Elisabetta Marmolo^a & Nimai M. Mehta^b

Contra to these views, what matters in our story is that a systematic bias towards implicit deficits existed in East Asian countries because of their specific development model. In assuming substantial responsibility for the extra-normal allocation of private resources to selected productive sectors, governments had necessarily to take up responsibility for the negative impact of possible misallocations, while ensuring adequate returns to private capital. This entailed both ex-ante and ex-post commitments: ex-ante, towards policies that created adequate rent for private capital; and, ex-post, to bailouts of banks and corporations, were adverse circumstances to threaten their profitability. Implicit deficits existed in the East Asian economies long before the crisis. And rational economic agents could not have been unaware of their existence, which was made quite obvious by the web of relationships and obligations connected with the state direction of the economy.

Further, as misallocation risks and potential policy distortions are necessarily large, and are perceived to be so by economic agents, there is a tendency in these systems to overextend the socialization of investment risks⁷. For the non-socialist, developmental state⁸, implicit deficits are a critical tool in this respect because they effectively ease the direct budget financing constraint to the socialization of investment risks. Therefore--in a sort of circular logic that leads from strategic direction of the economy to misallocation, and back to the need for more public intervention – there is a natural tendency in these economies to overextend the public through the implicit deficit. This is something akin to the tragedy of the commons, and was clearly observable in the developmental states of East Asia⁹.

It is important to understand why implicit deficits are such an important tool in the context of the developmental state model, and why they are sustainable over long periods of time. There are two main reasons for which governments may prefer implicit over explicit deficits:

• Lack of transparency. While agents may know that implicit deficits exist, they cannot know how large they are nor they perceive their burdens. Until things go well, the resistance to implicit deficits and their political costs, both internally and externally, are likely to be minimal
• Flexibility. As implicit claims against the government materialize only if things go wrong, and there is no pressure to actually budget for these, there is always room for new, open-ended commitments by the government if the economy appears to be working well. This grants the government enormous leeway in pursuing an aggressive growth strategy

The advantages deriving from lack of transparency and flexibility may induce a government to shift its obligations to the implicit sphere. However, there are two critical conditions to the sustainability of the implicit deficit. From the economic standpoint, sustainability requires that the government be able to deliver high growth through its development strategy. From the political standpoint, it is only when a government has an acknowledged and substantially unrestrained mandate for direction of the economy that a large implicit debt may be sustainable for an extended period of time. Individually, each of these conditions is necessary, but not sufficient for the sustainability of implicit deficits. It is, in our view, likely that both these conditions may indeed exist for developing countries, and that they were in fact present in the case of the East Asian economies.¹⁰

It is this last point that we wish to explore further by linking it with the constitutional metaphor. A constitution is defined here as the basic document establishing to what extent the public might interfere with the private, including the economic sphere. In other words, the constitution determines to role of the government. The constitutional calculus of rational individuals, under a veil of uncertainty, will place in the public sphere those activities for which interdependence costs tends to be high, i.e., those activities that are likely, in post-constitutional settings, to generate externalities which much exceed private costs/benefits. These include not only the provision of public goods such as justice, defense, or money, but also goods which are not conventionally considered public but are characterized by high utility interdependencies.¹¹ The latter may encompass economic resources that are critical to economic development.

An interesting conjecture to make is that there is a link between the constitutionally determined scope of the public sector and the stage of development. As economies mature, the role of the state tends to be more narrowly defined by individuals at the constitutional stage, and constitutions will be periodically amended to reflect this. In societies that are poorer, individuals will tend to be more skeptical of the powers of the "invisible hand" and more supportive of an extended, active role for the state, because resources and opportunities are extremely scarce. In a situation of extreme scarcity, independent use of resources by each individual will impose—by definition—relatively much larger external costs on others in post-constitutional settings than in a situation where there are more resources and opportunities available. In other words, the domain of high interdependence costs will be generally perceived to be much larger in the constitutional calculus of individuals in poorer countries. The role of the state may be correspondingly larger and deeper, and the basic mandate for the government is likely to be development itself, defined as both economic growth and social progress through access to basic goods.¹²

At the same time, the costs from misallocation of resources are likely to be much lower than the benefits from socialization of investment risks at the initial stages of development. This situation will change—with misallocation costs becoming relatively larger and social benefits smaller—as an economy moves up the development ladder. While certainly there is a need to look more in depth into this conjecture in another work, it has a certain intuitive appeal. At the initial stages of the catch-up process, developing countries are less likely to make "mistakes" in their strategic choices because they can follow the example of the more developed economies. As developing countries progress, the old economic game becomes progressively less rewarding.¹³ Further, as economic growth brings relative abundance, the social benefits of further state intervention start to shrink.

