recognized its weaknesses and wanted to force the firm to exit, they faced considerable legal constraints. Insolvency procedures favoured the debtor firms over creditors and could last more than

Sung Wook Joh 225 10.0

5.0

0.0

⫺5.0

⫺10.0

⫺15.0

⫺20.0 64

Figure 8.2

67

70

73

76

79

82

85

88

91

94

97

Profitability relative to capital cost

a decade. Likewise, legal constraints forbidding hostile M&As prevented outsiders from taking over the firm to run it more efficiently. Finally, the government itself had intervened (especially for chaebols) to avoid massive unemployment and financial instability. Inadequate financial information, legal constraints, the legacy of government control and interventions all undermined the incentive for financial institutions to monitor firms closely. Furthermore, those financial institutions with links to chaebols faced debilitating conflicts of interest. In short, minority shareholders, the board of directors, financial institutions and potential corporate raiders were too weak to stop the controlling shareholder while the government was unwilling to let large firms fail. Thus, the high levels of debt and low firm profitability continued. 8.3.3

Firm failures

However, the high debt levels and low profitability of Korean firms were unsustainable. In the past, the government was much larger than the failing firms and could bail them out. But in 1997, the magnitude of the corporate failures was too large. Thus, the government had no choice but to let the firms fail. Six of the 30 largest chaebols went bankrupt before the currency crisis, starting with Hanbo in January and Kia (the eighth largest) in July of 1997 (see Table 8.7). These corporate insolvencies in turn severely weakened related firms, causing further bankruptcies. Moreover, the corporate failures caused devastating losses to financial institutions, provoked a domestic financial crisis and ultimately caused the external liquidity crisis.

226 Governance of the Private Sector Table 8.7

Six bankrupt conglomerates among the 30 largest chaebols

Default data Size rank

Hanbo

Sammi

Jinro

KIA

Haitai

New-Core

23 Jan. 14th

19 March 25th

21 April 19th

15 July 8th

1 Nov. 24th

4 Nov. 28th

Note: All defaulted in 1997. Source: Shin and Hahm (1998).

8.4

Reforms after the crisis

After the crisis, the government implemented corporate reforms to prevent a similar crisis from recurring. The government argued that chaebols were a major cause of the crisis and has developed restructuring policies aimed at these firms.29 In January 1998, the government announced five such policies: (i) increasing controlling shareholder accountability; (ii) increasing transparency of corporate management; (iii) concentrating chaebols on their core businesses; (iv) introducing a 200 per cent debt–equity ratio ceiling; and (v) banning debtpayment guarantees. In August 1999, it announced three more policies, aimed at reducing: (vi) equity investments to affiliated firms; (vii) intra-group trading among affiliated firms; and (viii) unlawful bequests and giving. In this section, I review the reforms of the corporate governance system in five areas: (i) reducing the control–ownership disparity; (ii) improving the transparency and accuracy of financial information; (iii) increasing the exit threat; (iv) big deals; and (v) other chaebol-specific reform measures. 8.4.1

Reducing control-ownership disparity

To improve internal corporate governance, the government sought to reduce control–ownership disparity. The government declared that controlling shareholders were de facto directors and held them legally accountable for mismanagement. In addition, the government tried to reduce the scope and degree of controlling shareholders’ power and control by increasing minority shareholders’ rights and boards of directors’ independence and responsibilities. The government has lowered the minimum shareholding requirements for many shareholder rights to encourage greater shareholder activism (see Table 8.8). For example, any shareholder with 0.01 per cent of firm ownership can file a mismanagement derivative suit. Despite the reduced barriers, monitoring and other activities by other shareholders remains costly. For example, an investor who actively monitors his/her firm must bear the monitoring costs alone. However, all the shareholders benefit, including those who do not monitor the firm. Because these activities are public goods, investors are unlikely to perform them unless the benefits are extremely high or unless their ownership is sufficiently large. As a result, unaffiliated financial institutions with extensive information and

Sung Wook Joh 227 Table 8.8 Percentage of firm ownership needed to exercise the following shareholders’ rights (per cent)

Requesting removal of a director Right to injunction Derivative suit Shareholder’s proposal Demand for convocation Inspect account books Inspect affairs and property Requesting a new liquidation receiver

Former commercial code

Amendments

5 5 5 – 5 5 5 5

3 1 1 3 3 3 3 3

Securities and exchange act 0.5 (0.25) 0.5 (0.25) 0.01 1 (0.5) 3 (1.5) 1 (0.5) 3 (1.5) 0.5 (0.25)

Note: Appraisal rights of general shareholders’ meeting convocation and shareholder proposals estimated on the basis of voting stocks. Numbers in parentheses show the smaller percentage of ownership needed to exercise these rights for firms with more than 100 billion won paid-in capital at the end of the most recent business year. Source: Kang (1999).

stockholdings in a Korean firm are the likeliest investors to perform these types of activities. The government also seeks to increase the board of directors’ independence through a cumulative voting system, outside directors, and greater board responsibilities. As each share can vote for only one board member in a cumulative voting system, the likelihood of minority shareholder representation on the board of directors increases. The government also required outside directors to hold at least 25 per cent of the board seats in each publicly traded firm and at least 50 per cent in large firms. In addition, privately held financial institutions are also required to have outside directors. As of October 1998, 752 listed firms had assigned 764 outside directors. The government also strengthened the responsibilities of each firm’s board of directors. For example, intra-group transactions now require the board’s approval. 8.4.2

Transparent and accurate financial information

The Korean government now requires public disclosure of firm information to increase dissemination of information. An electronic public announcement system increases access to this data. Project and auditing reports are already available and all corporate reports will be accessible through the system since 2000. In addition to an electronic system, the government increased auditor independence and accountability. The government also requires firms to provide substantially more information, including semi-annual financial statements, all capital losses, and combined financial statements (group-consolidated financial statements) for chaebol firms starting from the 1999 fiscal year. The new chaebol financial

228 Governance of the Private Sector

statements will clarify intra-group transactions, shares held between affiliates, cross-debt payment guarantees and credit trading. Strengthening the independence and accountability of auditors also increases the credibility and accuracy of financial statements. The government now requires external auditors for all firms with over 7 billion won in assets. For all listed firms, outside directors must participate in the selection of the auditing agency. Furthermore, the government has imposed severe penalties for certified public accountants that accept bribes to falsify data. However, firms are likely to continue accounting fraud to hide past frauds rather than admit them, which would risk lower stock valuation and criminal penalties. For example, some subsidiaries of SK Group (one of the five largest chaebols) were hiding their losses for some time. In early 2003, however, the government arrested and jailed the chairman and controlling shareholder of SK for accounting fraud, showing that it would seriously punish accounting fraud. 8.4.3

Increasing the exit threat

The Korean government has increased the exit threat by (i) improving insolvency procedures; (ii) reducing obstacles to M&As; and (iii) letting large firms fail. The government has amended bankruptcy-related statutes and has created informal procedures to favour creditors more. The 1996 amendments to the Company Reorganization Act and the Composition Act imposed an economic test, a time limit, and a mandatory reduction of shares. To help judge the reorganization’s viability, the economic test compares the liquidated company’s assets with the reorganized company’s going-concern value. The courts must now judge whether the reorganization should proceed within a specific time. Finally, it punishes the existing shareholders of failing firms, especially the largest shareholder, by reducing their capital in the reorganized firm. The 1998 Corporate Restructuring Agreement, signed by all financial institutions, provided informal debt-workout procedures. If debtors can get lender approval for these workouts, they can negotiate term extension, deferred payment and/or reduction of principal and interest. After due diligence, the main bank proposes a restructuring plan. If the creditors representing more than 75 per cent of the firm’s debt agree, it becomes binding on all institutions. If the creditors cannot reach an agreement after two attempts, the case is referred to the Corporate Restructuring Coordination Committee (CRCC), whose decision becomes binding. The CRCC is responsible for arbitrating differences among creditors and modifying workout plans. Compared to formal procedures, informal workouts can be faster, more flexible and less costly. However, the recent performance of firms under workout programmes has been disappointing. Many of them exhibit no performance improvement and yield worse performance than firms under formal bankruptcy procedures.30 The poor performance may be related to the fact that workout programmes can be legally challenged, and thereby rules on evaluation criteria,

Sung Wook Joh 229

loss sharing among creditors and debtors, termination procedures, deviation penalties, and so on, may be difficult to specify. Without such explicit specification, the programme’s preferential financial treatment for firms can deteriorate banks’ assets as around 10 per cent of the outstanding loans are converted into equity.31 Such treatment reduced resource allocation efficiency by exploiting bank assets to sustain failing firms while reducing available credit to other firms. Moreover, it did not necessarily reduce the controlling shareholders’ control of firms. The government also opened up the market for corporate control by reducing obstacles to M&As. By eliminating several M&A regulations, the government allowed purchases of more than 10 per cent of chaebol firms’ shares, hostile M&As, foreign M&As and M&As involving purchases of less than 50 per cent of the target firm’s shares.32 The government also allowed large firms (especially chaebols) to fail and stopped its past practice of guaranteeing their investment. In particular, it allowed the second-largest chaebol, Daewoo, to fail. In addition, 16 of the 64 largest chaebols had entered the debt-workout process as of February 1999. However, the government’s policy after 1999 towards distressed Hyundai, the largest chaebol, raised some doubts about its commitment to end ‘too big to fail’. For example, the government directed financial assistance to Hynix and Hyundai Engineering and Construction, both of which had negative net worth and were losing money. 8.4.4

Big deals

The government publicly and repeatedly urged highly diversified chaebols to concentrate on a few core business areas to reduce excessive capacity and high debt–equity ratios. As its counterpart did during 1979–83, the government proposed business swaps and consolidations among chaebols. To encourage compliance, it announced the following tax advantages for consenting firms: reduced swap-related taxes, deferred capital gains, deferred corporate taxes, and reduced individual taxes. To discourage opposition, the government threatened to cut off the credit of reluctant firms.33 In August 1998, the Ministry of Trade, Industry and Energy identified ten industries with excess capacity that required restructuring. Debt-ridden and desperately needing credit from government-directed banks, the top five chaebols announced their support for the ‘Big Deal’ plan in October and December 1998 for the following eight areas: semiconductor, power generation equipment, petro-chemicals, aircraft manufacturing, railway vehicles, ship engines, oil refining and automobiles. The ‘Big Deal’ suffered from (i) the continuing financial distress of new firms; (ii) continued excess capacity; (iii) collusive behaviour; and (iv) continued reliance on the government. The newly created firms’ finances did not improve without government-directed debt reduction or the injection of new capital. Furthermore, excess capacity remained without cost cutting (for

230 Governance of the Private Sector

example, layoffs and plant closures). Reducing the number of firms in each industry also reduced competition and aided collusive behaviour that hurts consumers. Consider, for example, the big deal between Lucky-Goldstar (LG) Semiconductor and Hyundai Electronics that created Hyundai Electronic Industry (later called Hynix).34 Although Hynix temporarily became the largest dynamic random access memory (DRAM) producer, it suffered from operation losses, heavy debt financing of the big deal, and transfers of funds to Hyundai subsidiaries via intra-group transactions. Rather than letting Hynix fail and ignite another series of economy-wide bankruptcies, a government agency (Korea Development Bank) underwrote nearly 3 trillion won of Hynix bonds in 2001. At best, the ‘Big Deal’ temporarily avoided huge layoffs of workers and mitigated firms’ financial and overcapacity problems at the cost of consumers. At worst, continued government intervention in corporate affairs undermined market mechanisms, continued moral hazards and created larger conglomerates that pose a systemic risk to the Korean economy. 8.4.5

Other chaebol-specific reform measures

The government also implemented two more chaebol-specific policies: a ceiling on debt–equity ratios and reduction of unfair intra-group transactions. The government argued that reducing debt–equity ratios would promote stable growth and required each chaebol firm’s debt–equity ratio to fall below 200 per cent by December 1999. Firms could reduce their debt–equity ratios by selling their assets, issuing new stock or closing failing businesses. In its criticism of the debt-equity ceiling, the Organization for Economic Co-operation and Development (OECD 1999) argued that it did not consider firm profitability and that it could restrain firms with high growth potential. In any case, many firms circumvented this debt–equity ceiling with internal-circular equity financing, which resulted in higher intra-group shareholding. The government also tried to reduce chaebols’ intra-group transactions: debt-payment guarantees, investments, trades, and unlawful bequests and giving. It banned all debt payment guarantees to firms in different industries after December 1998 and banned all debt payment guarantees after March 2000. Furthermore, the Korean Fair Trade Commission (KFTC) required the board of directors’ approval on any intra-group purchase or sale of over 10 per cent of total firm assets (or over 20 billion won). As mentioned earlier in the introduction, Chang and Choi (1988) and Leff (1978) argued that chaebols benefited from internal capital markets and intra-group trading in the early stage. In particular, Williamson (1975) argued that intra-group trades can reduce transaction costs. However, the lower performance of chaebols in the 1990s suggests that some of the chaebols’ potential advantages over independent firms disappeared over time. The government policies on within-group transaction were consistent with the view that it was destroying firm values rather than adding value to the firm.

Sung Wook Joh 231

8.5

Stock market evaluation of corporate restructuring

This section analyses how the stock market evaluates policies regarding corporate governance reform. It is too early to evaluate fully the effects of corporate governance reforms on firm performance. Nevertheless, stock prices provide an initial guide. The rise and fall of stock prices is likely to reflect investor beliefs regarding the reforms. Using a daily movement analysis of stock market return between each chaebol and its affiliated firms for the largest 25 chaebols, Joh (2000b) argues that the largest 5 chaebols still maintain their tight interconnections and act as entities rather than as independent firms. On the other hand, she shows that small chaebols behave more independently than before. In addition to the independence of chaebol-affiliated firms, this study examines whether investors believe that the corporate governance system has improved sufficiently to hinder controlling shareholders’ pursuit of private gains. 8.5.1

Measuring controlling shareholder’s private gains

Because the extent of a controlling shareholder’s private gains is difficult to detect, the proportional voting rights premium (PVRP) is used. PVRP is the difference in common stock price and preferred stock price divided by the preferred stock price. Common stocks have voting rights and lower dividends. In contrast, preferred stocks have no voting rights but receive higher dividends. Thus, when control rights are sought, voting rights become important, and the PVRP increases. It increases during corporate control contests over a firm (for example, M&As). It also increases when a shareholder can reap private gains through control–ownership disparity. Otherwise, the PVRP will be smaller. Due to legal constraints, takeover threats were almost non-existent before the 1997 crisis. Thus, the PVRP before 1997 reflects the size of controlling shareholders’ private benefits. Corporate control contests could have occurred after the government removed all M&A restrictions (May 1998) or when the 200 per cent debt–equity ceiling became effective (December 1999). (As discussed earlier, controlling shareholders in chaebols personally owned only 6 to 25 per cent of total shares.) If a firm offers voting stock to meet the debt–equity ceiling, the controlling shareholders’ ownership level falls and his/her vulnerability to a corporate takeover increases. Between 1998 and 1999 however, chaebols used circular equity investments to remove any corporate takeover threat. As shown in Table 8.9, most chaebols, particularly the largest 5, exploited the circular equity investment technique to increase both cross-holdings and equity levels. Increased crossholdings effectively removed the M&A threat, and the increased equity levels allowed chaebols to meet the debt–equity ceiling. Thus, the PVRP of chaebol stocks could not be attributed to a corporate takeover threat before 1998 when hostile M&As were illegal.

232 Governance of the Private Sector Table 8.9 Intra-group ownership after the 1997 economic crisis (per cent)

30 largest chaebols Controlling shareholders Group-affiliated firms

April 1998

April 1999

44.5 7.9 36.6

50.5 5.4 45.2

Source: Korea Fair Trade Commission (1999).

