VOLUME I, NO. 1
SEPTEMBER 2005
FRONT MATTER
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Editor’s Note
6
Is the Allocation of UK Development Aid Driven by Good Governance?
Timothy Stern
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111
121
133
151
ARTICLES
The External Accountability Gap of Private Regulators: Accountability
Paradoxes and Mitigation Strategies – The Case of Credit Rating Agencies
Marc Robi Das Gupta
ESSAYS & NOTES
Form vs. Function: Prospects for Convergence in Global Corporate Governance
Regimes
Jonathan C. Bond
Secularism: Liberalism’s Achilles Heel at the ‘End of History’
Ploutarchos Evlogimenos
The European Commission as an Agenda-Setter: Lessons from and Limitations of
Formal Analysis
Daniela Ulicna
Can National Executives Use IMF Conditionality as Leverage for Domestic
Bargaining? Argentinean National Executive and Provincial Negotiations for the
IMF’s Financial Shield in November 2000
Andres Tacsir
Power vs. Pride: U.S. Policy Toward Iran’s Nuclear Ambitions
Iyanuloluwa Adewuya
INTERNATIONAL PUBLIC POLICY REVIEW
Editorial Staff, Volume I (2004/05):
Iyanuloluwa Adewuya
Fay Aubrey
Jonathan C. Bond
Mateo Gori
Ploutarchos Evlogimenos
Cordelia Hamed
Sarah McLaughlin
Jo Setters
Maurice Wong
Editorial Board
M.Sc. International Public Policy
M.Sc. International Public Policy
M.Sc. Public Policy
M.Sc. International Public Policy
M.Sc. International Public Policy
M.Sc. International Public Policy
M.Sc. European Public Policy
M.Sc. International Public Policy
M.Sc. Public Policy
Academic Review Panel
Dr. Fiona Adamson, chair
Dr. David Coen
Dr. Fabio Franchino
Dr. David Hudson
Dr. Jennifer van Heerde
The INTERNATIONAL PUBLIC POLICY REVIEW (ISSN: 1748-5207) is a peer-reviewed,
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INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (October 2005).
[ISSN 1748-5207]
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
EDITOR’S NOTE
When I began thinking seriously about the idea of launching a studentedited journal within the School of Public Policy, my fundamental concern
was how to ensure that such an effort did not become a mere replication of
the efforts of existing academic journals. In my mind, it was crucial for this
journal to offer a unique contribution to what is becoming a rather crowded
research area. The birth of the International Public Policy Review is therefore
the product of a desire for a top-notch academic journal that is uniquely
situated in the relatively new academic field of ‘international public policy’. As
its most fundamental aims, the journal intends to serve as an effective research
tool for practicing policymakers, members of the academia and students; and
to provide a platform for first-time publication efforts among post-graduates.
Although the term ‘international public policy’ has yet to establish a firm
foothold within the vocabulary of the academic community, it is clear that a
nascent research field exists which is devoted to examining areas of
governance and public policy that are either international or strongly affected
by international factors. It delineates itself from the traditional field of
international relations and its ‘great power’ focus in two unique ways: by
emphasizing the ‘governance’ element in world politics and international
affairs; and by operating within a broad framework of interdisciplinary work
which effectively combines the various approaches, methods, and substantive
questions which are traditionally associated with international relations,
international economics, comparative politics, political philosophy and public
policy studies. As such, it is perhaps best described as an expansion (or
amalgamation) of the traditional fields of international relations and public
policy, as opposed to being subfields of it.
It is clear that new empirical research over the past decade has increasingly
fallen outside the traditional boundaries of IR and its security and IPE
subfields. These include issues such as the globalization of world politics,
human rights, international environmental policy, economic sanctions and the
economic roots of conflict. The IPPR hopes to facilitate the process of
developing a recognized research area within which such studies can be
situated and identified. Although the yet undefined research area may appear
to pose a crisis of self-definition, I instead see this as an exciting challenge
because it allows the IPPR to publish in the most productive fields of political
3
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INTERNATIONAL PUBLIC POLICY REVIEW
science and facilitate communication between them. In order to explore the
creative tensions between the various fields as well as their areas of agreement,
the subject matter appropriate for articles submitted to the IPPR will be quite
broad. The journal will also welcome the submission of manuscripts that use
less social-scientific methodologies.