These two conjectures—i.e., one, that the developing countries are likely to endorse larger governments, and, two, that the benefits of larger governments are likely to decrease as these countries progress—have an important implication. This is that the fundamental problem of how to constrain the Leviathan is even more significant in the context of developing countries than it is for developed countries. The issue is how to avoid that state intervention may lead to the destruction, rather than the creation of economic value.

The destruction of economic value is directly related to the possible overextension of the public sphere in postconstitutional settings. A government is overextended when its interventions cause misallocation costs that exceed substantially social benefits. The possibility of substantial overextension of the public makes it essential that a developmental mandate, to work effectively, must be accompanied by sufficient constraints on the explicit and implicit size of the government. The key issue is how to limit the scope of the pervasive tragedy of the commons.

The tragedy of the commons arises from a situation where a common resource generates economic value through the application of privately owned inputs. Generally, the independent exploitation of the common resource will extend use beyond the optimal level. This notion of commons can be extended to the public sector budget. Budgetary financing of partitionable goods, which are allocated through criteria other than price, can generate situations similar to the tragedy of the commons. Buchanan and Tullock have shown that the logic of majoritarian choice may stretch public provision of partitionable goods beyond the desirable or optimal level. There is a natural propensity in majoritarian democracy for overextending the budget as the commons at the post-constitutional stage. As we have discussed, there is a natural propensity to overextend the commons in directed, non-socialist economies such as the developmental states of East Asia.

There is much to be learned from looking into other rules, besides decision-making rules, that may either contain or compound the natural tendency to overextend the common. One of these is, of course, the balanced-budget rule. This may help reduce the scope for overextension of the commons. However, as the Asian experience shows, the balanced-budget rule can be substantially circumvented by the existence of a large implicit deficit. The existence of an implicit public deficit makes the threat of the Leviathan more elusive if pervasive.

It is certainly beyond the scope of this paper to look into institutional set-ups that might help constrain the explicit (budget) and implicit size of government intervention. However, a few general points can be made.

First, there is the issue of transparency. It is our view that in a context such as that of developing countries, where the scope of government intervention and interference with the economy tends to be wider, particular care should be taken to assure at the constitutional level that the government initiatives are kept on, rather than off, the books. An explicit budget deficit is definitely the lesser evil as compared to the unchecked growth of the implicit public sector. There reason for this is simple. Visibility allows for oversight, and a more consistent check on government activities. The implicit budget only comes to light when it is too late. The extent of damage is therefore potentially much larger.¹⁴

Second, there is the issue of voice. Clearly the availability of institutional means to express disapproval of economic choices is important. This should not be necessarily understood as a need to import acritically models of western-style, representative democracy. In some cases, these may work well. In other, they may be rather ineffectual, as for example in a context—not the East Asia one--where income inequalities are extremely large, and there are large number of poor lacking access to basic education, information, etc. What is necessary is that appropriate institutional vehicles to voice and address grievances must exist. It also means that a system of checks and balances must be carefully built and embodied in the constitution in a way that is best suited to the cultural, traditional, and institutional milieu of a country. In some cases, this may mean a strong role for the judiciary. In other cases, it may work out in the form of an effectively decentralized system of government where exit becomes a meaningful choice option. If a strong executive, and in the context of Asia, charismatic leadership, may have a role to play in spurring development, this should not go unchecked.

Third, there is the issue of consistency between economic policies and the basic principles informing a country’s constitution. In contexts where the state has a clear constitutional mandate to promote development, and where the government’s model of development is generally supported, external attempts to impose alternative models may be highly counterproductive. They may simply induce a policy move towards the implicit budget with a larger wastage of resources that is likely to result from unchecked expansion of the size of implicit government interference.

It is important to stress that the economic reforms which started taking place in Asia from the end of the eighties did not affect in any substantial way the nature of the developmental state and its role in directing the economy. As a fall-out of the Latin American debt crises, strong international pressures were placed on developing countries to put their fiscal and monetary house in order. Privatization and deregulation became the name of the game. East Asian countries adapted the neoclassical creed, as distilled through the Washington consensus, to suit their model of development highly dependent on state intervention.