250.00%

Premium

200.00% 150.00% 100.00% 50.00% 0.00% 960103

960705

970111

970715

980121

980724

990204

990910

Date

Figure 8.3

Voting Rights Premium (1st–25th biggest groups, simple average)

On the other hand, improvements in the corporate governance system can limit abuse on the part of controlling shareholders. With more legal responsibility and greater transparency, controlling shareholders with less power might reduce their pursuit of private gains. In this case, the PVRP would be smaller. 8.5.2

Results

Figure 8.3 shows the PVRP during the four-year period between 1996 and 1999. The PVRP has been very large in Korea with wide fluctuations. Before the crisis began, the average PVRP was around 95 per cent of a common share in 1996. In contrast, the average PVRP in the United States, Sweden, and the United Kingdom are 5.3 per cent, 6.5 per cent, and 13.3 per cent, respectively. The average PVRP in 1999 after restructuring was lower than in 1996, but still around 81 per cent. This result suggests that investors believe controlling shareholders’ private gains are still high, but will become smaller than before the crisis. By extension, the data suggest that the corporate governance system for chaebols has also improved slightly.

Sung Wook Joh 233

8.6

Summary and conclusion

This chapter examines the corporate governance system of Korean chaebols before and after the 1997 economic crisis. Before the crisis, the Korean system relied on individual and hidden relationships. In the past, the governance system depended on very few rules and discretionary decision-making by the controlling shareholders. Such a system might have facilitated coordination of projects with other producers and also collusive relationships with the government. Indeed, it could have been efficient in some earlier stages of development. However, in a larger, more developed economy, without proper monitoring from the markets, the corporate governance system can be inefficient or even subject to abuse. Disparity between control and ownership, inadequate financial information, ineffective exit threats and inadequate financial institution monitoring all contributed to a poor corporate governance system in Korea. As a result, it did not prevent controlling shareholders from diverting firm resources for private gains at the expense of other shareholders. On the aggregate, firms under such a corporate governance system helped produce an overall system failure. Joh (2003) showed that poor corporate governance lowered firm profitability before the crisis. In particular, firms with higher control–ownership disparity (lower ownership concentration or publicly traded firms) showed lower profitability. Chaebol firms also performed worse than did independent firms, in part because they diverted their assets through financial investment to their affiliated firms. Financial investment in affiliated firms reduced profitability, whereas investment in non-affiliated firms increased profitability. Thus, financial investment in affiliated firms is a candidate mechanism by which controlling shareholders divert firm resources for private gain. The low levels of profitability of Korean firms could not support their high debts. The average rate of return on equity was lower than the prevailing loan interest rates for 30 of the 38 years from 1960 to 1997. Undeterred by the weak corporate governance system, firms continued to follow an unsustainable spiral of poor performance and higher debts. Unable to absorb the huge corporate losses, the government let the firms fail. The failing firms’ huge losses triggered a cascade of insolvencies among its subcontractors, debt guaranteeing firms and lenders. Their failures provoked a domestic financial crisis and ultimately caused the external liquidity crisis. To prevent a similar crisis from recurring, the Korean government implemented corporate reforms. Reforms of the corporate governance system include reducing the control–ownership disparity, improving the transparency and accuracy of financial information, increasing the exit threat, and several chaebol-specific reforms. Chaebol-specific reforms included concentration on core businesses, a debt–equity ceiling, and a reduction of within-chaebol transactions. Although it may be too early to evaluate these reform measures,

234 Governance of the Private Sector

these reform measures can improve corporate governance and, eventually, improve corporate performance. However, recent events cast some doubt on the government’s commitment to ending the ‘too big to fail’ doctrine and reducing the systemic risk to the economy caused by large conglomerates. In addition, empirical analysis of stock market data suggests that investors believe that the corporate governance system has improved somewhat. In particular, investors believe that controlling shareholders’ private gains are still high, but are smaller than before the crisis. The 1997 economic crisis introduced a new system to the Korean economy. After a negative growth of gross national income in 1998, the Korean economy has shown positive growth rates while the unemployment rates fell from 7.0 per cent in 1998 to 3.1 per cent in 2002. The macroeconomic performance showed that after the crisis and reform, the economy is again improving. Together, these are optimistic signs for Korea’s economic future.

Notes 1 See Williamson (1975) for more on transaction costs. 2 Chung and Yang (1992) report that the shares of the top 5 and top 30 chaebols in gross national product (GNP) were 9.2 per cent and 16.3 per cent, respectively. According to the Korea Economic Research Institute, the shares of the top four and top 30 were 9.2 per cent and 16.2 per cent, respectively, in 1995. 3 With financial market liberalization and globalization, shareholders’ interests become most important. 4 Shin (1986) and Lim (1989). 5 Seoul National University (1992). 6 It is well known that the largest conglomerates are under the control of founding families. For example, Samsung-affiliated firms are controlled by the family members of the late Lee Byung Chul, Hyundai by the Chungs, LG by the Koos, and SK by the Chois. 7 Direct ownership understates the true ultimate ownership by the controlling shareholders as it does not take into account their stakes in other affiliated firms, which hold shares of the firm. However, as overall controlling shareholders’ ownership in a group is small, it is expected that the differences are also negligible. 8 See La Porta et al. (1998). 9 According to Claessens et al. (1998), Korean firms show the second-lowest ownership concentration, following Japan, among nine Asian countries. 10 According to the Korea Fair Trade Commission (KFTC). 11 Banks (with about 10 per cent of shares) were virtually controlled by the government and hence did not monitor firms independently. Other non-bank financial institutions, including insurance companies, security firms, and investment trust companies, owned more than 10 per cent. Non-financial corporations held around 20 per cent of shares. 12 According to the Fair Trade Commission of Korea, the weighted average ownership of the controlling shareholder and families was 10.3 per cent in 1993, 9.7 per cent in 1994, 10.5 per cent in 1995, 10.3 per cent in 1996 and 8.3 per cent in 1997.

Sung Wook Joh 235 13 The other 20 per cent are likely to be state-controlled enterprises and financial institutions. 14 The minimum ownership requirement for shareholders’ rights has been lowered since 1998. 15 The aggregate individual ownership has been large: 60 per cent in the 1980s and nearly 40 per cent in 1997. Source: Korea Stock Exchange. 16 Jensen and Meckling (1976). 17 Over 60 per cent of firms subject to external auditing report that they have legally affiliated firms. See Joh (2001). 18 Bank of Korea. 19 OECD (1998). 20 The August 1972 government emergency measure to rescue the debt-ridden firms included an immediate moratorium on the payment of all corporate debt to curb lenders and extensive rescheduling of bank loans. All corporate loans from the curb market (which amounted to around 42 per cent of total bank loans) were converted to long-term loans, at a maximum interest rate of 16.2 per cent, while the prevailing curb-market rate was over 40 per cent. About 30 per cent of the short-term high interest bank loans were converted into long-term loans at a reduced interest rate. This conversion was ultimately backed by the Central Bank, which accepted the special debentures issued by commercial banks. Cited from Cho and Kim (1997). 21 These included firms involved in power generating equipment, cars, engines, heavy electric equipment, telephone switching systems, refined copper, and so on. Economic Planning Board (1994). 22 Particularly firms in the overseas construction, shipping and textile, and machinery and lumber industries. 23 The Bank of Korea provided six commercial banks with 1.7 trillion won between December 1985 and May 1987 and recovered only 0.37 trillion won by September 1990. See S. Lee (1995) and Kim (1991). The government revised its tax exemption law to facilitate the insolvency procedure in December 1985. 24 See Cho and Kim (1997) and Kim (1991). In total, acquiring firms and consolidating firms received subsidies worth 7.28 trillion won. Source: Ministry of Finance document submitted to Congress (1988). 25 The collapse of Kukje in 1985 and 1986 was an exception. 26 Chang (1998) argues in favour of government bailouts for failing firms as they encourage the country’s industrialization. Furthermore, he argues that the underregulation by the government caused the 1997 crisis. However, his claim ignores the chronic underperformance of Korean firms and its social costs. 27 Yoo (1997). 28 The average debt–equity ratios for the following countries’ firms were as follows: Korea – 396 per cent, United States – 154 per cent, Japan – 193 per cent, Taiwan – 86 per cent. All figures are based on 1997 data except for Taiwan’s, which are based on 1996 data. Source: Financial Statement Analysis for 1997. 29 See Yoo (1998, 1999) for more discussion on chaebol reform and restructuring. 30 Joon Kim (2000). 31 OECD (1999). 32 The government removed the 50 per cent restriction in February 1998 and removed all the other listed restrictions in May 1998. 33 The Wall Street Journal (8 October 1998) reported, ‘Korea threatens to halt credit to five chaebol after talks stall.’ The Maeil Economic Daily also reported that the

236 Governance of the Private Sector government wanted banks to cut off new loans and even call back old loans from the top five chaebols if corporate restructuring was not satisfactory. 34 LG Semiconductor decided to yield its business to Hyundai Electronics on 7 January 1999. LG was reportedly under pressure from the government to yield its business. See Maeil Business Newspaper (7 January 1999).

References Blustein, Paul (2003) The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF (New York: Public Affairs). Chang, Ha Joon (1998) ‘Korea: The Misunderstood Crisis’, World Development 26. Chang, Sea Jin and Jaebum Hong (1998) Economic Performance of the Korean Business Groups: Intra-Group Resource Sharing and Internal Business Transaction. Mimeo, Korea University. Chiu, Ming Ming and Sung Wook Joh (2003) Bank Loans to Distressed Firms: Cronyism, Bank Governance and Korea’s 1997 Economic Crisis. Working Paper, Centre for Economic Institutions, Hitotsubashi University. Chung, Byong Hyou and Young Shik Yang (1992) Korean Chaebols (Seoul: Korea Development Institute). Cho, Dong Sung (1990) A Study of Korean Chaebols (Seoul: Maeil Economic Daily). Cho, Yoon Je and Joon Kyung Kim (1997) Credit Policies and the Industrialization of Korea (Seoul: Korea Development Institute). Claessens, Joseph, P.H. Fan and Larry Lang (1998) Ownership Structure and Corporate Performance in East Asia. Mimeo, World Bank. Graham, Edward (2003) Reforming Korea’s Industrial Conglomerates (Washington, DC: Institute for International Economics). Jensen, Michael and William Meckling (1976) ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure’, Journal of Financial Economics, 3, 305–60. Jun, In Woo and Byeong Ho Kong (1995) Corporate Governance in Korea (Seoul: Korea Economic Research Institute). Joh, Sung Wook (2003) ‘Corporate Governance and Firm Profitability: Evidence from Korea before the Crisis’, Journal of Financial Economics, 68(2), 287–322. Joh, Sung Wook (2001a), ‘The Korean Corporate Sector: Crisis and Reform’. In Y. Kwon and W. Shepherd (eds), Korea’s Economic Prospects: From Financial Crisis to Prosperity (Cheltenham, UK: Edward Elgar), pp. 116–32. Joh, Sung Wook (2000), ‘Stock Market Evaluation of the Chaebol’s Corporate Governance Reform’, Korea Development Institute Forum, 152. Jones, Leroy and SaKong Il (1980), ‘Government Business, and Enterpreneurship in Economic Development: The Korean Case’, Studies in the Modernization of the Republic of Korea: 1945–1975 (Cambridge: Harvard University Press). Kang, Myung Hun (1999) Minority Shareholders’ Rights in Korea (Seoul: Korea Development Institute). Kim, Chung-Yum (1997) ‘Policymaking on the Front Lines: Memoirs of a Korean Practitioner, 1945–1979’, Jung-Ang Daily Press. Kim, Joon Kyung (1999) ‘Chaebols’ Ownership of NBFIs and Related Problems’, KDI Economic Outlook, 1/4 quarter, 83–94. Koo, Bonchun (1998) Reform Measures for Korean Bankruptcy Reorganization and Composition (Seoul: Korea Development Institute). La Porta, Rafael, Florencio Lopez-De-Silanes and Andrei Shleifer (1998) Corporate Ownership Around the World, NBER Working Paper No. 6625.

Sung Wook Joh 237 Lee, Byong Ki (1998) Debt Payment Guarantees of Korean Chaebols (Seoul: Korea Economic Research Institute). Shin, Inseok and Joon-Ho Hahm (1998) The Korean Crisis – Causes and Resolution, KDI Working Paper No. 9805. Shin, Yoo Keun (1984) Characteristics of Korean Firms and the Challenges Facing Them (Seoul: Seoul National University Press). Scharfstein, David and Jeremy Stein (1998) The Dark Side of Internal Capital Markets II: Evidence from Diversified Conglomerates, NBER Working Paper No. 6352. Scharfstein, David and Jeremy Stein (1996) The Dark Side of Internal Capital Markets: Divisional Rent Seeking and Inefficient Investment, NBER Working Paper No. 5969. Stein, Jeremy (1997) ‘Internal Capital Markets and the Competition for Corporate Resources’, The Journal of Finance, 52(1), 111–33. Williamson, Oliver (1975) Markets and Hierarchies: Analysis and Antitrust Implications (New York: Free Press). Yoo, Seong Min (1999) Corporate Restructuring in Korea: Policy Issues Before and During the Crisis (Seoul: Korea Development Institute). Yoo, Seong Min (1997) Evolution of Government–Business Interface in Korea: Progress to Date and Reform Agenda Ahead (Seoul: Korea Development Institute).

9 Institutionalizing Creative Destruction: Predictable and Transparent Bankruptcy Law in the Wake of the East Asian Financial Crisis Bruce G. Carruthers and Terence C. Halliday

Indeed, ‘creative destruction,’ as Joseph Schumpeter put it, is often an important element of renewal in a dynamic market economy, but an efficient bankruptcy statute is required to aid in this process: (Alan Greenspan, 1998) After the collapse of Enron, WorldCom and the associated corporate scandals in the United States, it is useful to reflect on how vigorously the system of American corporate governance was proffered as the cure for post-crisis Asian ‘crony capitalism’. Legal predictability and financial transparency were the stolid Anglo-Saxon virtues that were supposed to help resolve the problems that culminated in the East Asian financial crisis of 1997. The crisis unleashed a flurry of interest in financial architecture and institutional re-engineering not only because it created a political opportunity for change, but also because it seemed that East Asian developmentalism had gotten its comeuppance. Now, however, former Treasury Secretary Lawrence Summers’ dramatic claim that: ‘the single most important innovation shaping that market [the American capital market] was the idea of generally accepted accounting principles. The transparency implicit in the generally accepted accounting principles (GAAP) promotes efficient market responses to change, and it supports stability’ (Summers 2000: 10) seems faintly ridiculous. The ability of Enron management to undermine and corrupt the independence of their auditors, the thenprestigious but now defunct accounting firm Arthur Andersen, revealed the gaps in GAAP and showed how transparency could be turned into opacity (Demski 2003). Yet, just as it was a mistake to dismiss East Asian developmentalism after the 1997 crisis, it would also be an error to overreact to Enron-like developments. Whether or not they are best achieved specifically through GAAP and common law, the issues of predictability and transparency remain central to the 238