All articles published in the IPPR will be theoretically informed.
However, it is acknowledged that the balance between theory and empirical
work may vary. We wish to encourage submission of manuscripts that span
the spectrum from introducing abstract new theoretical claims to applying
theory in well-developed empirical settings. Central to the strength of the
journal will be its ability to maintain a balance between broad theoretical
statements and research that adopts a narrower, issue-specific focus. Thus, we
welcome manuscripts that develop broad approaches, such as identity
formation and manipulation, as well as work that contributes to welldeveloped research agendas, such as the domestic politics of trade policy or
the impact of international institutions on patterns of interstate cooperation.
All submissions—even those by the most respected authorities—are
subjected to a rigorous editorial process designed to sharpen and strengthen
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the author's name, affiliation, prior publications, or pending publication
projects. The Review publishes works of academic scholarship under two
rubrics: Articles and Essays/Notes. While articles typically occupy traditional
zones of scholarship and treat their subjects comprehensively, essays/notes
tend to open novel areas of discussion and propose new scholarly vocabularies.
Though both must meet rigorous academic standards, essays press up against
established academic boundaries more than articles. Essays typically devote
less attention to canvassing existing scholarship or situating themselves within
an ongoing debate. Instead, they outline new parameters of discussion or
engage in highly focused analysis of an illustrative scholarly problem.
The Review is run by an editorial board composed of nine editors who are
students in the School of Public Policy. The Editors read articles that are
submitted to the Review and select, using uniform standards, the best articles
to forward to an academic review panel. An academic review panel composed
of five members of faculty from the School of Public Policy reviews all articles
recommended by the Editorial Board and, in consultation with the Board,
makes a final selection of all articles that are published in the Review.
Throughout the process of launching this journal, I incurred debts to many
people and am pleased to be able to thank them in print at last. The project
benefited greatly from the timely advice and steady support of Dr. Fiona
VOL. I,
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1 — OCTOBER 2005
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Adamson who served as our principal academic adviser, and the expertise of
Dr. David Coen, Dr. Fabio Franchino, Dr. Jennifer Van Heerde and Dr. David
Hudson who sat on the Academic Review Panel. I am profoundly grateful for
the hard work and dedication of the initial group of Editorial Board members:
Fay Aubrey, Jonathan Bond, Mateo Gori, Ploutarchos Evlogimenos, Cordelia
Hamed, Sarah McLaughlin, Jo Setters and Maurice Wong. I am also indebted
to Sally Welham for offering her administrative expertise, Aaron Compton for
the journal’s outstanding web site and David Woods for the Review’s official
logo.
A popular maxim claims that an educated person is one who can cope
with ambiguity. Indeed, there is much to cope with today. Through published
manuscripts, the journal will attempt to come to grips with the major dramas
now being played out between the forces of globalism and regionalism,
nationalism and transnationalism, security and welfare, and order and change.
The International Public Policy Review does not seek to make the
ambiguous simple but rather a bit more fathomable.
Iyanuloluwa A. Adewuya
London
September 2005
IS THE ALLOCATION OF UK DEVELOPMENT AID
DRIVEN BY GOOD GOVERNANCE?
Tim Stern
ABSTRACT
This study analyses whether the allocation of UK bilateral development aid is
driven by good governance in recipient countries. Linear regressions are run with
data from the Department for International Development for 1998, 2000, and
2002, and governance is measured using the World Bank Governance Indicators,
which rank countries on the basis of political stability; voice and accountability;
regulatory quality; government effectiveness; rule of law; and control of
corruption. The results show that in 1998 and 2000, none of the governance
variables were statistically significant except for voice and accountability, which
had a positive coefficient, implying that more democratic and accountable
countries received more UK aid. By 2002, government effectiveness also had a
positive and statistically significant coefficient, but regulatory quality and control
of corruption had negative and statistically significant coefficients, implying that
the UK was sending more aid to countries which were corrupt and poorly
regulated.
1.