As East Asian governments divested of state-owned enterprises, their influence over the economy all but disappeared. In fact, it strengthened. The East Asian governments continued to support those sectors of the economy they deemed critical to their growth agenda. These included now the former state-owned enterprises.¹⁵ Similarly, capital account opening did not mean freer markets or the end of state direction of the economy. It simply implied that the government would, through the guarantees to the banking sector, allow the injection of external funds into the economy to ease the pressure on the current account deriving from a slow-down in exports.

These reforms caused a further shift from explicit public budget financing into implicit support of critical economic sectors—reinforcing a tendency that already existed in East Asia. In this sense, the "reforms" might have contributed to aggravate rather than solve the problems of these economies¹⁶.

Our account is admidtedly still quite rough. We believe, though, that it is broadly consistent in that

• It provides a fundamental explanation of the crisis that is rooted in an understanding of the East Asian development model
• It attempts to link the macroeconomic side and the institutional/political decision-making side of the story (in the spirit of Buchanan’s contribution) and to see through the Keynesian delusion
• It is not characterized by the discontinuities of models that assume radical and sudden shifts in the economic beliefs held by the East Asian decision makers. Among practicioners, models of development do not change overnight

Going back to East Asia, in the crisis-affected countries there might have been a ground level mandate for the developmental state, at least up to a point. But this was allowed to grow beyond limits that were acceptable by absence of constitutional checks and the increasingly off-budget nature of government commitment. Solutions to the crisis will have to go beyond the quick fix of banking and corporate sectors. They will need touch the heart of the constitutional set-up of the countries affected. And solutions will need to be essentially homegrown.

In talking of homegrown solutions, we essentially refer to solutions that must be attuned to the politial realities of the countries affected, without being complacent. The East Asian economies will certainly need to take a hard look at whether their traditional model of development can still work. We also hope that the political pressures generated by the crisis may lead to constitutional compacts that more effectively constraint the Leviathan.

At this point, it may be appropriate to introduce some qualifiers to the approach followed in this paper.

First, our analysis is concerned with the fundamentals of the crisis, rather than with the specific trigger factors that may have contributed to the timing of the crisis. On the basis of fundamentals, one way to explain off-the-cuff why, for example, Korea had a crisis and Taiwan had not, is that the latter relies on more explicit forms of public control over the economy than the former. For example, public enterprises play a much larger role in Taiwan than in Korea. A complete explanation would need, however, a much deeper examination of the two economies, and might also encompass some of the trigger factors besides fundamentals.

Second, on a somewhat broader point, the paper examines factors that make implicit deficits a preferred and sustainable instrument in the context of the developmental state model. However, it does not look sufficiently at the specific dynamics that may undermine sustainability of implicit deficits as a country moves up the development ladder. Also, it does not look at the instructive cases where a developmental mandate could have been justified and sustainable in principle, but, differently from the East Asian cases, it has not emerged or it has not worked—e.g., India. There is room for expanding our research in these directions.

Finally, our conclusion that solutions to the problems of East Asia must be homegrown, may seem not to square well with a fact that the crisis has brought dramatically to the forefront, that is that economic problems have today a "global" dimension. The single factor that has been most emphasized in explanations of the crisis has been the role of external finance, as a source of increasing vulnerability and economic instability and an immediate trigger of the crisis. Some have gone to the extent of seeing this as the main culprit in the downfall of East Asian economies and of recommending capital controls as a legitimate solution to the economic troubles in East Asia.

As discussed earlier, open capital accounts were not in dissonance with, but necessitated by the demands of the developmental state in East Asia. As economic ambitions grew, steering of domestic savings was not sufficient any more. Luring in capital, by deliberately allowing speculative gains (this was no lack of oversight), was a consistent, not a "wrong" move from the perspective of the developmental state. In our constitutional approach, the opening up of capital accounts removed an important limit on the size of the implicit budget. Contra to the common wisdom, it may have helped delay, rather than accelerate the exposure of the economic problems of East Asian economies. These problems are essentially due to the absence of effective constraints on the proliferation of state interference, and, therefore, require domestic solutions which will address this.

However, external private and public finance has certainly a role to play in our story to the extent that it causes significant crossboundary externalities through the transfer of resources from tax-payers in developed countries to ill-disciplined governments and international speculators--something the IMF has been much criticized for helping. The interesting issue this transfer of resources poses from a constitutional economic perspective is that the costs of developmental choices of the East Asian governments are partly born by individuals who were not party to the (implicit) agreement on the mandate of the developmental state. These individuals were not voluntarily drawn in by the search of profit as in the case of speculators. It is our view that the current debate on the re-design of the international financial architecture should focus on this supranational dimension, i.e., how to minimize these crossnational externalities. These are again areas for further research.