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effective operation of capitalist economies. The Asian Financial Crisis provides a rare opportunity to develop theoretical arguments and challenge assumptions about the necessity for predictability and transparency in market economies. Many influential western analysts and policy makers believed that financial transparency and legal predictability were key to resolving the crisis. In his testimony before Congress, Federal Reserve Board Chairman Alan Greenspan noted that: ‘Here a major improvement in transparency, including both accounting and public disclosure, is essential’ (Greenspan, 30 January 1998). With some benefit of hindsight, Lawrence Summers affirmed the significance of transparency: ‘And the most important thing that the international community can do in achieving this goal [prevention of financial crises] is to promote transparency’ (Summers 2000: 10). A World Bank document spelled out the case for transparency: ‘Policymakers, investors, financial markets, and market discipline all depend on timely, accurate information on financial institutions, firms, and the macroeconomy . . . At the firm level, supervisors and regulators need to ensure that corporations and financial institutions publish timely, accurate information in line with generally accepted accounting standards’ (World Bank 2000: 38). Given that lack of transparency was part of the problem, enhancing it became part of the solution. During the crisis, the World Bank stated that: ‘A main element of such reforms is to introduce truly transparent accounting and auditing systems, consistent with international best practice’ (World Bank 1998: 126). Two years later, the Bank was still pushing transparency: ‘Enhancing transparency through more stringent disclosure requirements – based on international accounting and auditing standards – will be essential to strengthen investor protection’ (World Bank 2000: 83). The same chorus also sang the virtues of predictable law: ‘Predictability results primarily from laws and regulations that are clear, known in advance, and uniformly and effectively enforced’ (Asian Development Bank [ADB] 1998: 17). The focus on predictable law was part of a larger set of claims about the importance of the rule of law (Davis and Trebilcock 1999, Dezalay and Garth 2002, Jayasuriya 1999). While the idea of the rule of law obviously has strong political implications, in the market context it ostensibly curtails the kind of favoritism and patronage known as ‘crony capitalism’ (Flynn 1999: 32–6). Furthermore, it prohibits predatory actions on the part of the state, or the kind of arbitrary interventions that are associated with patrimonial rule. As the General Secretary of the World Bank put it: ‘establishment of the rule of law attracts private investment to the extent that it creates a climate of stability and predictability, where business risks may be rationally assessed, property rights protected and contractual obligations honoured’ (Shihata 1995: 360). The legal system is particularly fateful for the development of capital markets (La Porta et al. 1997), and one of its key foundations is an independent judiciary (Clark 1999: 37, Shihata 1995: 361). According to this analysis, insufficient transparency and predictability make it hard for investors and other market actors to evaluate their alternatives and

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choose the best one, to execute a course of action once chosen, or to pursue legal remedies if their choices do not bear fruit. ‘Generally [in developing countries], a borrower’s operational, financial and investment activities are not transparent to creditors; substantial uncertainty exists with respect to the substance and practical application of contract law, insolvency law and corporate governance rules’ (Group of Thirty 2000: 18). The emphasis placed by the IMF and World Bank on transparency and predictability as the cure for what ailed East Asia unintentionally echoed Max Weber’s analysis of the role of rational capital accounting and predictable law in the historical development of capitalism in western Europe (Weber 1978). But the IMF argument looks like an inadvertent caricature of Weber, done without reference to his work and lacking Weber’s characteristic subtlety. And it is based on an implicit historical narrative about how market society emerged and operates in the west, a kind of crude Occidentalism that over-generalizes from AngloAmerican capitalism (Riesenhuber 2001: 113). Convictions about the necessity of predictability and transparency didn’t arise out of thin air, nor from purely theoretical arguments about how to organize an economy (and certainly not from a careful reading of Weber). They were part of a larger practical and theoretical focus on the role of institutions in market economies,1 and derived from a stylized and even monolithic summary of the western experience. They ignored the variety of capitalisms (Dore 2000; Hall and Soskice 2001), and were expressed as what the consultants called ‘international best practice’. In this chapter, we will discuss how these convictions played out in three of the crisis countries, and what these experiences imply for the ‘exportability’ of predictability and transparency. Despite much talk in policy circles about the importance of the ‘rule of law’, calculable law is not a necessary precondition for market transactions, even in advanced capitalist societies. Sometimes business people forgo predictable law because they don’t need it. Under certain circumstances, people are able to provide functional substitutes for law, and given the choice will opt for the substitutes and avoid the law. Similarly, many claims about the superiority of western accounting methods are overblown and as the Enron case (and countless income and profit ‘restatements’) demonstrated, accounting figures that appear to be precise measures of economic fact are in reality more akin to numerical rhetoric (Carruthers and Espeland 1991; Lev 2003). We will orient our discussion by focusing on the particular case of corporate bankruptcy law in three East Asian countries. As a mechanism for the enforcement of creditors’ rights, and as a process which necessarily involves the quantitative measurement of assets and liabilities, bankruptcy law poses issues of both legal predictability and financial transparency. Bankruptcy law is also a basic part of the commercial legal framework for market economies. Indeed, standard arguments favouring capitalism over socialism stress the central role played by bankruptcy law in weeding out inefficient firms and putting their assets into more capable hands. During the transition from socialism to

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capitalism, bankruptcy law hardens budget constraints and ensures efficient markets by supporting a neo-Darwinian process of economic selection among firms. Scholars have also come to understand the important role that bankruptcy law can play in corporate governance. Whether restructuring occurs in a bankruptcy court, or in the ‘shadow of the law’, the substantive and procedural rules set out by the law constitute a distinctive arena in which various questions about the allocation of corporate assets and liabilities can be posed, contested, and resolved. The political attention now given to the reform of bankruptcy law also mirrors the more general concern with institutions and markets. The world has witnessed several waves of legal reform, including Eastern Europe and Central Asia starting in the early 1990s,2 East Asia in the late 1990s, and numerous OECD countries over the past two decades.3 In Eastern Europe and Central Asia, new laws were put in place as part of a massive institutional transformation that ostensibly turned socialism into capitalism and established the ‘rule of law’. Reformers devised bankruptcy laws against the backdrop of a legal tabula rasa, and in countries with a weak judicial system and virtually no legal profession. By contrast, in OECD countries like Britain, the United States and France, laws were updated to reflect new models of insolvency and in response to domestic political imperatives to bolster employment and protect jobs (Carruthers and Halliday 1998; Carruthers, Babb and Halliday 2001). Furthermore, the direction of legal change was shaped by entrenched legal professions working out of long-standing common law and civil legal traditions. In East Asia, legal reform came in the wake of a severe financial crisis, and was propelled forward by international financial institutions like the International Monetary Fund and World Bank. The impetus for change came less from within countries than from externally based organizations attaching legal strings to bailout loans. Nor was reform part of a fundamental transformation of the entire political economy. But in both East Asia and Eastern Europe, reformers (whether domestic or not) borrowed heavily from a limited set of foreign legal paradigms (usually British, American or German law). In this chapter, we discuss recent legal reforms in East Asia, recognizing their connection to prior experiences with legal reform. Thanks to Eastern Europe, international financial organizations like the IMF were attuned to the importance of bankruptcy law, and more willing to focus on it in setting the terms of its bailout loans. Thus, the lessons of Eastern Europe helped shape the conditions for the response to the Asian crisis (World Bank Interview #1). But IMF prescriptions contained a heavy dose of what Stiglitz terms ‘market fundamentalism’ (Stiglitz 2002: 36). Furthermore, legal reform in East Asia was often justified using ‘rule of law’ rhetoric that stressed the importance of transparent, predictable law for the operation of capitalism, an argument with deep roots in social science (Kamarul and Tomasic 1999; Weber 1981). For efficient markets to operate and for market actors to behave rationally, so the argument goes, capitalists need a certain level of certainty, predictability, and knowledge.

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The institutional models proffered to embody transparency and predictability came from the USA and Europe, and were labelled as ‘international best practices’. The creation of more predictability and transparency called on the abilities of the legal and accounting professions (and could uncharitably be considered ‘public works’ projects for lawyers and accountants). In order to understand how these models have migrated to Asia, and their potential effects, we shall also briefly consider how they operated in their context of origin. While most commentators have stressed the role played by bankruptcy law in creating efficient markets, efficiency is not the only outcome that results from such a law, nor is it even the most politically consequential. As an institution, bankruptcy law raises many distributional questions as well (Knight 1992; Pagano and Volpin 2001: 514–15). While market efficiency is a ‘motherhood’ issue (who isn’t in favour of greater efficiency?), the distributional consequences are often at the heart of political contention over bankruptcy law. Many constituents have an economic stake in the survival of an insolvent corporation, including creditors, suppliers, customers, employees, shareholders, as well as the communities in which the corporation operates. But only some of these constituents have standing in a bankruptcy court. Thus, the social consequences of corporate insolvency outside of formal bankruptcy law are represented very selectively inside the law. Typically, from among the entire set of corporate stakeholders, only shareholders, creditors, and management get a voice in the formal proceedings. This means that non-bankruptcy institutions frequently have to deal with the consequences of bankruptcy (e.g., social safety nets help to ameliorate the consequences of job-loss for the employees of an insolvent firm that has been liquidated). Other constituents (lawyers, accountants, judges) have a greater interest in the process of bankruptcy than its outcome. Furthermore, insolvency by a balance-sheet definition literally means that a firm’s total liabilities exceed its total assets. This means that not all claimants on a firm can be fully satisfied, and so in a straight liquidation the burden of the financial shortfall has to be shared. Since more money for one claimant means less for the others, the distributional problem is zero-sum. Bankruptcy laws usually resolve the problem by rank-ordering claimants into different classes, giving higher priority creditors access to the assets before those with lower priority, but distributing assets on a proportional basis within classes (Jackson and Kronman 1979). Finally, bankruptcy law necessarily deals with the issues of who should own or control the assets of insolvent firms.

How bankruptcy law works An effective bankruptcy law plays a key role in the governance and restructuring of troubled firms. In general, it offers a number of legal alternatives for the insolvent corporation and its creditors. These options can be arrayed along a continuum with straight liquidation at one end to reorganization at

Bruce G. Carruthers and Terence C. Halliday 243

the other, although in both cases the assets and liabilities of the debtor have to be determined and valued. At the first extreme, the bankrupt firm gets terminated as a going concern. Its assets are liquidated and the proceeds are used to repay creditors. The other alternative restructures the firm so as to save it. Unprofitable subdivisions get sold off, loans are renegotiated, and in general the asset and liability side of the corporate balance sheet are altered so that the firm can perform profitably again. As noted in Carruthers and Halliday (1998; see also EBRD 1999: 160; Flaschen and DeSieno 1992), how much weight to put on one or the other of these two possibilities, is one of the key choices faced by the architects of bankruptcy law. But whichever alternative occurs, the effect is to intervene using the law in the affairs of poorly performing firms and either shut them down, or transform their operations and their financial relationships with creditors, shareholders and employees. Liquidation stops a money-losing operation from losing even more money, and allows creditors to be repaid some proportion of the money owed them by the debtor. But it also means that the insolvent firm ceases operation as a going concern, and frequently results in the loss of jobs for the employees, the loss of a customer for suppliers, and the loss of a supplier for customers. In the short run at least, liquidation leads to higher unemployment and lower levels of economic activity, although it also means a better payoff for highly-ranked creditors. If markets operate efficiently, in the long run the human and productive assets used by the insolvent firm will be redeployed to serve other firms. Reorganization, on the other hand, holds the creditors at bay and preserves the insolvent firm via a restructuring. An insolvent firm has too few assets and too many liabilities, and so saving it usually requires making changes on both sides of the balance sheet. Consider the debtor firm’s liabilities or costs. It may have delinquent loans payable to banks, outstanding trade credit owed to suppliers, and a wage bill owed to its employees. To become profitable again, the firm will have to lower its costs, which means some combination of lower interest rates on its debts, lower payments for its supplies, and lower labour costs. Thus, for a reorganization to succeed, lenders, suppliers and workers will have to reduce the magnitude of their claims. Collectively, they benefit from the survival of the firm and so have an interest in helping the reorganization to succeed, but individually they have an interest in seeing that other parties bear as much of the financial burden as possible. Workers, for example, would rather see loans get rescheduled rather than wages reduced. As compared to liquidations, successful reorganizations can result in the short run in lower unemployment and higher levels of economic activity. But this often comes at the direct expense of secured creditors, whose renegotiated loans typically are stretched out over longer repayment periods and at a lower interest rate, or who may have to exchange debt for equity and become part-owners. Reorganizations are better for workers and managers (they get to keep their jobs), better for suppliers (they retain a customer),

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advantageous for shareholders (since their shares retain some value), and better for the communities in which firms are based (the local economy stays buoyant). Today, most bankruptcy laws allow for both outcomes, although laws differ in the emphasis they place on one versus the other. Through its procedural and substantive provisions, the law can facilitate reorganizations (a ‘debtorfriendly’ law) or ensure swift and thorough liquidations (a ‘creditor-friendly’ law). Historically, liquidation was the default option. The law offered a framework for the orderly liquidation of insolvent firms and payment of creditors. Corporate reorganization through bankruptcy law was not recognized as a viable alternative. But more recently, bankruptcy laws have offered rehabilitative options to help troubled firms before their financial decline became irreversible (Wood 1995b: 109). The shift from liquidation to reorganization is one way for governments to ameliorate the consequences of market competition. Looking cross-nationally, bankruptcy laws can be arrayed from the ‘hardest’ (which protect as much as possible the property rights of creditors, and so only allow liquidations) to the ‘softest’ or most liberal (which encourage reorganizations as much as possible, even at the expense of creditors, see Wood 1995a: 96).4 Hard laws enshrine the most rigorous selective pressure within markets, and punish inefficient firms with quick extermination. Soft laws entail weaker selective criteria, and give the inefficient another chance at survival (Chapter 11 in the US Bankruptcy Code makes American law relatively ‘soft’). Whether the law is hard or soft, bankruptcy experts have always assumed that creditors are interested in maximizing their recovery of funds from insolvent debtors (an assumption that proved problematic in the Asian case). Although liquidations and reorganizations are both distributional undertakings, economic groups are not indifferent between them. Generally speaking, secured creditors do best in a liquidation, since their collateralized loans give them high priority and consequently first crack at the debtor’s assets. Unsecured creditors (who have no collateral) frequently get very little, shareholders receive nothing, and the firm’s employees simply lose their jobs. A reorganization, in contrast, resembles a calculated gamble. If the debtor firm recovers, then creditors get their money back, shareholders retain their wealth, and employees keep their jobs. The upside benefits all. But if the firm fails again, the burden of the additional loss normally falls on the secured creditors, since it is their money which gets depleted during the unsuccessful reorganization attempt. In a sense, the reorganizing firm is gambling with the secured creditors’ money. Thus, secured creditors generally prefer liquidations over reorganizations, while groups like employees, managers and shareholders prefer reorganizations over liquidations. In its simplest and traditional version, bankruptcy law enshrined hard budget constraints, liquidating unsuccessful firms and distributing their assets to creditors. It functioned as a debt-collection device which had the added virtue of pushing inefficient firms out of the market. More recent laws have

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created the possibility of legally-governed reorganizations which try to save a troubled firm. In ‘softening’ hard budget constraints, newer laws recognize the great social and political cost of liquidation, but unlike the more direct forms of government intervention in the marketplace that also address these social costs (e.g., nationalization, protective regulation, subsidies, loans, bailouts, etc.), rehabilitative bankruptcy laws stay more firmly within a neoliberal policy regime. The chances of firm survival are increased without additional public spending or direct public responsibility for corporate affairs. The modification of bankruptcy law therefore represents an unusual opportunity for governments to shape national markets. Bankruptcy law is a broad instrument in that its provisions influence insolvencies throughout the economy, not just in a specific industry, region, or sector. Such laws usually only differentiate between individuals, corporations, and financial institutions (the latter are often excluded from bankruptcy law). But if bankruptcy law encourages reorganizations rather than liquidations, it can address political concerns to maintain employment and bolster economic growth (Wood 1995b: 110). It can reduce or redistribute market-based risks and help manage economic insecurities without relying on direct public spending or intervention (Moss 2002: 125, 150; Garrett 1998: 7). The risks of reorganization are borne disproportionately by secured creditors, usually the biggest and most sophisticated lending institutions. If a reorganized firm fails again, secured creditors lose their money. This trade-off complicates the politics of a bankruptcy law that strongly favours reorganizations, particularly when a substantial proportion of the investment comes from overseas lenders. Overly ‘soft’ bankruptcy laws bring domestic political benefits, but at the cost of making foreign investors unhappy. But too much obvious appeasement of foreign lenders can offend nationalist sensibilities, especially if it means liquidating domestic firms in order repay loans to foreigners, or transferring ownership of productive assets to foreigners. Furthermore, systemic corporate insolvency can threaten the entire banking sector, and if domestic secured creditors are hit too hard the government may have to step in with a costly ‘bailout’. In such instances, the public may have to shoulder some of the cost of corporate failure. Politicians, employees, shareholders and creditors are not the only ones with an interest in the insolvency system. Those who ‘operate’ the system also have a stake in its substantive and procedural provisions. The valuation, liquidation or reorganization of a large corporation requires a substantial amount of professional labour and expertise. Lawyers and accountants, to name the two most relevant professions, can earn a lot of money in bankruptcy, and they play a key role in making an insolvency system function properly. Professional interests in establishing or defending jurisdictional claims over bankruptcy work can also shape the trajectory of reform (and did so in the cases of the 1978 Bankruptcy Act in the USA, and the British Insolvency Act of 1986, see Carruthers and Halliday 1998).