INTRODUCTION
Development aid has frequently been the subject of debate. Some
observers argue that with millions of people living in extreme poverty, an
immediate increase in national aid budgets is essential. Others claim that
corrupt and inefficient governments in recipient countries waste millions of
pounds of aid every year and that until those governments clean up their acts,
sending them more money will have little effect. According to this latter
argument, accountability, control of corruption, and competent public
management are essential for economic growth (the goal of development aid).
These qualities are clearly desirable in their own right, but whether they are a
prerequisite for aid to be effective, or whether aid should be used to promote
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005):6-36.
[ISSN 1748-5207]
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
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them, is vociferously disputed. In this context, examining the degree to which
national aid agencies use international development assistance to combat
corruption and promote better public management may a useful exercise.
This paper looks at how the UK’s Department for International Development
(DFID) allocates financial aid, and how the distribution of that aid relates to
the policy environment in recipient countries.
1.1. The Origins of Aid
International development aid, generally speaking, has its origins in the
Marshall Plan (1948-52) - a programme through which the US provided
economic assistance to post-war Europe in an effort to stabilise the region and
secure allies against Soviet and Communist influence. Throughout most of the
Cold War period, development aid was seen largely as a strategic tool in
foreign policy and was therefore influenced as much by donor interests as
recipient needs. US aid was predominantly driven by political and diplomatic
goals, whilst Japan used it to promote domestic trade and industry (see P.
Burnell, “The Changing Politics of Foreign Aid – Where to Next”, Politics 17,
no. 2 (1997): pp. 117-118). In fact, the aid patterns of most OECD donors
showed that considerations of poverty reduction were limited and national
interests dominated decisions about the allocation of financial assistance. As a
result, recipient governments tended to be rewarded for their political
allegiances rather than efforts to reduce poverty or control corruption.
Even as recently as 1991 the UK government became embroiled in a
scandal over the allocation of aid for political rather than developmental
objectives. The then Overseas Development Administration (now DFID) had
provided £234 million for the construction of a dam on the Pergau River in
Malaysia. At the same time, the Malaysian government bought around £1
billion worth of arms from the UK. Objections were raised from within ODA
that the project was an abuse of the aid system and in November 1994 a High
Court ruled that British funding for the dam was illegal, on the grounds that it
was not of economic or humanitarian benefit to the Malaysian people (see
ibid., and www.tiscali.co.uk/reference).
1.2. The Washington Consensus
By the 1980s it had become apparent that development aid was often
having little positive effect in recipient countries. Aid allocation was still
largely driven by political motivations, but with growing aid budgets donor
governments could not continue to spend increasing amounts of the public’s
money without seeing some results. Economists in the World Bank and the
IMF held the view that the economic environments in recipient countries
were often to blame for both the lack of endogenous growth and the failure of
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financial assistance programmes. It was thought that dirigiste policies and
overbearing governments stifled the free market and that economic
liberalisation was the sole solution. This line of reasoning became known as
the ‘Washington Consensus’ and prevailed throughout most of the 1980s,
arguing that for a national economy to grow it needs low inflation, open trade
policies, and minimal government intervention. It was claimed that aid would
only work in countries which adopted these policies and therefore if donors
wanted to see positive results from their assistance programmes they should
encourage recipient governments to implement economic reforms. This view
led the World Bank and the IMF to attach conditions to their aid programmes,
requiring recipient governments to follow strict fiscal guidelines, and
throughout most of the 1980s and 1990s ‘conditionalities’ on concessional
(soft) loans and programme aid packages forced developing states to open
their economies and adopt more neo-liberal policies.
However, despite some examples of success – most notably in countries
which experienced the ‘Asian Miracle’, such as South Korea and Thailand –
there are also many cases in which economic liberalisation has had adverse
effects. In Mexico, a program of rapid trade liberalisation and deregulation
was followed by the collapse of the peso in December 1994. Tanzania, forced
to adopt a program of trade liberalisation and the dismantling of state
financing for small farmers, has experienced expanding rural poverty and
income inequality, despite growth in exports. And Senegal, after following
IMF guidelines for 18 years, has seen declining education quality and healthcare systems and a growth in maternal mortality, unemployment and the use
of child labour. The reforms clearly were not working for everyone (see
http://www.developmentgap.org/imfconclusions.html).
1.3. Good Governance
In the early 1990s new theories about development started to gain
currency, claiming that whilst the right economic policies are important for
growth, on their own they are not enough. The aid industry began to take the
view that for aid to be effective it also requires transparency and
accountability, control of corruption and competent public management –
qualities collectively referred to as good governance – to be present in recipient
countries. With the end of the Cold War the strategic motivations behind aid
became less important and instead its effectiveness at encouraging growth and
reducing poverty became the more crucial issue. Good governance became
increasingly accepted as a necessary condition for aid to be successful, and it
therefore also became the focus of much of the literature on development.
For the last decade, virtually all the debate about aid policy has included at
least a reference to issues of governance. Whilst some still dispute its
importance, more and more governments and aid agencies are now accepting
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the need to take governance criteria into account when deciding on aid
allocations. In fact, as early as 1994, the OECD Development Assistance
Committee stated:
It has become increasingly apparent that there is a vital connection
between open, democratic and accountable systems of governance
and respect for human rights, and the ability to achieve sustained
economic and social development. (…) This connection is so
fundamental that participatory development and good governance
must be central concerns in the allocation and design of development
assistance. (Orientation endorsed at the DAC’s High Level Meeting
on 13 and 14 December 1993. See http://www.acdi-cida.gc.ca/
INET/IMAGES.NSF/vLUImages/HRDG/$file/Dac-e.pdf)
1.4. The Assessing Aid Report
One seminal publication on the subject of good governance and
development aid was the 1998 World Bank report Assessing Aid: What Works,
What Doesn’t, and Why (Washington: Oxford University Press, 1998) written
by David Dollar and Lance Pritchett under the tenure of Joseph E. Stiglitz as
Chief Economist to the Bank. The report argues that “stable macroeconomic
environments, open trade regimes, and protected property rights, as well as
efficient public bureaucracies that can deliver… public services” (Ibid., p. 14)
are essential for financial aid to be effective at increasing growth and reducing
poverty. It also maintains the importance of institutional quality – the rule of
law and control of corruption – for aid to be successful, concluding that aid
will only work in ‘good policy environments’. The report was important for
two reasons. Firstly, it showed the World Bank to be explicitly moving
beyond the Washington Consensus view that economic liberalisation is the
sole key to development, and embracing the idea that a broader range of
factors, such as strong institutions, needs to be considered. Secondly, and
perhaps more significantly in terms of policy implications, the report
recommended that donor governments should increase aid to good policy
performers and cut aid to poor ones. Whilst this may seem like a logical
conclusion to the argument that good governance is essential for development,
cutting aid to those countries which suffer the worst public management and
have the weakest institutional capacity, a policy known as ‘selectivity’, would
have constituted a dramatic about turn for many national aid agencies.
Furthermore, it risked leaving donors open to the charge that they were
abandoning the very countries which most needed development assistance.
Consequently, although the 1990s saw the good governance argument
being widely accepted, often the policy conclusions drawn from this were
simply that more conditions should be attached to aid packages. Poorly
performing countries should still receive aid, but only if they promised to
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INTERNATIONAL PUBLIC POLICY REVIEW
improve their policy environments. However, as argued in the Assessing Aid
report, ‘conditionality’ is likely to be ineffective unless there is a genuine desire
for reform within the recipient country. Without existing commitment to
sound economic management, control of corruption, and general good
governance, aid will neither create growth nor reduce poverty. “Efforts to
‘buy’ policy improvements in countries where there is no movement for
reform… have typically failed” (Ibid., p. 3). The reasons for this can be lack of
‘ownership’ of the reforms by the recipient country (the feeling that they are
being imposed rather than chosen); corruption in the bureaucracy; or
weakness in the enforcement of conditions on the part of donors (continued
donations regardless of whether the conditions are met). Whatever the cause,
the result, argues the World Bank, is that conditionality is rarely very effective.