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Bankruptcy reform in East Asia Bankruptcy law was identified as an important component of East Asian structural reform (Lane et al. 1999: 18, 71). One prominent commentator stated that all countries: ‘must have transparent and efficient insolvency codes’ (Eichengreen 1999: 21). Both the IMF and the World Bank issued reports discussing the centrality of bankruptcy laws and insolvency systems at a high level of generality (International Monetary Fund 1999; Johnson 1999). The Asian Development Bank has pursued programmes in legal reform, recognizing the role of law in economic development (ADB 1999, see also OECD 2000). Indeed, in the wake of the crisis of 1997 many fingers have been pointed at many culprits, including ‘crony capitalism’, an over-leveraged corporate sector, a weak financial sector, premature financial liberalization, over-exposure to short-term foreign capital, and a lack of transparency and accountability. But the finger was also pointed firmly at bankruptcy law: ‘Another factor contributing to the severity of the crisis was the absence in most Asian countries of adequate bankruptcy and insolvency procedures and independent judiciaries’ (Eichengreen 1999: 164).5 In his testimony before Congress on the Asian crisis, Alan Greenspan underscored the need for an effective bankruptcy system (Greenspan 1999, 1998). Diagnoses of the significance of bankruptcy law were given operational effect as both the Indonesian and Thai governments undertook to reform their bankruptcy laws as one of the conditions for their IMF bailout loans (Government of Indonesia 1998; Government of Thailand 1999; Lindgren et al. 1999: 47). And the Korean government also agreed to review and streamline its bankruptcy procedures (Government of Korea 1997). The Asian crisis put bankruptcy law squarely on the political agenda in these countries. This new policy focus on bankruptcy law raises a number of questions. First, how was bankruptcy law used in East Asian before the crisis? What changes to bankruptcy law were engineered in response to the crisis? And what political forces propelled the reform process forward? Is this simply a case of external financial institutions doing their own version of ‘cramdown’, forcing change onto weakened Asian economies? And will legal change beget substantial transformation in corporate governance, or function as legal ‘window dressing-cum-institutionalized myth’ (Meyer and Rowan 1977)? We do not propose to address these questions for East Asia generally, for the political and economic patterns vary too much from one country to the next, and given the recent nature of events the analyses are necessarily provisional. But we shall focus on Indonesia, Thailand, and South Korea, and use these cases to shed some light on legal reform in East Asia.

Bankruptcy law and the crisis A combination of many different factors helped to engender the crisis of 1997–98. Behind some of these, but by no means all, lurked the ineffectual,

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underutilized and sometimes obsolete insolvency systems of East Asian countries. The factors can roughly be grouped into proximate and background, with the latter ‘setting the stage’ for the former. According to many analysts, by 1996–97 the corporate and financial sectors in many East Asian countries had become highly vulnerable, and while in a weakened state had the misfortune to experience an exogenous shock that soon spread throughout the entire region. The national financial system was one background factor. A nation’s financial system functions to mobilize capital and redeploy it for investment. Money is taken from savers and investors and given to corporate and individual borrowers. Generally speaking, financial systems can be distinguished between those dominated by banks, e.g., France and Germany, and those dominated by markets, e.g., the UK and the USA (Demirgüç-Kunt and Levine 1999: 2). In the former, banks or similar financial institutions perform the work of intermediation: gathering capital from savers and lending it out to borrowers. In the latter, stock and bond markets function to mobilize and deploy capital (Zysman 1983). Many East Asian economies possessed bank-dominated financial systems, including Japan, South Korea, Indonesia, and Thailand (World Bank 1998: 34). These played a central role in developmentalist policies as they gave to the state the instruments needed to direct investment to favoured industries and promote economic growth (Woo 1991; Loriaux 1997). The result was a highly successful form of export-oriented developmentalism that from the 1970s through the mid-1990s produced rapid economic growth. But it also led to a highly-leveraged corporate sector, with uncommonly high debt-to-equity ratios. The more leveraged a firm, the more vulnerable it is to high interest rates or to liquidity crises. Capital raised through equity gives to the firm the ability to reduce dividends if the firm experiences trouble, but capital raised through bank loans grants no such flexibility. Debt is a fixed cost which a borrowing firm is contractually obliged to repay. Yet debt offers an important advantage as a way to raise capital: the owners of a firm need not dilute their control. By borrowing rather than issuing stock, owners remain unchallenged, no small matter in countries where family firms dominate the economy (IMF 2000: 12; Iskander et al. 1999).6 Banks typically ration credit. Under the usual condition of asymmetric information in credit markets, borrowers know more about their own creditworthiness than do lenders. When that is true, banks do not lend money to all those who wish to borrow it, even at very high rates of interest. It is their job to investigate borrowers diligently (by gathering information) and lend only to those who are creditworthy. When a debtor fails to repay, banks may invoke bankruptcy law to reclaim their money, forcing a corporate debtor into liquidation or reorganization depending on whether the firm’s liquidation value is greater or less than its value as a going concern. An effective insolvency system allows creditors to exercise their rights in a predictable manner, and encourages the legal alternative (liquidation or reorganization) that maximizes economic value.

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In many East Asian countries, this seemingly straightforward task was complicated by four additional features: regulatory failure in the context of financial liberalization; poor credit assessment on the part of banks; explicit or implicit government guarantees (creating a moral hazard problem); and government directives to channel loans to corporations on non-economic grounds. Together, these features created a corporate sector–financial sector nexus that was vulnerable to rapid changes in investor expectations and sudden reversals in the market. Financial liberalization in the late 1980s and early 1990s opened many East Asian financial markets to foreign capital (Wade 2000: 88; Warr 1999: 634). Global capital flows grew enormously during the 1990s, increasing five-fold between 1990 and 1997 (World Bank 1998: 4). Much of this money flowed into Asia, attracted by a combination of political stability, high rates of economic growth, and orthodox macroeconomic policy. Some 60 per cent of all shortterm capital flows to developing countries went to East Asia. The inflow of private capital created something of a credit boom. Whether the money was loaned directly to East Asian firms, or was intermediated by East Asian banks (Hawkins and Turner 1999: 10), the rapid expansion of credit led to overborrowing and increasing asset prices, particularly in real estate (which commonly served as collateral for bank loans). This inflow of short-term capital rather overwhelmed the capacity of existing regulatory and supervisory systems. Before, national governments directed much of the lending done by domestic East Asian banks, offering implicit guarantees to bail them out should loans go sour. Many loans went to corporations that were deemed ‘too big’ or ‘too politically connected’ to fail. Once opened up to the world of global capital flows, however, financial markets became a good deal more unpredictable. Capital requirements for banks, loan classification criteria, and credit assessment methods all proved to be rather inadequate. Banks were undercapitalized, they made inadequate provision for loan losses or non-performing loans, and they tended to emphasize collateral (usually real estate, which in the mid-1990s possessed inflated value) or political considerations rather than future cash flows in assessing the creditworthiness of a borrower (ADB 1999: 22; Kim 1999: 146; Lindgren et al. 1999: 11, 14; Thai Banker Interview #1; World Bank 1998: 16, 34–5). Consequently, banks made many loans that did not make economic sense strictly from the standpoint of the bank’s own portfolio. When the real estate market collapsed, the value of collateral fell and creditors could not recover their money. Banks were rather reluctant creditors when their debtors could not repay their loans.7 Rather than declare the loan in default and aggressively pursue the debtor’s assets, banks often preferred to overlook loan delinquency, roll over debts, and remain optimistic that things would work out in the end, papering over their losses while hoping for a turnaround. Explicitly declaring a loan to have non-performing status forced banks to make provision for loan losses (by setting aside reserves), which ate into their inadequate capital base and

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was a public admission that the bank had made a mistake. Furthermore, many banks failed to diversify their loan portfolios adequately. To paraphrase Keynes, when a debtor has borrowed a million won and cannot repay the bank, the debtor is in trouble. But if the debtor has borrowed a trillion won and cannot repay, then the bank is in trouble. Banks refrained from pushing their borrowers into insolvency for fear that the banks would be dragged down too. Banks also recognized that the courts were not a very effectual means for debt recovery. Pre-existing law moved very, very slowly and with unpredictable results, and it could be years before a creditor saw any money (ADB 1999: 12; Hawkins 1999: 217). There may also have been cultural factors at work in that the status of being a ‘bankrupt’ bore a special stigma (OECD 2000). This made debtors disinclined to go into bankruptcy voluntarily, and also made creditors reluctant to ‘shame’ a debtor so publicly. Finally, banks often made loans that were not at ‘arm’s length’. For example, a family bank might lend money to other firms in the same business group. If so, it made no sense to force an insolvent debtor into court. Once the crisis began, money was pulled out of the whole region almost as fast as it had flowed in. Net private capital flows into Malaysia, the Philippines, Indonesia, Korea and Thailand went from $97.1 billion (US) in 1996 to negative $11.9 billion in 1997, which put enormous pressure on East Asian economies (World Bank 1998: 10). Investor worries took on a self-fulfilling quality as the stampede to withdraw money engendered the very circumstances that made it rational to divest. These common factors created common vulnerabilities, but, of course, the progression of the crisis, as well as the response, varied from one country to the next. To understand how bankruptcy law figured into both the crisis and its resolution, we now turn to specific countries. We begin with Thailand, if only because the crisis started there first and then later spread elsewhere. Crisis in Thailand Thailand had enjoyed high rates of growth before the crisis, with an average annual growth rate in GDP of 8.7 per cent in the period 1987–97. It had also significantly liberalized its financial markets in the early 1990s (Alba, Hernandez and Klingebiel 1999: 18–20). In general, the crisis was triggered by a dramatic slowdown in export growth and a widening current account deficit in 1995–96 (Warr 1999: 642), and more specifically by severe financial problems among a large number of finance companies in the spring of 1997. These finance companies operated somewhat like banks, but were more loosely regulated and poorly capitalized. Furthermore, they were disproportionately overexposed to the property sector of the economy, which threatened their loans and collateral when the real estate bubble burst (Lindgren et al. 1999: 94; Alba, Hernandez and Klingebiel 1999: 31). Despite the discreet efforts of the Bank of Thailand during the first half of 1997, numerous finance companies experienced liquidity problems and had

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to be suspended. Fearing a run, the government guaranteed depositors’ funds in the surviving finance companies (before the crisis, neither Thailand nor Indonesia had a formal deposit insurance system). Pressure built up against the national currency, the baht, which was floated on 2 July 1997 and immediately depreciated by 20 per cent. Since many Thai companies and financial institutions had short-term foreign currency-denominated liabilities, they were caught in a squeeze between liabilities that grew and assets (loans and the real estate that secured them) that shrank. In early August, the operations of a further 42 finance companies were suspended. The Bank of Thailand exhausted its foreign currency reserves trying to defend the baht and so the country turned to the IMF for help. Part of Thailand’s problem was directly political: public measures announced to counter the crisis were stymied from within the government by those who, for example, opposed the closure of politically-connected finance companies. As MacIntyre (1999: 153, 2003: 43–4) points out, Thailand’s combination of a parliamentary system and weak political parties made decisive action hard to achieve.8 As in other crisis-affected countries, the IMF program went beyond the traditional package of macroeconomic measures to include policies aimed at structural reform (Lane et al. 1999: 1). The IMF approved a three-year standby arrangement on 20 August 1997 amounting to $4 billion, with additional financing coming from the World Bank, Asian Development Bank and other sources that together totalled over $17 billion. The liquidity crisis necessitated measures to restore confidence and offer financing, but behind this lay other problems in the corporate and financial sectors. These problems would not be resolved by, for example, having the government balance its budget or raise interest rates. Rather: ‘The structural reform strategy in the programs was exceptionally comprehensive and went to the heart of the weaknesses in financial systems and in governance that were seen to be at the root of the crisis’ (Lane et al. 1999: 18). The Financial Sector Restructuring Agency (FRA) was established on 24 October 1997 to deal with finance companies whose operations had been suspended. The idea was to shut down non-viable institutions and recapitalize those that could be saved. A new Thai government came to power in November with a greater commitment to reform and further measures were taken: loan classification criteria were changed, loan provisioning requirements were enhanced, and new rules set for the valuation of loan collateral – together these would make it harder for banks to ‘nurse along’ non-performing loans without being forced to do something about them. In early December 1997, the FRA announced the permanent closure of 56 finance companies. The Thai economy continued to sink, and so the government announced a new set of measures in August 1998, committing public funds to the recapitalization of viable banks and finance companies, disposing of non-viable banks and finance companies through liquidation, merger or sale, strengthening publicly owned banks to prepare them for privatization, and accelerating

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the introduction of ‘international best standards’ for financial supervision and reporting (Lindgren et al. 1999: 98–9). The FRA sold off in a series of auctions the assets of the 56 closed finance companies. The first two auctions sold the best assets, and realized between 47 and 48 per cent of their value. The last auction sold off assets of poor quality (reflecting the poor credit decisions of the now defunct finance companies) and realized only 37 per cent. By the end of 1998, the total cost to the government of financial sector restructuring was $34 billion. Nevertheless, both investment and consumption fell during 1998, while unemployment more than doubled between February 1997 and May 1998 (E. Lee 1998: 40). In addition to macroeconomic and structural changes, the Thai government also addressed some of the social costs of the crisis. These were considerable as unemployment soared and the poverty rate increased dramatically in a country with very little by way of a social safety net (IMF 2000: 9). Thus, Thailand devoted $2.3 billion to various employment schemes (E. Lee 1998: 47, 56; Government of Thailand 1997, 1999). As time has passed, the unemployment situation has eased somewhat, but not to pre-crisis levels (unemployment was at 0.9 per cent in 1997, almost quadrupled to 3.4 per cent in 1998 and declined to 2.6 per cent by 2001, ADB 2002b: 387). The Thai government revised its bankruptcy law in both 1998 and 1999, drawing on American, British and Singaporean law (Urapeepatanapong et al. 1998: 2). The old 1940 law made no provision for reorganization as it envisaged only the liquidation of insolvent firms (Nimmanahaeminda 1999: 164). Thus, the new law provided for both corporate reorganization and liquidation, offering reorganization procedures for the first time and encouraging creditors to continue to lend to distressed debtors (Urapeepatanapong et al. 1998; Vatikiotis 1998a; IMF 2000: 16). Facilitating corporate rehabilitation helps to deal with problems like unemployment and falling incomes, albeit indirectly. To enhance predictability, new bankruptcy courts with specialized judges were established in 1999 (Baker 1999). Furthermore, the law instituted a seemingly clear and straightforward balance sheet test for insolvency: firms could be declared insolvent if their assets were worth less than their liabilities. The new law also made it easier for creditors to collect their money (Mertens 1997). Although they represented some improvement, the provisions of the new law were not as stringent as some foreign creditors had hoped. In particular, the combination of weak governments, many ‘veto players’, the political difficulties facing passage of ‘hard’ bankruptcy laws in a low-growth highunemployment economy, and a Senate filled with powerful debtors (or people closely connected to insolvent companies) meant that provisions were watered down considerably. It remains difficult for creditors to enforce their claims over an insolvent firm (Baker 1999; MacIntyre 1999, 2003; Mertens 1999). The Thai economy did not rebound quickly from the crisis. One estimate put real growth in GDP in 1999 at 4.0 per cent, an improvement from the previous year but still less than half of the growth rates experienced in the

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period 1991–96 (IMF 2000: 3). Growth remained uneven, dropping from 4.6 per cent in 2000 to 1.9 per cent in 2001, and then rebounding to 5.2 per cent in 2002 (ADB 2003: 95). The extent of leverage in the Thai corporate sector has declined somewhat from the end of 1997 to the middle of 1999, although it is still high (IMF 2000: 20; 2002b: 23). Furthermore, the proportion of non-performing loans held by banks continued to grow from 22.5 per cent at the end of 1997 to over 35 per cent in mid-1998, and then to 47.5 per cent in June 1999 (IMF 2000: 37; Economist Sept 4, 1999). The establishment of the Thai Asset Management Corporation (TAMC) in June 2001 was intended to rejuvenate Thailand’s banks by removing non-performing loans from their balance sheets. So far, state-owned banks benefited much more than private banks (ADB 2002a: 86), but across the entire banking sector the proportion of non-performing loans certainly improved (down to 12.9 per cent by September 2001, ADB 2001a: 100). Many of the problematic finance companies have been shut down as their numbers declined from 91 to 23 between June 1997 and December 1999, and their share of total assets shrank from 18 per cent to 4 per cent (IMF 2000: 40). To the time of writing, the new bankruptcy system has not suffered from overuse. Although some companies went into formal reorganization under the new law (for example, Srithai Superware and Thai Modern Plastic, see Keenan 1999a, 1999b), in general debtor firms are staying out of the courts (Goad et al. 1999). As of 11 November 1999, only 30 rehabilitation proceedings had been formally initiated. The balance sheet test of insolvency (are assets worth more or less than liabilities?) proved to be much more problematic than expected from a creditor standpoint because creative accounting granted considerable flexibility to the valuation process (IMF 2000: 25). The decision of the Thai courts to declare Thai Petrochemical Industry (TPI) insolvent was viewed at the time as a great victory for western creditors since it took the firm out of the hands of its original owner (Prachai Leophairatana) and installed new management picked by the creditors (Asiamoney 11[4]: 4–6; Sunday Times (London) 31 December 2000). To accomplish this, creditors had to dispute incumbent management’s claim that TPI’s assets were greater than its liabilities through lengthy court proceedings. Subsequent rulings, however, showed that the TPI case did not represent a major turning point, and that Thai bankruptcy judges continue to be as likely to believe the creative accounting of insolvent Thai firms as that of the firm’s creditors as they contest the value of assets and liabilities (ADB 2001b: 128). Overall, the reluctance of creditors to use the new bankruptcy law stems from the fact that it continues to favour debtors in many respects, and it doesn’t allow for easy conversions from a failed reorganization to liquidation. As long as Thailand’s economy struggles without a robust social safety net, it will be difficult to institute a ‘hard’ bankruptcy regime and unleash widespread liquidations and restructuring of the Thai corporate sector. Another problem is the fact that many banks continue to hide non-performing loans,

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and to pursue defaulting debtors in court will require banks to write down or write-off the loans, realize on over-valued collateral, and thereby weaken their capital. Tougher loan provision standards and higher capital requirements have made Thai banks even more vulnerable to the backlog of bad debts they currently hold. For these reasons, the new law has not unleashed a wave of court-administered reorganizations. Crisis in Indonesia The crisis began in Thailand, but it soon spread to Indonesia and there became enmeshed in a political crisis that eventually toppled the long-term leader Suharto. In some respects, Indonesia seemed an unlikely candidate for economic disaster: it enjoyed high rates of economic growth during the 1990s, balanced budgets, and stable exchange rates.9 There were widespread problems with corruption, but as one development specialist commented: ‘it was predictable and reliable, so foreign direct investment came into the country’ (Indonesia interview #1, see also Riesenhuber 2001: 149–50). Indonesia had liberalized its capital markets in the late 1980s, but not until the mid-1990s did private capital flows into the country increase substantially. Despite its robust economic appearance, Indonesia was engulfed in the same collapse as other countries, partly because its financial system shared many of the same problems. As the value of the Thai baht fell on foreign exchanges in early July 1997, pressure built up against the Indonesian rupiah. The Indonesian authorities stopped trying to defend the rupiah and it fell substantially starting in August. By October, the value of the rupiah had declined more than 30 per cent further than the currency of any of the crisis countries (Lindgren 1999: 54). A three-year $10 billion Stand-By Arrangement was reached with the IMF on 5 November 1997, with more funding from other international financial institutions for a total package worth $36.1 billion. Despite this intervention, the exchange rate fell again in December as investors pulled their money out of Indonesia. A revised programme was announced in January 1998, but had little immediate effect as the country became caught up in the presidential election. The Indonesian Bank Restructuring Agency (IBRA) was established to monitor and then manage the 54 weakest banks (out of a pre-crisis total of 238), and the government guaranteed bank deposits across the board (previously, Indonesia had no deposit insurance program, see Lindgren et al. 1999: 59). Given a high level of foreign indebtedness, this massive outflow of capital and collapse of the rupiah rendered many Indonesian firms and financial institutions effectively insolvent. Exact estimates are hard to obtain, but non-performing loans as a share of total bank loans were somewhere in the 65–75 per cent range (Kim and Stone 1999: 25). Furthermore, widespread bank runs forced the Bank Indonesia to inject liquidity into the banking system, which resulted in a substantial growth in the money supply and high inflation (Lane et al. 1999: 38–9). The rise in the cost of necessities like food

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and medicine brought real hardship to the Indonesian population (Lee 1998: 46–7). Profitability in the corporate sector plunged further than in any of the other crisis countries, leaving firms unable to repay their loans (World Bank 1998: 61). Non-performing loans thus increased to the point where the country was left with a massive restructuring task: how to sort out financial institutions so as to close down the terminally insolvent and resuscitate those which were salvageable. Several new institutions were created to deal with this problem, both in and out of the courts (IBRA and the Jakarta Initiative Task Force, JITF). But political instability compounded the problem by making credible, decisive action almost impossible (MacIntyre 1999: 155). The government repeatedly failed to live up to its own policy commitments and sent out decidedly mixed signals on the question of cronyism (Schwarz 2000: 339). The value of the rupiah continued to fall, and Suharto became increasingly isolated after his ‘reelection’ in February 1998. He finally resigned amidst widespread rioting and bank runs in May, having been unable to stem the tide. His fall created new opportunities for the government to respond to the crisis, but serious problems remained. For example, as IBRA proceeded to deal with insolvent banks, a multi-pronged approach was developed: new and more rigorous standards for loan classification and provisioning, new standards for capital adequacy, greater disclosure of financial information, and tighter rules for connected lending. After an extensive audit, IBRA also proposed to merge, recapitalize, reorganize or liquidate various of the most insolvent banks. Politically-connected owners of banks that were to be closed lobbied intensively and succeeded in getting the government to postpone action (not for the first time, see Lindgren et al. 1999: 22, Enoch 2000: 5). Yet eventually the enormity of the problem forced the government to act, and so between June 1997 and July 1999, the number of banks declined from 238 to 165 as the financial sector was consolidated. Much of the cost of restructuring was publicly born, totalling about $85 billion, or 51 per cent of GDP (Lindgren et al. 1999: 64–5). The Indonesian government has also spent billions on subsidies for food, fuel, medicines and other necessities in order to counter the social consequences of near hyperinflation (Lee 1998: 56). Together, the bailouts and subsidies left the government deeply in debt (Severino 2000a: 2). The government also tried to encourage private sector restructuring out of court. The Jakarta Initiative Task Force (JITF), launched in November of 1998, emulated the so-called ‘London Rules’ devised by the Bank of England. These rules are an internationally recognized protocol for informal voluntary workouts that try to put troubled firms back on their financial feet. But the results have not been impressive. By the end of 2001, only 122 cases had been registered with the organization (JITF 2001) and even when successfully completed the mediation process usually accomplished only a financial restructuring, not an operational restructuring, of insolvent firms. As of July 2003, the number of cases remained roughly the same, indicating that the JITF had little new work to do.10

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At the behest of the IMF, the Indonesian government also revised its bankruptcy law in April 1998 (Cartwright and Boggs 1998: 13). The pre-crisis law dated from 1906, and derived from Dutch law of even more ancient vintage. It was a law which had no conception of reorganization or rehabilitation – it was merely an obsolete, ineffectual and seldom-used collection device for creditors (Hornick 1998). Under the old law, creditors found it almost impossible to push debtors into bankruptcy or to enforce their claims (Murphy 1998: 69; Montgomery 1997: 15–16; Schwarz 2000: 70). Indeed, Hussain and Wihlborg (1999) find that among pre-crisis Indonesia, Korea, Malaysia, Philippines, Taiwan and Thailand, creditors’ rights were weakest in Indonesia. To counter the corruption and unreliability of the Indonesian judiciary, the new law established a specialized Commercial Court to handle bankruptcy cases (training of judges was funded by the IMF) and in general creditors’ rights were strengthened (Schwarz 2000: 66, 78). The new law allowed for both reorganizations and liquidations, tried to speed up proceedings (by requiring, for example, judges to rule on petitions within 30 days, see The Banker 1998), and spelled out clear criteria for insolvency: the debtor must have at least two creditors, and the debtor must have failed to pay at least one of its debts when due and payable (ADB 2001b: 39). The new law has been a big disappointment. Although some expected that the improvements would lead to high usage of the courts to resolve debts and reorganize firms,11 in fact: ‘. . . the expected deluge of cases has turned out to be but a trickle’ (Murphy 1998: 69). The court has made some surprising rulings and in general has been perceived as unpredictable, incompetent and/or corrupt (Severino 2000a: 7; Schwarz 2000: 413). Its first major ruling in September 1998 threw out a bankruptcy petition filed by a group of foreign and domestic banks (led by American Express) against Ometraco Corporation on the grounds that the petition was incorrectly filed. The court’s decision was widely regarded as simply wrong (Murphy 1998: 69). Other court decisions seemed to fly in the face of the literal and seemingly self-evident meaning of the law (ADB 2001b: 39, 45–6), and the fate of the Canadian insurance company Manulife, whose profitable Indonesian subsidiary was declared bankrupt by a Commercial Court judge, seemed to encapsulate all that remained wrong with the new Commercial Court system. In general, creditors have stayed away from the Commercial Court, perceiving it to be unpredictable and corrupt (Kamarul and Tomasic 1999: 163).12 One prominent Indonesian litigator admitted that the low wages paid to Commercial Court judges made it hard to attract the best lawyers to the bench, and led judges to be susceptible to bribery (Indonesia interview #2). Debtors simply cannot be forced through the courts to pay their debts as originally contracted, or to reschedule them during a reorganization. Part of the problem also lies outside the courts, for an effective insolvency system needs well-trained professional accountants and lawyers as well as formal laws and a judiciary. The capacity of the Indonesian legal and accountancy

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professions is low (Cole and Slade 1996: 27, 203; Schwarz 2000: 65). Indeed, the IMF insisted that Indonesian residents rather than citizens be eligible to act as insolvency practitioners since this meant that foreign employees of the big international accounting firms could supply professional talent to the insolvency system, so long as they resided in Indonesia (IMF Interview #1; IMF Interview #2). The Indonesian economy has still not recovered from the crisis. Five years later, unemployment was about twice the pre-crisis level and growth in GDP about half (ADB 2003: 69). International capital market inflows are at a much reduced level, public indebtedness remains very high (IMF 2002a), and the proportion of non-performing loans also remains high (ADB 2001a: 127). Through the end of 2001, IBRA had received assets worth about 43 per cent of total GDP, and had become the single biggest owner in Indonesia. The process of restructuring these assets and then privatizing them has gone very slowly. As a creditor, IBRA has fared poorly in the Indonesian courts, and sometimes has even been unable to exert control over assets it ostensibly owns (Indonesia Interview #1; ADB 2001b: 47). And selling assets to foreigners (as in the famous case of the Bank Central Asia [BCA]) has raised all kinds of political problems for IBRA and the Indonesian government. IBRA nominally owns a very large part of the Indonesian economy, and its internal rules and procedures and modest political clout are simply inadequate to deal with the basic question of who should own Indonesian financial and industrial assets and under what terms: the state, pribumi business, foreign investors, or wealthy ethnic-Chinese families? Such a question can only be answered politically, not through bureaucratic rules and legal procedures, however transparent and predictable they are. Crisis in South Korea In 1996, South Korea possessed the world’s 11th largest economy and had just triumphantly joined the OECD after several decades of phenomenal growth.13 Korea enjoyed low unemployment, high growth, and balanced budgets. Yet the crisis apparently snatched defeat from the jaws of economic victory and brought Korea crashing down as worried investors, who had already pulled out of Thailand and Indonesia, decided it was high time to get out of Korea, too. In the years leading up to 1997 Korean firms had become very highly leveraged, and Korea’s financial markets had been opened up to the outside in preparation for OECD membership (Baliño and Ubide 1999: 14–15; World Bank 1998: 57). The largest chaebol, Hyundai, for example, had a debt–equity ratio of 578.7 per cent in 1997 (Nam et al. 1999: 3). Thus, Korea was vulnerable to a sudden exit of short-term capital (World Bank 1998: 6). In Korea, foreign banks generally loaned to Korean banks, which in turn loaned money to the chaebols.14 Korean banks had been a key instrument in Korean developmentalism as the government directed capital to particular firms and industries, via the banks and policy loans (Woo-Cumings 1999).

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As a consequence of the preponderance of politically directed loans (and an implicit guarantee that chaebols were ‘too big to fail’), Korean banks (which had been government owned until 1983) possessed underdeveloped skills in credit analysis and risk management (Baliño and Ubide 1999: 16; Chopra et al. 2001: 6–7). When not dictated by the state, lending decisions were based on the availability of collateral rather than cash-flow projections, on the existence of cross-guarantees among chaebol firms, and with less detailed financial information about the borrower than a western bank typically would require (Woo-Cumings 1999: 123; Borensztein and Lee 2000: 11). Furthermore, loan classification was lax and loan provisioning inadequate, especially given that many Korean banks were poorly capitalized. When the financial crisis hit, the won fell sharply in November of 1997, banks were unable to rollover their short-term debts, and international reserves dried up. The chaebols were hit by a sharp fall in sales and the decline in the exchange rate (Nam et al. 1999: 7). The Korean government guaranteed the foreign obligations of Korean financial institutions but money still flowed out, and Korea was forced to seek help from the IMF in December (Lindgren et al. 1999: 67). Meanwhile, many of the chaebols were in deep financial trouble, which meant that the banks lending them money were also in deep trouble. The chaebols were highly leveraged, and so consequently vulnerable to cash flow problems. But, it turns out they were not too big to fail. By the end of November 1997, six of the top thirty chaebols had filed for court protection, and another filed for bankruptcy in December. As corporations become insolvent, non-performing loans at the banks grew to a point where they reached about 80 per cent of bank capital, a level that seriously threatened the solvency of many banks (Baliño and Ubide 1999: 30). The basic problem in Korea was similar to that in the other two countries: how to provide enough liquidity to the financial system to keep illiquid, but solvent, firms and banks afloat while at the same time sorting out nonperforming loans so as to separate salvageable firms and financial institutions from the unsalvageable. Korea differed from the other countries in two important respects: first, Korea was central to American diplomatic and security interests in the Far East, second, its economy was organized around the chaebols and their close relationship to the Korean state.15 Hence, Korea was assisted by the IMF and others to the tune of $58.4 billion in official financing. In late 1997 Korea reconstituted a pre-existing organization, the Korean Asset Management Corporation (KAMCO), as an asset-management company with additional funds to deal specifically with the crisis. KAMCO purchased problematic loans from banks in order to free up their balance sheets, paying 45 per cent of face value for secured loans and 3 per cent for unsecured loans (Lindgren et al. 1999: 38, 72). KAMCO then disposed of the loans, either by selling them off to international investors, foreclosing on the loan and seizing the collateral, auctioning the loans off, or by collecting on them. As of 31 October 1999, KAMCO had an inventory of 343,548 non-performing loans,