Instead, countries should be selected as aid recipients on the basis of an
assessment of their policy environments. “Clearly, poor countries with good
policies should receive more financing than equally poor countries with weak
economic management” (Ibid., p. 4). Because “countries without good policies,
efficient public services, or properly allocated expenditures will benefit little
from financing” (Ibid., p. 5), limited development budgets should not be
wasted on them: donors should provide these countries with non-financial
assistance in the form of ideas, training and technical expertise instead. The
resounding conclusion of the World Bank report is that the aid industry should
be more selective, and that “donors should be more willing to cut back
financing to countries with persistently low-quality public sectors” (Ibid., p.
21).
1.5. Examples of Selective Aid Policies
The good governance argument, having been accepted and advocated by
such an influential institution as the World Bank, has had wide-ranging effects
on the aid industry. One country which has subsequently adopted good
governance as a criterion for selective aid allocation is the US. It has recently
undertaken a major policy shift with its decision to “allocate funds from the
new $5billion per annum Millennium Challenge Account (MCA) towards
countries that ‘govern justly’, ‘invest in people’, and ‘promote economic
freedom’.” (D. Kaufmannm and A. Kraay, “Governance Indicators, Aid
Allocation, and the Millennium Challenge Account”, World Bank Research
Paper (draft for comments - online at http://www.worldbank.org/wbi/
governance/pubs/mca.html)). Using a range of indicators provided by
Freedom House, the World Bank and the IMF among others, the MCA
account ensures “that resources are channelled towards countries that are
performing well in a variety of dimensions of governance” (Ibid., pp. 3-4). The
system is wholly transparent and creates clear incentives among potential
recipients of aid, as ‘role model’ states receive more financial assistance than
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those which pay scant attention to good governance. Another country which
has changed its aid policy as a result of the good governance argument is the
Netherlands. The Dutch government has recently reduced the number of
recipients of its aid from over a hundred to twenty and now only countries
which can demonstrate a previous record of good governance receive financial
assistance.
Perhaps if it is increasingly being accepted that financial assistance only
works in a good policy environment, and that selective aid allocation is the
most effective way to promote better governance, we should expect to see
more aid agencies following the examples of the US and Dutch governments
and using good governance as an objective criterion of allocation.
1.6. The Department for International Development
The UK’s Department for International Development (DFID) has
undergone some significant changes since the current Labour government
came to power in 1997. Aid has been categorically ‘untied’ – meaning that the
practice of making aid packages conditional on the purchase of UK goods and
services by recipient countries has been abandoned – and the aid budget as a
proportion of GDP has increased from approximately 0.25% in 1997 to 0.33%
in 2003 and is set to rise to 0.47% by 2007/8 (see http://www.dfid.gov.uk and
http://www.hm-treasury.gov.uk/media/249EE/sr2004_ch15.pdf). Like the
US and Dutch aid agencies, DIFD has also accepted the argument that good
governance is a necessary condition for economic growth. Its first major
statement of policy came in the 1997 White Paper Eliminating World Poverty:
A Challenge for the 21st Century (London: Crown, 1997). Outlining its
commitment to promoting better governance in poor countries, this paper
adopted much of the prevalent rhetoric on aid: “Raising standards of
governance is central to the elimination of poverty” (Ibid., p. 30), “we shall
give particular attention to human rights, transparent and accountable
government and core labour standards” (Ibid., p. 9), and “we want to see
economic endeavour hand-in-hand with accountable government, the rule of
law and a strong civil society.” (Ibid., p. 12). And since then subsequent
publications have reiterated this commitment: “In all regions, to varying
degrees, we need to work to… combat corruption and promote honest and
accountable government” (Making government work for poor people: building
state capacity (London: Crown, 2001)).
Given DFID’s repeated and explicit commitment to the promotion of
good governance, we might reasonably expect to see some reflection of this in
the allocation of UK development aid. And if, like the US and Dutch
governments, DFID accepts that an existing good policy environment is
essential for development, we might also expect to see a positive correlation
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between the quality of a country’s governance and the amount of UK aid it
receives. Now, more than seven years after its creation in 1997, DFID has had
plenty of time to back up its rhetoric with action and it is an apposite time to
assess its performance. Furthermore, with a continuously increasing aid
budget, currently at a record level in real terms (£3313 million in 2002/3, see
http://www.dfid.gov.uk/aboutdfid/statistics.asp), we would do well to
examine the criteria by which this significant proportion of public spending is
allocated. This research paper therefore sets out to analyse the degree to
which UK aid allocations are influenced by the policy environments in
recipient countries.
2.
THE EXISTING LITERATURE ON DEVELOPMENT AID
The existing literature on development aid can be roughly divided into
two parts. One studies the effects of aid on recipient countries and the factors
that affect its success. The other looks at what drives aid allocation - namely
why some countries receive more aid than others. The following section of
this paper provides an overview of the most important publications in both of
these areas and then discusses how we should go about measuring governance
and some of the indexes which purport to do this.
2.1. Does aid work?
The first part of the literature – on the effects of aid – began with a
number of fairly unenlightened macroeconomic models which perceived
financial assistance as increasing the capital stock in recipient countries
without otherwise affecting their economies. Rosenstein-Rodan (1961), one of
the early pro-aid economists, believed that each dollar of foreign aid would
lead to a dollar increase in savings and investment. His work was underpinned
by the Harrod-Domar growth model and the two-gap model of Chenery and
Strout (1966), which assumed that economic growth is constrained either by
lack of savings or by the trade balance gap (importing more than is exported).
Chenery and Strout thought that an injection of capital was all that is needed
to encourage development, and many subsequent studies were conducted on
the basis of this two-gap assumption (Chenery and Eckstein in 1970, Robinson
in 1971, and Papanek in 1972). However, this was ignoring the possibility that
aid, by increasing income, might simply lead to higher consumption and
possibly even a lower rate of savings and investment.
On the other side of the debate, Griffin and Enos had argued that there
was a weak negative correlation between aid and growth (“the greater the
capital inflows from abroad, the lower the rate of growth of the receiving
country” (K. Griffin and J. Enos, “Foreign Assistance: Objectives and
Consequences”, Economic Development and Cultural Change 18, no. 3 (1970):
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p. 318)), observing that aid leads to lower domestic savings rates, and hence
aid-dependency. Rahman (1968) and Weisskopf (1972) came to the same
conclusions, as did Bauer – who provided a polemical critique of the aid
industry with works such as Dissent on Development (1971) and Reality and
Rhetoric (1984). Mosley, Hudson, and Horrell (1987) further supported these
studies, also arguing that aid does not spur growth. However, what was most
notable about the literature on development aid in the 1970s and 1980s was
the lack of consensus. The number of studies showing that aid did not cause
growth was closely matched by the number of studies showing the contrary.
This led to the emergence of a literature which considered the
institutional structure of recipient countries in an attempt to explain why the
effects of aid seemed so unpredictable. Stokke’s Evaluating Development
Assistance (1992), Toye’s Dilemmas of Development Assistance (1993), and
Morton’s The Poverty of Nations (1994) all consider institutional factors which
might negate the effects of financial aid. Cassen and Associates’ seminal 1994
book, Does Aid Work? continued the analysis and provided an excellent
examination of the aid industry and the factors which influence its efficacy.
These studies led the debate onto issues of governance, and work such as that
by Burnside and Dollar (1997) has emphasised the positive effect aid can have
when used in a good policy environment. As discussed above, the World
Bank also supported the argument that a good policy environment is a prerequisite for development in its 1998 report, Assessing Aid: What Works, What
Doesn’t, and Why?, concluding that aid has a positive effect on growth only if
it is allocated to countries which demonstrate good governance. There
remains, however, a section of the literature which dissents from this view.
Authors such as Harold Brumm, an economist with the US federal
government, for example, has recently published an article in the Cato Journal
arguing that foreign aid has a negative growth effect even where economic
policy is sound. “Brumm examines data for 53 underdeveloped countries and
finds a statistically significant but negative relationship between aid to
countries with good policies and growth of real gross domestic product per
capita” (from a news release by the Cato Institute, January 12, 2004, see
http://www.cato.org/new/01-04/01-12-04.html).
Since the emergence of the concept, the role that governance has to play
in international development has been continually assessed and re-assessed.