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purchased for a total of 12.4 trillion won, or about $7.1 billion (Yoon 1999). By June 2001, the inventory of NPLs had increased to 71.6 trillion won (ADB 2001a: 120). The Korean government also centralized government financial supervisory and regulatory functions into one organization, the Financial Supervisory Commission. Formerly, supervision of financial institutions was fragmented, with the Bank of Korea, Ministry of Finance, and Office of Banking Supervision all sharing responsibility. The new Financial Supervisory Commission audited many institutions to determine their solvency, and as of mid-1999, closed down 23 banks and over 100 non-bank financial institutions, ordered the merger of 11 other banks, and intervened directly in four commercial banks (Lingren et al. 1999: 36). In addition, the government raised the standards used by banks for loan classification and loan provisioning (Baliño and Ubide 1999: 43). At the insistence of the IMF, in February 1998 Korea also modified the three laws that pertained to corporate insolvency. Unlike the USA, which offers different procedures under one bankruptcy code, Korea had different laws for each separate procedure: the Bankruptcy Act, the Corporate Reorganization Act (CRA), and the Composition Act (CA). The Bankruptcy Act was for liquidations, while the other two were aimed at reorganizations. Under a composition, management of the insolvent firm stayed in control, whereas with a reorganization management were replaced by a courtappointed receiver. Consequently, insolvent debtors strongly preferred CA over CRA. CRA and CA both allowed troubled firms to defer payments on their loans for very long periods of time, in the case of the CRA for an average of 14 years, while under the CA for an average of 5–7 years (Oh and Byung 1998: 31). This kind of experience gave creditors little incentive to push debtors into formal insolvency. Few filings were made under any of these three Acts in the early 1990s, or indeed since they were enacted in 1962 (Nam et al. 1999: 34). For example, insolvency cases filed under the Corporate Reorganization Act numbered 15 in 1990 and 52 in 1996 before rising to 132 in 1997. The Composition Act was used even less, with no filings in 1990 and only nine in 1996 before increasing to 322 in 1997. The pattern for the Bankruptcy Act was similar: 27 filings in 1990, 18 in 1996 and then 38 in 1997 (Rim 1999: Table 1). Even at the height of the crisis, when the number of insolvent companies (that is, firms that were unable to pay their debts) shot up, only a small number ended up in court. The lack of use of the three proceedings stemmed not only from the generally good economic conditions prevalent in Korea before the crisis, but also from the uneven balance of power between chaebol debtors and bank creditors. Banks were relatively weak as compared to the chaebols, and hence reluctant to ‘pull the plug’ on a debtor that wouldn’t repay its debts. Part of this weakness stemmed from sheer size differences (small banks vs large chaebols), but also from the fact that many banks were

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partly owned by the chaebol (Lee and Timewell 1997; Nam et al. 1999: 17–18). The usual strategy was to roll over the debt and hope that matters would improve in the future, a strategy that risked throwing good money after bad, but which postponed the day of financial reckoning. Hence, insolvent companies continued to operate and continued to lose money (C. Lee 1998). The reforms were intended to speed up proceedings, but they also introduced a measure intended to make the decision about whether to liquidate or reorganize an insolvent firm as predictable and transparent as possible. After 1998, judges in bankruptcy cases were to apply an ‘economic criterion test’ that directly compared the liquidation-value with the going-concern-value of the insolvent firm (Nam and Oh 2000: 41).16 Previously, judges generally considered whether a proposed reorganization seemed ‘viable’ and exercised judicial discretion (taking into account not only the likelihood of survival for the reorganized firm but also the preferences of the affected creditors). With the new rule, however, judicial discretion was greatly reduced and the economic test determined the outcome (Korea Interview #1). The economic test also constrained the discretion of creditors since it no longer mattered whether they supported reorganization or liquidation (Oh 2003: 5). Ironically, however, the new test merely shifted discretion away from judges and creditors and towards accountants, rather than eliminating discretion altogether. Accounting firms are typically retained by judges to do the valuations that underpin the test, and according to one Korean attorney, a judge can influence to some extent the optimism or pessimism of going-concern projections (Korea Interview #2). At the very least, the accounting rules that guide valuations cannot be applied mechanically and require that accountants make expert judgements and exercise some discretion.17 Restructuring in Korea after the crisis was deemed too important not to involve the state (Chopra et al. 2001: 58). Prior waves of government-led ‘rationalization’ of industry had occurred before the 1990s – in the 1969–72 and 1984–86 periods. In October 1998, several big deal mergers were announced that consolidated capacity in a variety of troubled industries, including semiconductors, petrochemicals, aircraft manufacturing, oil refining, and railway vehicle manufacturing (Nam 1999: 86–7). Restructuring of the second largest chaebol, Daewoo, included the sale of its automobile division to GM, while the other top five have raised more capital to reduce their debt-to-equity ratios (Severino 2000b: 4, 8–9; Anonymous 1999). The government has also tried to encourage informal workouts to help reorganize the smaller chaebols (numbers 6 through 64), as well as getting them to recapitalize. In addition to direct involvement in restructuring the largest troubled firms, the government modified the bankruptcy laws in early 1998, and further reform seemed likely (in particular, the consolidation of the three separate laws into one encompassing procedure, see Oh 2003). The legal changes generally tried to speed up proceedings, and make incumbent management of an insolvent debtor corporation subject to supervision during

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CA proceedings (Oh and Byung 1998). More changes were made in December 1999, making it easier for reorganization plans to get creditor approval, speeding up proceedings, and automatically applying liquidation procedures if a reorganization failed (Severino 2000b: 12; Nam et al. 1999: 94–5). If these changes succeed and more firms go through formal insolvency proceedings, it will tax the capacity of the Korean legal profession, which is small and exclusionary (Tonkovich 2001). The Korea economy has rebounded strongly, with economic growth rising and unemployment dropping. While certainly welcome, the recovery is an ambiguous outcome, subject to conflicting interpretations. Does it represent the first fruits of structural reform, or simply the reassertion of a fundamentally robust economy after temporary troubles? The fear among IMF and World Bank officials was that recovery reduced the incentive to press on with the reforms, and that Korea would revert to some prior version of business as usual (Severino 2000b: 3). Certainly, early repayment of the loans in August 2001 reduced the IMF’s leverage over the government of Korea.

Three countries compared Despite some important differences, the three countries follow a common pattern. All three experienced considerable inflows of short-term foreign capital in the period leading up to the crisis. All three were characterized by a highly-leveraged corporate sector and poorly capitalized banks with a high proportion of non-performing loans. In addition, bankruptcy law in all these countries was generally unused. Partly this was because the laws were themselves simply inadequate and the necessary accounting and legal expertise was in short supply. But it was also because much lending was done without due diligence or credit assessment on the part of lenders. Many banks believed their government offered an implicit guarantee which ensured that the state would bail out troubled debtors. Such guarantees created a moral hazard problem. Under such circumstances there was little perceived need to assert creditor rights in a court of law, or to use bankruptcy law to recover a debt. Banks were also passive creditors in those cases where loans went to an affiliated corporation from the same chaebol or family conglomerate.18 The panic of divestment set off in Thailand soon engulfed the other two countries and liquidity dried up. Even solvent companies had a very hard time paying their debts as they became due, and together with the insolvent companies dragged down the entire financial sector. The IMF was called in to assist all three countries and did so on condition that they undergo structural reforms. These reforms included tougher regulation of financial institutions and new bankruptcy laws. Eventually, Thailand joined the other two in setting up a public asset management company to remove non-performing assets from troubled banks. In 2001, IBRA, KAMCO and TAMC, held $32 billion (US), $78 billion and $13 billion worth of assets, respectively, and had

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helped to relieve the troubled banking systems of the three countries (ADB 2001a: 120). This amounted to a massive nationalization of assets, and a massive public underwriting of the losses, but it also made the public sector the biggest domestic creditor. It is one thing for a private creditor to vigorously press its claims in court, but public creditors must often temper their claims in light of political realities and the public interest. The prospect of privatizing assets into the hands of foreign buyers has been particularly problematic. At the urging of the IMF and World Bank, these countries modified their bankruptcy laws so that more economic restructuring would occur in a formal legal setting. And the hope was that making the formal insolvency proceedings more credible would encourage more informal reorganizations. But complex corporate reorganizations do not simply require law, they also require expert inputs from the legal and accounting professions, and even in Korea these were in short supply both before and after the crisis (Nam and Oh 2000: 129). If such reorganizations become common, it will mean a lot of work for the professionals (Haley 2000; Pomerleano 2002). The three cases differ, however, in that ‘soft budget constraints’ worked somewhat differently in Korea than in Thailand and Indonesia.19 For one thing, the economies of the latter two had much bigger agriculture sectors. In 1996, for instance, 44 per cent of the Indonesian workforce was in agriculture, 40.4 per cent of the Thai workforce, but only 10.6 per cent of the Korean workforce (E. Lee 1998: 36). The collapse of the corporate sector thus had a potentially much bigger social impact in Korea than the other two economies, and so encouraged promulgation of ‘soft’ bankruptcy law. And although corporations in all three countries were highly leveraged, the problem was most acute in Korea and so, again, the potential for widespread corporate insolvency was highest there (Kim and Stone 1999: 17). Furthermore, Korean firms were generally bigger than those in Thailand or Indonesia. Countering these differences was the fact that social safety nets were relatively more generous in Korea than in Thailand or Indonesia. So, overall, the magnitude of the social problem which systemic corporate insolvency threatened to unleash was somewhat greater in Korea than in the other two countries. If social arguments for soft bankruptcy law were more compelling in Korea, what domestic considerations helped to propel legal change in Thailand and Indonesia? Clearly there was, as in Korea, a general interest in avoiding mass liquidation, but particular interests played a role as well. Family ownership over corporations was much greater in Thailand and Indonesia than in Korea (Hussain and Wihlborg 1999: 16; Claessens, Djankov and Klapper 1999: 22), and ownership was more concentrated than in Korea (Hussain and Wihlborg 1999: 20). Thus, debtor-friendly arrangements were more protective of the interests of specific families and their cronies, and played a role in the reproduction of ‘booty capitalism’ (Hutchcroft 1998). Even if the social costs of hard bankruptcy laws were not as great in Indonesia and Thailand, economic elites were able to ‘soften’ the new laws as they battled to maintain

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control over their family banks and other corporate assets. Furthermore, creditors were often reluctant to press their formal legal claims if it meant having to recognize loan losses and write-down capital (Schwarz 2000: 413). Such reluctance characterized both domestic banks and foreign creditors (including Japanese and Korean banks lending in Thailand and Indonesia, see Linnan 1999: 115). In other words, Asian creditors frequently did not follow the ‘recovery-maximization’ script written for them by western advisors. In general, the East Asian economies hit hard by the crisis have not done as well after 1997 as they were doing before (ADB 2007: 46, 61). But there are significant differences among them. Today, the Korean economy is doing substantially better than the other two. Foreign capital flows into all three countries contracted sharply after the crisis, but they have rebounded strongly for Korea (World Bank 2001: 8). Foreign direct investment in Korea in 2004 totalled $9.2 billion (US), versus $1.9 billion for Indonesia and $5.8 billion for Thailand (ADB 2007: Table A16). Korean GDP grew by 7.0 per cent in 2002, as compared to 4.5 per cent for Indonesia and 5.3 per cent for Thailand (ADB 2007: Table A1). In 2006, those growth rates were 5.0 per cent, 5.5 per cent and 5.0 per cent, respectively, which is remarkable given how much higher Korea’s GDP was to begin with. Corporate leverage declined much more between 1997 and 2000 in Korea than in Thailand or Indonesia (in the latter case, debt–equity ratios actually increased, see ADB 2001a: 124), although in general corporate indebtedness has improved in all three countries as compared to the pre-crisis situation (ADB 2007: 57). Indonesia is doing noticeably worse than the other two when it comes to unemployment, registering 9.1 per cent in 2002 vs 3.0 per cent for Korea and 2.4 per cent for Thailand (see ADB 2003: Table A6), and 10.3 per cent in 2005, as compared to 3.7 per cent for Korea and 1.8 per cent for Thailand (ADB 2007: Table A6).

Rule of law and rule of numbers Revision of bankruptcy law was considered by international financial institutions to be a key piece in the larger package of institutional changes needed in East Asia.20 The entire package was intended to enhance the transparency of investment and the predictability of insolvency. That is, lenders will have better information about the true financial situation of borrowers (thanks to new accounting standards up to ‘international best practices’), and will thus be able to make rational economic decisions. But if their investments do not pan out and a borrower becomes insolvent, not only will lenders have to gauge the full extent of the problem (thanks to more rigorous loan classification schemes) and provide for it (because of better loan provision standards), but they will have more effective legal means either to collect their money (in a straight liquidation of the debtor) or to negotiate getting the debtor back on its financial feet (in a reorganization). In a nutshell, said

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a World Bank counsel: ‘What is therefore required is a clear, predictable and transparent insolvency process . . .’ (Johnson 1999: 5). Behind these policy recommendations lies the firm conviction that the rationality and sovereignty of markets depends upon the existence of a set of unambiguous rules enshrined in law, and the provision of transparent information to market decision makers. Predictable commercial law means, more or less, that firms and investors will know with a high degree of certainty what rights they possess over assets, what liabilities encumber them, and how the assertion of such rights would play out in court. Transparency means they are also able to assess, with a high degree of accuracy, the magnitude or value of assets and liabilities under different scenarios. Together, predictability and transparency create a world in which economic actors face risks, not uncertainties (Winters 1999: 87). In a world of risk, decision makers can be rational. Various reform measures well exemplify the attempt to institute predictability and transparency: Korea’s ‘economic criterion test’, Indonesia’s requirements for initiating insolvency proceedings, and Thailand’s test of insolvency. The Korean measure was intended to increase predictability by, in effect, taking the decision about whether a firm should be liquidated or reorganized out of the hands of judges and putting it into a simple rule: compare liquidationvalue with going-concern-value. The assumption that valuation in accordance with accounting rules would be a straightforward process was naïve, and in practice accounting discretion replaced judicial discretion (although in selecting an accounting firm to perform the valuation, judges could still influence the outcome). Likewise, the literal and seemingly self-evident meaning of Indonesia’s new insolvency requirements were not immune to creative readings, and a number of judicial rulings have surprised western commentators. Thailand’s balance-sheet test of insolvency was vulnerable to creative valuations, and could not guarantee a definitive answer to the question of whether a particular firm was insolvent or not. Instituting predictability and transparency is not such a straightforward process. Given the ‘self-evident’ necessity of predictability and transparency, it is curious that even after reform, after bankruptcy laws have been changed and brought into greater conformity with ‘international best practices’, the law is still seldom used in East Asia (World Bank 2000: 77). Its neglect is even more remarkable given how many corporations became insolvent as a consequence of the crisis (ADB 1999: 10). Non-performing loans remain a big problem, and much of the restructuring has been only financial rather than operational (ADB 2001a: 128). Why aren’t these new and improved laws working? Could it be that the reforms have simply failed, notwithstanding the vigorous efforts of the IMF and numerous international consultants and experts, and despite the very considerable leverage the IMF and other international financial institutions enjoyed over Thailand, Indonesia, and Korea? Or does the neglect of law reflect a more basic problem than just flawed reforms? If the first claim is true, then the issue is a relatively mundane one of making

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sure that the flaws get fixed, that the new laws are ‘fine-tuned’ to iron out the wrinkles. But if the second is true, then the entire project of structural reform is problematic at a deeper level. These convictions about the necessity of predictability and transparency are based on a stylized and exaggerated summary of the western experience. Max Weber (1978, 1981), and many others since, claimed that modern capitalism needs both calculable law (Kamarul and Tomasic 1999: 151–4; Swedberg 1998: 19), and rational capital accounting (transparency). But is this really the lesson to be drawn from Anglo-American economic history, and transplanted to East Asia? Two literatures should give us pause. Despite much insistence in policy circles on the importance of the ‘rule of law’ (see Ohnesorge and Upham, this volume), research points out that calculable formal law is in fact not a necessary precondition for commerce or market transactions, even in advanced capitalist societies. Stewart Macaulay’s famous study of Wisconsin manufacturers (1963) showed that many firms choose not to use modern contract law, even when it is readily available. Macaulay argued that various non-legal devices can perform many of the same functions as a legal contract. Not only are formal contracts unnecessary, they can actually damage business relationships by signalling a lack of trust, and by nailing down specific commitments in situations where a degree of open-ended flexibility might be more advantageous. Macaulay’s basic argument has been extended and confirmed by others in a variety of other markets in the Anglo-American context (Beale and Dugdale 1975; Bernstein 1992; Charney 1990; Ellickson 1991; Macaulay 1977; VincentJones 1989). Furthermore, as Upham (this volume) points out, the American judiciary is so embedded in politics as to be hardly capable of ‘machine-like’ regularity in its production of legal judgements. Reliance on juries simply multiplies the likelihood of unpredictable legal outcomes. The chief lessons of this literature are that capitalist markets in the US and Britain did not require as much calculable law as has been claimed; extra-legal market transactions occur even when an effective legal system is available, so long as functional substitutes operate satisfactorily; and the functional substitutes for law are rooted in informal social structures and relationships. Even when formal law is applied, its import or effects are not always predictable. O’Barr and Conley’s (1992) study of institutional investors in the USA shows that legal mandates are subject to conflicting interpretations, especially among lawyers. Pension funds are subject to ERISA, the 1974 Employee Retirement Income Security Act, which stipulates that fund managers have a fiduciary responsibility to act in the interests of fund beneficiaries. O’Barr and Conley found that many fund managers believed their fiduciary responsibilities unequivocally made ‘social investing’ impossible (1992: 89, 96, 102, 117).21 In their perception, the law tied their hands. But the lawyers who worked for the very same pension funds often viewed matters differently, and where the managers saw legal clarity, the lawyers perceived legal