Hirschman (1999) looks at the actual process of improving governance
structures and bureaucratic institutions in developing countries, as well as the
difficulties faced by governments when they attempt to pursue reforms.
Whilst the end goals may be clear (control of corruption, sound economic
management, efficient government) the means for achieving them are not.
Efforts at civil service restructuring, incentivisation, decentralisation, and
privatisation, he argues, are often misguided, mistimed, or ineffectively
implemented. Similarly, Grindle (2002) looks at what we mean by good
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governance and how it can be achieved. He analyses the World Bank’s
Poverty Reduction Strategy Papers, comparing the list of goals and targets they
present for each developing country, and showing that their recommendations
are often non-specific and lacking any clear plan of action or timescale.
Another critical analysis of the aid industry is provided by Duffield who looks
at the effects of aid when it is used to support social reconstruction in postconflict environments, arguing that it is thereby becoming a tool of global
liberal governance – which he sees as “fraught with difficulty” (M. Duffield,
“Social Reconstruction and the Radicalisation of Development: Aid as a
Relation of Global Liberal Governance”, Development and Change 33, no. 5
(2002): p.1049). His work goes some way towards bridging the gap between
the first part of the development literature, concerned with the effects of aid,
and the second part, which focuses on how aid is allocated.
2.2. Who Gives Aid to Whom and Why
This second part of the literature can be further divided into two strands –
one which considers the arguments in favour of selectivity and conditionality,
and another which uses statistical analysis to study the driving factors behind
aid allocation for the major OECD donors.
2.2.1. Selectivity vs. Conditionality
The first strand includes work by Pronk (2001), Hout (2002), Singh (2002)
and Degnbol-Martinussen (2002) who argue that it is important to decide
whether aid should be sent to countries which already demonstrate good
governance or to poorly governed countries in the hope of inducing reforms.
Pronk and Degnbol-Martinussen hold the view that aid should be seen as a
catalyst to development, encouraging it when good policies have been adopted
and a country is already making progress, but not acting as a ‘prime mover’ in
countries with bad policy environments. Hout disagrees though, arguing that
better governance should be seen as a goal in itself, rather than a precondition
for aid. If we do not support countries which have been unable to make
progress towards better governance, he argues, then those countries will
languish in poverty whilst money flows to the more fortunate ones which are
already showing signs of progress. And, as Peter Burnell pointed out in his
article “The Changing Politics of Foreign Aid – Where to Next?” (Politics 17,
no.2 (1997)) as good governance becomes viewed not only as a prerequisite for
development but a goal in itself, questions about conditionality become
blurred and “aid’s objectives and conditionality’s objectives become one” (Ibid.,
p. 120). Finally, some of the literature in this strand takes an abstracted view
of the debate and focuses on the fundamental purposes of development
assistance and the moral justification behind it, questioning its role in the post-
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modern contemporary world - for example, see Parfitt’s The End of
Development (2002).
2.2.2. What Drives Aid Allocation: The Evidence
The second strand – analysing which factors have had most influence on
donors’ aid allocations (in the tradition of which this paper follows) – begins
with studies such as “Motivations for Aid to Developing Countries” by Maizels
and Nissank (World Development 12, no. 9 (1984)) which argues that aid
allocations can be explained in terms of strategic foreign policy. This was
followed by Lumsdaine’s Moral Vision in International Politics (Princeton:
Princeton University Press, 1993), which emphasises colonial history,
democratic status, and income levels as the main determinants of aid patterns.
A more recent study by Alberto Alesina and David Dollar of the US National
Bureau of Economic Research, entitled “Who Gives Foreign Aid to Whom
and Why?” (NBER Working Paper, no. 6612 (1998)) concluded that aid is still
predominantly strategic. They considered trade openness; democracy; civil
liberties; colonial status; foreign direct investment; initial income; and
population as independent variables and assessed how these factors affect aid
allocations by the major OECD donors. Their results emphatically showed
that strategic issues and colonial legacies, rather than good governance, were
still the driving forces: “An inefficient, economically closed, mismanaged nondemocratic former colony politically friendly to its former coloniser, receives
more foreign aid than another country with a similar level of poverty, a
superior policy stance, but without a past as a colony” (Ibid., p. 1). However,
they also show that, ceteris paribus, donors, including the UK, tend to give
more aid to poor countries with open economies – but this tendency is
undermined by colonial links and political friendship. Their conclusion is that
one of the reasons for foreign aid’s limited success at promoting growth and
reducing poverty is that “factors such as colonial past and voting patterns in
the United Nations explain more of the distribution of aid than the political
institutions or economic policy of recipients” (Ibid., p. 22).