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ambiguity. For them, the law did not necessarily prohibit social investing, and matters were not simply black and white (O’Barr and Conley 1992: 119–20). Thus the predictable effects of ERISA on pension fund investments depended on who was doing the predicting. For some, the law was clear-cut. Others perceived legal gaps and ambiguities. Similarly, those who invented the ‘economic criteria test’ to select between liquidation and reorganization for insolvent Korean firms imagined that this test would increase the predictability and rationality of Korean court rulings, but in fact the rule simply shifted discretion away from judges and creditors and towards Korean accountants, who can be as creative as their western counterparts. If calculable law wasn’t and isn’t absolutely necessary for the US or British economy, why is it needed in East Asia? In fact, a number of scholars have found that commerce in East Asia can work just fine without a pristine formal legal edifice (Ohnesorge this volume, Upham this volume). Wank (1999) shows how vague, uncertain or otherwise problematic property rights in Xiamen (in Fujian province, China) do not inhibit economic growth, despite many predictions to the contrary. Winn (1994) illustrates how effectively small business credit markets can operate in Taiwan outside, rather than inside, the ambit of the formal legal system. And, clearly, outside investors had no real qualms about pouring money into East Asian economies with unreformed bankruptcy laws, for up until 1997 that is exactly what they did. To be sure, firms and investors welcome a significant measure of predictability and calculability, but law isn’t the only way to provide it. And, furthermore, there are some forms of legal predictability which are highly undesirable from the standpoint of foreign investors: trade disputes between foreign investors and their Chinese counterparts are predictably resolved in favour of the latter in Chinese courts (Guthrie 1999: 160–4). Although reformers may not realize it, what they now seek in East Asia is not so much predictability per se as a particular kind of predictability, predicated on the operation of the specific institutional structures we call ‘law’, and predictable in ways that are familiar to foreign investors and which serve their interests. If the Anglo-American experience shows that claims about the necessity of predictable law are exaggerated, the same is true for the ability of western accountancy to create transparency for investors. However much accountancy is made out to be an rule-governed exercise in ‘financial science’, or the dispassionate measurement of economic truth, it is in fact neither (Miller 1994).22 Accounting rules, all based on convention, grant an important and unavoidable measure of flexibility and discretion to accountants, who within the bounds of such rules can be remarkably creative about ‘cooking the books’, or ‘massaging the numbers’ (Baskin and Miranti 1997: 228, 259). For example, Briloff (1972: 39) shows how different valuation rules (LIFO vs FIFO, or last-in-first-out vs first-in-first-out) applied to business inventories can raise or lower profits during times of rising prices (see also Press and Weintrop 1990). Depending on when firms recognize income in their accounts,

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they can raise or lower their income during a fixed time period (Briloff 1972: 163). Firm managers often use accounting tricks to ‘smooth out’ their income and make it seem more predictable (Barnea, Ronen and Sadam 1976: 110–11; Baskin and Miranti 1997: 191). They use the flexibility of GAAP to ‘manage’ their earnings to meet analysts’ forecasts or the firm’s own targets, or simply to sustain recent performance (Degeorge, Patel and Zeckhauser 1999). Even the simplest and oldest accounting method, double-entry bookkeeping, has a rhetorical aspect that belies the image of accounting as a neutral measure of economic fact (Carruthers and Espeland 1991, Thompson 1994). Recent American corporate scandals have put the flaws of US GAAP accountancy on full display. The conflict of interest between accounting firms as auditors and accounting firms as consultants helped to undermine Arthur Andersen’s independence and hence its willingness to question the financial manipulations of clients like Enron (Demski 2003; Swedberg 2003). For accounting firms, consulting had displaced auditing as a profit centre, and so they were loath to be such stern auditors that they would lose a client’s consulting business (Healy and Palepu 2003: 15). GAAP possesses large grey areas which can be used to manipulate earnings, even without resorting to outright fraud (Lev 2003: 34–5). Deception and opacity via creative accounting are not unprecedented, as the example of the 1980s savings-and-loan crisis attests (Calavita, Pontell and Tillman 1997: 57, 65–7, 72). The ambiguity of accounting information is especially apparent during corporate insolvency, when the conflicting interests of different parties exploit the flexibility of accounting rules to the fullest. For instance, as asbestosis lawsuits against Johns Manville Corporation began to accumulate in the late 1970s, Manville’s auditors noted in the company’s annual report the existence of a financial liability of undetermined magnitude.23 Manville’s accountants believed that the numerous lawsuits would eventually lead to substantial payments by Manville, but that the value of the payments could not then be estimated. Were the liabilities estimable, Manville would have to set aside funds to cover it, thus hurting profits. At some point, the management of Manville Corporation decided to file for a Chapter 11 bankruptcy to reorganize the firm and settle its mass tort liability. To do this, they needed to convince a bankruptcy judge that they were insolvent, i.e., that their liabilities were greater than their assets. And to do this, in turn, they needed to give the financial liability arising from the lawsuits a definite (and very substantial) value. Since their old accounting firm believed the liability could not be estimated, Manville switched accounting firms. Overnight, an inestimable liability became estimable. More generally, one often sees ‘valuation wars’ in which accountants for debtors and creditors come up with sharply different estimates of the value of various corporate assets (Delaney 1992: 165–6; Lawless and Ferris 1995). Under such circumstances, economic value is anything but transparent, even when measured following ‘international best practices’.

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Outside the highly contested realm of corporate bankruptcy, numerical measures of corporate performance can still be cumulatively opaque. Using a data set of about 2,700 business units from both Europe and North America, Meyer and O’Shaughnessy (1993) calculated the correlations among a number of different measures of performance, including return on investment (ROI), return on sales (ROS), internal rate of return (IRR), productivity (PROD), product quality (QUAL), growth in sales, growth in market share, and growth in assets. The correlations are not impressively high. For example, the correlation between IRR and ROI ranged across subsamples from a low of 0.283 up to 0.517 (Meyer and O’Shaughnessy 1993: 267). The correlations were positive, to be sure, but well below 1.0. One is lead to conclude that even standard performance measures do not necessarily offer a coherent and stable picture of a firm. Furthermore, the discrepancies between different measures of value (say, between the market value and book value of a firm) are common enough to generate conventional explanations for the difference (e.g., ‘good will’). Equivocal evidence of financial status is common, not rare. Accountancy and law combine together in securities regulations (which, among other things, mandate disclosure requirements, annual audits, and so on). If predictability and transparency are necessary for capitalism, we should find overwhelming evidence of their effects on US and British securities markets. One recent study (Banner 1998) suggests that how securities markets were legally regulated in the USA and England depended less on the functional necessity of predictable rules and transparent information, and more on the cultural and political legacies of the past. As he puts it: ‘most of the ways of thinking about and regulating securities markets characteristic of the twentieth century were present in England and the United States long before securities markets were important economic institutions’ (Banner 1998: 4). One doesn’t have to subscribe to all of Banner’s argument to recognize that the kind of transparency created in securities markets through legal regulations may be culturally specific, and not a universal standard. Research on western accountancy and law suggests that the roles of predictable law and transparent accounting information in the functioning of western capitalism are not so straightforward. Commercial life can be made predictable in a number of ways, not just on the basis of law. And information created and promulgated following western accounting rules remains manipulable, ambiguous, and sometimes downright deceptive. Conformity with GAAP or some other accounting convention, for example, doesn’t necessarily produce transparency. The current neglect of bankruptcy law in East Asia partly reflects the fact that the premises underlying the program of structural reform are exaggerated representations of empirical fact, at least in the case of western law and accountancy. Besides misguided convictions, the non-use of bankruptcy law is also motivated by good political and economic reasons. Liquidation of a large proportion of a domestic economy is politically unfeasible. Not only would

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the court system be overwhelmed, but the resulting unemployment and economic dislocation would be politically unacceptable. The likelihood that rigorous implementation of bankruptcy law would lead to even more economic and political turmoil makes the decision an easy one. Furthermore, in situations of systemic insolvency, a country’s juridical apparatus simply lacks the capacity to deal with serious questions about the ownership and control of national assets, questions which are fundamentally political. In this respect, East Asian countries are not unlike the transitional economies of Eastern and Central Europe. In order to have capitalism, transitional economies like Russia and Hungary passed bankruptcy laws in the early 1990s. Then one of two things happened. Either the new bankruptcy law wasn’t put into practice because it would lead to the liquidation of so many firms, as in the case of the Russian law of 1993 (Yakovlev 1994: 143). Or, as with Hungary, the new bankruptcy law of 1991 was applied vigorously and so many firms were closed down that the law was changed to make liquidations less likely and reorganizations more common (Stark 1996: 1010; Gray and Hendley 1997: 144). In both cases, politicians gauged the economic and political impact of a national wave of insolvencies and either avoided it or soon rectified it (Bufford 1996: 469–70; EBRD 1999: 149, 167; Kim 1996). On paper at least, the passage of a bankruptcy statute hardens budget constraints. But if that statute strongly favours reorganizations over liquidations, or it isn’t implemented, then the constraints may not be especially hard. The political consequences of widespread liquidations were also reflected in the fact that both Thailand and Indonesia created new legal procedures for corporate reorganization. Korea already had such procedures on the books, but in Thailand and Indonesia the pre-reform law conceived of bankruptcy as essentially a process of liquidation and debt recovery. To rejuvenate such a law without modification would have been politically catastrophic, especially in countries with a threadbare social safety net. It is also true, however, that cronyism or booty capitalism benefited from (and helped to motivate) the institutionalization of softer bankruptcy laws in Thailand and Indonesia. As with every other type of government intervention, bankruptcy reform can be harnessed to serve particular as well as general interests. For economic reasons, many creditors are reluctant to use the new laws because their fates are so closely tied to those of their debtors. Whether an insolvent debtor is liquidated or reorganized, creditors usually lose at least some money. Collateralization helps to minimize those losses, but it seldom reduces them to zero (and clearly will be of little help when the value of collateral has declined substantially, as is the case of Thai real estate). A weakly capitalized creditor bank is hostage to the financial status of its debtors if debtor insolvency will wipe out the bank. In such cases, neither the creditor nor the debtor wish to go in to bankruptcy court and trigger legal proceedings. If bankruptcy reform and the new financial reporting regulations are not implemented, but instead remain merely ‘law on the books’, then possibly

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structural reform has served a purpose more symbolic than substantial (Meyer and Rowan 1977). Perhaps legal reform has been used to signal to outsiders adherence to values of predictability and transparency. And if those outsiders are comforted by or impressed with the appearance of predictability and transparency, so much the better.

Conclusion Social scientists and policy makers have all discovered the importance of institutions. Many have argued that legal institutions in particular have a profound influence on markets, investment, economic growth, and the relationship between firms and the financial sector (e.g., La Porta et al. 1998; La Porta et al. 1997; Pistor 2000; Claessens, Djankov and Nenova 1999). Among social scientists this is not a particularly new insight, for Max Weber long ago underscored the importance of predictable law for capitalism. But recognition of this connection was revitalized by the recent East Asian crisis. The structural reforms pursued by the IMF and World Bank are intended to enhance predictability and transparency, and so speed along economic recovery. Bankruptcy law is one of the key elements to be reformed. In motivating these changes, much is made of the virtues of predictability and transparency. Together, they reduce uncertainty or convert it into risk, making rational decisions possible and thus creating a congenial environment for homo economicus. Analysts assume that these two features underpin the western economy, and that enhancing them in East Asia will therefore be beneficial. Such an assumption is unwarranted, however. Anglo-American commercial life unfolds outside the law as well as within it. And the variability of ‘law in action’, as opposed to ‘law on the books’, should never be underestimated. Furthermore, commercial predictability can be achieved outside the law as well as within it. The primary vehicle for transparency, accounting information, is as much a rhetorical device as an instrument for exact quantitative measurement, and it too contains a great flexibility. Despite these misguided premises, reform has gone ahead in Korea, Thailand and Indonesia, pulled along by the purse strings of the IMF and World Bank. Will reform lead to economic recovery? If foreign investors do not behave as in the past, but instead start to care deeply about things like bankruptcy law and accounting standards, then to the extent that these countries undertake structural reform, reform will have a positive effect. But this assumption seems unrealistic. Before the crisis, billions poured in from abroad despite the evident ‘inadequacy’ of law and accountancy and the fact of corruption (World Bank 2000: 22). With decades’ worth of rapid economic growth, punctuated only infrequently by brief slowdowns, investors seemed not to worry. Their lack of concern may have been quite reasonable if, as Rajan and Zingales suggest (2001), bank-dominated financial systems have less need for predictable laws and high transparency than market-dominated systems

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(perhaps the importance of law varies from one variety of capitalism to the next). How investors’ future expectations will be shaped by bankruptcy law and financial regulations remains to be seen, but corporate scandals in the US have shown that cronyism and financial fraud are not just Asian diseases. For the rule of law and numbers to work effectively, someone has to institutionalize the rule of lawyers and accountants. The implementation of reform and its material effect on commercial practice depends very much on the important matter of who does the implementing. The new legal rules that govern corporate restructuring and the regulations for financial reporting and accountancy do not implement themselves. Rather, they must be implemented or applied by someone, a someone who isn’t just anyone. In a professionalized division of expert labour, these rules privilege lawyers and accountants who possess both the skills and credentials necessary to implement them in practice. Without sufficient professional capacity (i.e., a large number of adequately-trained professionals), the new system of rules will not work properly. Lawyers and accountants have thus far not played a large role in initiating reform of these rules in East Asia (unlike the cases of the UK and the USA), but once in place they will constitute a supportive domestic constituency. They seek remunerative activity that affirms their expert judgment and experience, which means that legal or accounting work cannot become too routine or predictable. By the 1990s, auditing work in the USA had become so commodified, mechanical, and low status that accountants turned to consulting (Healy and Palepu 2003: 16). Purely routine or standardized legal work is similarly low status. Professionals have a vested interest in those forms of predictability and transparency that privilege their particular expertise, and so can help ‘lock in’ institutional changes, but they are unlikely to support machine-like predictability. As the case of GAAP illustrates, rules that are too literal and predictable only encourage professionals to get creative in exploiting loopholes and violating the spirit, if not the letter, of the rules. Professions can help reform first by legitimizing it with their expertise and authority, and second by bolstering the regulatory capacity of the state. Such professionalization projects can play a key role in long-term structural change. However much Koreans, Thais and Indonesians try to satisfy external demands for predictability and transparency, the direction and implementation of reform will, undoubtedly, continue to be influenced by the political interests that bankruptcy law engages. The political incentive to encourage corporate reorganizations over liquidations is very strong, especially in countries without comprehensive social safety nets. A corporate reorganization can be a relatively cheap way to try to maintain employment, support industry, or encourage continued growth. It doesn’t require public ownership, subsidies, bailouts or other forms of direct intervention (except when the state has to bail out the banks whose loans are being renegotiated) and so politically it appears consistent with neo-liberal imperatives. It benefits shareholders, management and workers, and generally only hurts secured

Bruce G. Carruthers and Terence C. Halliday 271

creditors. The latter may even tolerate reorganizations if the bankruptcy law benefits them in other ways. Debtor corporations support soft bankruptcy law (regardless of the social benefits) since it makes their survival more likely, even when their economic performance is inadequate. The debtors’ lobby may enjoy particular influence given the generally close ties between business and government that characterize ‘crony’ or ‘booty’ capitalism. When creditors tend to be foreign and debtors domestic, the debtors’ lobby may be even more powerful – and during a systemic crisis, their political strength contrasts sharply with their economic weakness. And professions welcome laws that do more than liquidate insolvent firms since corporate reorganizations demand substantial (and expensive) expert labour. Greater ‘softness’ can be achieved de facto, through the non-use of bankruptcy provisions that lead to liquidation, or de jure, through the passage of rehabilitative bankruptcy procedures. East Asia, it seems, has pursued both strategies at the same time. Creative destruction serves an important purpose in a capitalist economy, but through the law it can be shaped to be more creative than destructive.

Notes 1 The relevant literature is already vast. See, e.g., Åslund 1995, Beck et al. 2001, Gustafson 1999, North 1990, Eggertsson 1991, La Porta et al. 1998, La Porta et al. 1997, Levine 1998, Williamson 1998, Knight 1992, Thelen 1999, Hollingsworth and Boyer 1997, Powell and DiMaggio 1991, Nee 1998, Ohnesorge this volume, Posner 1998. 2 For example, Albania passed a new law in 1992, Armenia in 1995, Belarus in 1991, Hungary in 1991, the Kyrgyz Republic in 1993, Lithuania in 1992, Russia in 1992–3, Ukraine in 1992, and so on (European Bank for Reconstruction and Development [EBRD] 1999: 148). 3 Among the 28 most advanced countries, at least 24 substantially reformed their bankruptcy or insolvency laws in the 1973–98 period. 4 La Porta et al. (1998) argue that the strength of creditors’ rights enshrined in law in a given country depends very much on that country’s legal tradition (common law vs French civil law vs German civil law etc). In bankruptcy, creditors’ rights are most strongly protected in common-law countries (La Porta et al. 1998: 1138). 5 As the ADB reported: ‘The Asian financial crisis has brought to the fore many of the inadequacies of the legal regimes in the area, and in particular, the failings of the insolvency regimes in the Bank’s developing member countries in Asia’ (Asian Development Bank 1999: 7). See also Lindgren et al. (1999: 40). 6 Of course, there may be other reasons to issue debt rather than equity, including tax advantages. 7 The problem of creditor passivity exists in Eastern Europe as well, for similar reasons. See Mitchell 1993. 8 On the political difficulties encountered during the passage of new commercial legislation, see Vatikiotis 1998b, and Business Day, Bangkok 14 January 1999, p. 1. 9 Indeed, not until after the crisis hit did western credit rating agencies like Standard and Poor’s or Moody’s lower their ratings (World Bank 1998: 43).

272 Governance of the Private Sector 10 See the July 2003 report: http://www.jitf.or.id/publication/doc_report/report_july_ 0403.pdf. 11 For instance, one commentator expected that: ‘. . . a spate of bankruptcies should follow when the law comes into effect on August 20’ (Supit 1999: 28). 12 One interviewee at the IMF noted how creative Indonesian courts could be in interpreting law that seemed to outsiders to be cut-and-dried. The rule is that bankruptcy proceedings can be initiated when a firm has at least two debts, one of which is outstanding. Yet in protecting debtors, Indonesian courts have ruled that overdue debts either weren’t really overdue, or they weren’t really debts (IMF Interview #1, see also Gray 1999: 14–15). 13 The annual growth of GDP averaged 7.6 per cent between 1987 and 1997. 14 International interbank lending to Korea grew from $15 billion in 1994 to $108.5 billion at the end of 1996, with most of the latter debt having a maturity less than a year (Lindgren et al. 1999: 69). This differs from Indonesia, for example, where foreign banks generally loaned directly to Indonesian firms and circumvented local banks (Iskander et al. 1999). 15 In the wake of US military intervention in Afghanistan and Iraq, and as the world’s most populous Muslim nation, Indonesia has assumed greater importance in US foreign policy. 16 The idea for this new test apparently came from some government economists. 17 A number of Korean interviewees mentioned the Dong-Ah construction firm to illustrate the effects of the new economic test. In November 2000, Dong-Ah Construction went into receivership after its creditors refused to lend it more money. An affiliate of PriceWaterhouse Coopers did the valuations and concluded that the liquidation value of Dong-Ah exceeded its going concern value. After some further deliberation, the court ruled that the firm be liquidated, over the explicit opposition of the firm’s creditors (Korea Herald, March 10, 2001). 18 This same pattern is particularly obvious in another East Asian economy, the Philippines, where domestic banks were frequently used to support the other firms in a family conglomerate, and little ‘arms length’ lending occurred. See Hutchcroft 1998: 10, 82–3. 19 My thanks to Meredith Woo-Cumings, whose comments provoked this discussion of the differences. 20 Were the Asian Crisis to have occurred in 1987 rather than 1997, i.e., before the economic transition in Eastern Europe rather than after, it is unlikely the IMF would have stressed structural reform. Rather, it would have focused on the usual macroeconomic measures. The transition from socialism to capitalism helped to teach international financial organizations about the importance of institutions. 21 Social investing involves the use of social criteria as well as financial criteria for investment decisions. Social investment funds commonly avoid buying the stocks of companies that have poor environmental records, or which manufacture weapons, and so on. 22 For some examples of the accounting-as-science version, see Davidson et al. (1988: 17); Istvan and Avery (1979: 5, 8). 23 The discussion of Manville’s bankruptcy is based on Delaney (1992).

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Interviews IMF Interview #1, Washington DC, 18 January 2000 IMF Interview #2, Washington DC, 19 January 2000 World Bank Interview #1, Washington DC, 19 January 2000 Thai Banker Interview #1, Chicago, 12 October 1999 Indonesia Interview #1, Jakarta, April 2002 Indonesia Interview #2, Jakarta, April 2002 Korea Interview #1, Seoul, August 2002 Korea Interview #2, Seoul, August 2002

Index administrative decentralization, 5 administrative guidance 12, 16, 81, 82 Anglo-American stockholder system, 7 American legal system, 10, 41, 45, 46, 48, 56 ‘common sense’, 46 legal realism, 64, 65, 83 sociological jurisprudence, 64 structured irrationality, 10 jury system, 10, 45, 48 Asian Development Bank, 65, 250 Asian financial crisis, 1, 2, 238–9 Second Round of Reforms, 1, 2 liquidity crisis, 1 Association of Southeast Asian Nations (ASEAN), 91, 108 Australia, 187, 190, 191, 192, 193, 195, 201 Austria, 23, 29, 152, 1661, 185, 187, 188, 189, 191, 192, 201, 202 authoritarian developmental state, 23, 146, 167, 171 bankruptcy laws, 26, 27, 28, 240–52, 259, 260–8, 269–71 creditor-friendly, 77, 244 debtor-friendly, 27, 244, 26 functions, 240–52 hard budget constraints, 245 Korean reforms, 258–9 predictability and transparency, 263 revision, 262–8 Belgium, 191, 192, 196 ‘Big Deal’, 15, 82, 226, 229, 230, 259

Taiwan, 100–4, 112, 114, 118, 119 civil law, 4, 9, 11, 16, 30, 49–50, 73, 76, 271 Europe, 76 Japan, 49–50 judges, 73 civil servants, 12, 15, 124, 126, 136 common law, 4, 9, 13, 49, 70, 73, 76, 238, 241 corporate governance, 6, 7, 24, 25, 26, 110, 136–8, 215–33, 241, 246 bankruptcy laws, 241 contractual, 24 France, 136–8 global competition, 25 high-tech sector, 110 Korea, 26, 215–33 principal–agent problem, 7 traditional discourse, 24 corporate reorganizations, 261–71 Corporatism without Labor, 20 credit controls, 14, 123, 126 crony capitalism, 2–4, 136, 238, 239, 246 Davis, Kevin, 10 Denmark, 139, 163, 191, 192, 193, 204, 205 democratization, 18, 79, 92, 170 de Soto, Hernando, 36, 28, 29, 41, 47, 50, 53 dual legal system, 12

chaebol, 7, 25–6, 82, 87, 98, 126, 131, 169, 170, 215–33, 256–60 China, 7, 8, 93, 105, 107, 110, 113, 116, 118 diaspora Chinese, see Chinese diaspora Chinese diaspora 17, 25, 26, 39, 99, 100–4, 113, 114, 118, 119, 256 enterprises in Southeast Asia, 25, 26, 110, 256 causes, 99

Employee Retirement Income Security Act (1974), 264 Enron scandal, 8 enterprise unions, 6, 18, 19, 155, 157, 158 family ownership of firms, 7, 25, 110, 137, 164, 182, 184, 185, 186, 189, 203, 217, 218, 234, 247, 249, 260, 262 Finland, 23, 161, 163, 165, 168, 169, 170, 172, 185, 189, 200, 201

281

282 Index generally accepted accounting principles (GAAP), 238, 266, 267, 270 Germany, 20, 61, 68, 78, 79, 87, 133, 136, 140, 179, 186, 187, 188, 196, 197 Gerschenkron, Alexander, 2, 63 Gini index, 190, 196, 211 globalization, 5, 6, 21, 29, 31, 92, 115, 118, 130, 139, 164, 166, 170, 171, 177, 178, 180, 181, 197, 205 governance of private sector, see corporate governance Grands Corps de l’État, 15, 126 Holland, 20 indicative planning, 14, 123 Indonesia, 4, 6, 26, 27, 28, 29, 31, 108, 215, 246, 247, 249, 250, 253–6, 261, 262, 263, 268, 269, 270, 272, 273 creditor’s rights, 28 financial crisis, 253–6 Indonesian Bank Restructuring Agency (IBRA), 253, 254, 256, 260 industrial policy, 4, 6, 13–16, 28, 102, 107, 122, 123, 125, 130, 184 international financial institutions (IFI), 2, 3, 4, 13, 65, 241, 253 International Monetary Fund (IMF), 1–3, 18, 20, 23, 24, 29–31, 36, 65, 69, 77, 96, 215, 240–1, 246, 250, 257–69 structural adjustment programme, 18 international law & development movement, 70 internationalization, 15, 93, 96, 100, 107, 115, 116, 129, 132, 197, 198 Japan, 4–8, 11–23, 24–30, 37, 39, 42, 48, 49, 50–61, 72, 73, 75, 78–9, 92, 95, 98, 99, 109, 114, 132–6, 145–71 business, 132–6 culture and law, 50–61, 72, 73, 75, 78–79 labour, 145–71 Ministry of International Trade and Industry (MITI), 52–3 Ministry of Finance (MOF), 52–3 zaibatsu, see zaibatsu Jensen, Michael, 25 Johnson, Chalmers, 12, 15, 16, 30 judicial independence, 71, 76, 77, 78, 80

Kindleberger, Charles, 28, 30 Korea, 4–8, 12, 13–29, 72–9, 81–2, 91, 93, 96, 98, 99, 109, 114, 124, 126, 137, 141, 145–6, 159, 160, 164, 167–8, 168–72, 187, 204, 205–7, 215–19, 219, 219–34, 262–8, 269–70 bankruptcy law reforms, see bankruptcy law chaebol, see chaebol Chun, Doo Hwan, 19 militant enterprise unions, 18, 19 Roh, Tae Woo, 19 Young, Sam Kim, 19, 169, 170 Korean Asset Management Corporation (KAMCO), 257 Kuomintang, 16, 94, 104 labour, 6, 17–26, 51, 64, 91, 98, 130, 131, 133, 135, 143, 145, 146, 147, 152, 153, 154, 156, 159, 172, 181–207 labour corporatism, 23 law and development movement, 79, 83 legal formalism, 11, 13, 37 legal reform, 10, 13, 37, 58, 59, 60, 71, 83, 84, 241, 246, 269 Lerner, Max, 83 Loriaux, Michael, 14, 15 Nationalist Party, see Kuomintang nationalization, 14, 15, 92, 126, 130, 159, 261 banks, 14, 15 France, 126 industry, 14, 15 Taiwan, 92 neoliberalism, 1, 3, 92, 115, 270 New Zealand, 21, 187, 191, 193, 195, 196, 201 Nippon–Rhenish stakeholder system, 6–7, 24 Nordic model, 22, 204, 206 North, Douglas, 8, 9 Norway, 29, 163, 188, 191, 192, 193, 201, 204 Monica Lewinsky affair, 43

Index 283 Ohnesorge, John, 13 Organization for Economic Co-operation and Development (OECD), 12, 103, 135, 154, 163, 164, 170, 177, 179, 198, 202, 204, 205, 207, 230, 235, 241, 246, 256, over-the-counter market, 97, 104 postwar classic welfare regime, 22 poverty, 6, 21, 180, 190, 191, 192, 193, 196, 201, 205 progressive movement, 13, 64, 65, 69, 70, 111, 170 new deal, 13, 64 public health service, 186 Reagan, Ronald, 1, 22, 126, 129, 139, 195 Reagan administration, 116 Reagan dollar, 126 Reaganomics, 129, 139 tax cuts, 195 regulatory institutions, 1, 2, 4, 8, 38, 64, 75, 77, 78, 80, 81, 82–3 regulatory state, 4 formalities, 38 practices, 77, 78, 80, administrative guidance, 81 regulatory state, 5 rule of law, 2, 4, 7–13, 36, 37, 39, 41–2, 45, 46, 47–8, 79–80, 81–2, 83 Schumpeterian entrepreneurs, 26 Shihata, Ibrahim, 11, 36, 37, 61 Smith, Adam, 1 social democratic welfare state, 21, 182, 185, 186, 190, 191, 192, 196, 200 social safety nets, 6, 242, 261, 270 state intervention, 14, 98, 123, 132, 140, 167 subsidies, 14, 26, 98, 113, 114, 115, 123, 124, 125, 127, 134, 188, 222, 245, 254, 270 Sweden, 139, 146, 161, 165, 177, 191, 195, 197, 200, 201, 205, 209, 232 Switzerland, 161, 190

Taiwan, 5, 16–17, 23, 39, 62, 72, 78–9, 85, 91–3, 94, 96–101, 102, 104–19, 167, 205, 215, 255, 265 Central Bank of China (CBC), 93–7 coping with globalization, 91–3 executive yuan development fund, 17, 103, 104, 114 Hsin-Chu Science Park, 17 Industrial Development Consultation Committee (IDCC), 113 Ministry of Economic Affairs (MOEA), 94, 101, 102, 105, 107, 108, 109, 113 missile crisis, 97 National Science and Technology Conference (NSTC), 113 nationalist party, see Kuomintang obtaining intelligentsia, see Chinese diaspora political democratization, 79 Six-Year National Development Plan, 104 Thailand, 7, 26, 28–30, 215, 246, 247–50, 251–6, 260, 261–3, 268–9 Thai Asset Management Corporation (TAMC), 252, 260 Thatcher, Margaret, 1, 21, 22 , 195 Trebilcock, Michael, 10, 30, 37, 60, 61, 239 United States Agency for International Development (USAID), 37 Upham, Frank, 9, 10, 11, 12, 35, 37, 39, 41, 43, 45, 47, 51, 52, 53, 55, 57, 59, 60, 63, 71, 264, 265 ‘Washington Consensus’, 1, 3, 67, 92 Weber, Max, 7, 8, 11, 37, 49, 41, 58, 60, 61, 63, 68, 71, 88, 240, 241, 264, 269 Wolfensohn, James, 2, 31 women’s employment, 22, 203, 206 World Bank, 2, 4, 5, 6, 11, 24, 36, 37, 41–2, 43, 59, 65, 96, 239–41, 246, 250, 260, 261, 263, 269 Zaibatsu, 26, 99, 131