A subsequent paper by Alesina and Weder, “Do Corrupt Governments
Receive Less Foreign Aid” published in 1999 (NBER Working Paper, no. 7108)
found that corruption was actually correlated with higher levels of aid but
“could not find any evidence that an increase in foreign aid reduces corruption”
- suggesting that much of the aid sent to corrupt countries might be wasted
(Ibid., p. 2). This is consistent with the conclusion of the World Bank’s
Assessing Aid report that aid cannot buy reform, and leads Alesina and Weder
to support the view that “foreign aid programs are unsuccessful because they
are not well targeted” (Ibid., p. 19). Since then, assessments have also been
carried out of the effect of good governance on debt forgiveness (see
Neumayer, 2003, who finds that governance has some limited influence) and
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its impact on private sector investment (see Globerman and Shapiro, 2002,
who find that FDI increases with investments in governance infrastructure but
with diminishing returns to scale).
Perhaps the most relevant article for the purposes of this paper is “Good
Governance and European Aid: The Impact of Political Conditionality”
(Zanger, European Union Politics 1, no. 3 (2000)) which looked at the aid
patterns of Germany, France, the UK, and the EU. In this article Zanger uses
OLS regressions to analyse whether good governance, in the form of respect
for human rights, democratic structures and low military spending, played a
consistent or prominent role in European aid between 1980 and 1995. After
controlling for recipient needs (GNP per capita and life expectancy), donor
economic and strategic interests (weapons exports from donor to recipient;
trade; and former colonial links), and the amount of aid sent to a country by
other EU donors, she concludes that, overall, good governance did not play an
important role in aid allocations. Her analysis also shows that patterns of UK
aid have been inconsistent. Until the end of the Cold War, the UK favoured
countries which imported its weapons, but since 1990 weapons exports ceased
to be a driving factor. Aid decreased as human rights violations in a recipient
country increased, but it was higher for countries with extremely bad human
rights records (producing a U-shaped relationship between repression and UK
aid). Former colonies were favoured in aid allocations between 1980 and
1995, military spending by a recipient country had no significant influence, and
the UK gave more aid to democratising countries between 1991 and 1995, but
not from 1980 until 1990. Clearly, the role that good governance has played is
mixed – occasionally it had a positive effect, occasionally a negative one, and
frequently no significant effect at all. This leads Zanger to conclude with a
warning about the pervasive rhetoric on good governance. “Donors of official
development assistance should be aware of ‘side-effects’ when issuing certain
policy statements that are not backed up by actions. The mere proclamation
of such concepts is more likely to undermine their credibility than to
successfully promote good governance in developing countries.” (Ibid., p. 311).
2.3. Ranking Governance
In their 2004 article “The Good Governance Problem: Doing Something
About It” (World Peace Foundation Report, no. 39), Rotberg and West consider
the importance of being able to define and measure governance if we are to
understand its effects, and argue that this implies the need for a governance
ranking system, despite the inherent measurement difficulties involved. There
already exist a number of possible candidates. One of the most established of
these is the Freedom House ‘Freedom in the World’ country rating, used in
cross-country research since 1955 (when it was called the ‘Balance Sheet of
Freedom’), long before most other evaluative indicators were introduced. This
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ranks countries as ‘Free’, ‘Partly Free’, or ‘Not Free’ on the basis of their
citizens’ political rights and civil liberties. Other ranking systems include the
International Country Risk Guide (ICRG), which measures political, financial,
and economic risk, and the BERI (Business Environmental Risk Intelligence)
indicators, which assess countries’ operating conditions, political risk and
foreign exchange accounts. Both the ICRG data and the BERI indicators are
produced for sale to subscribers who are primarily investors interested in the
‘political’ risks associated with overseas investments. Along similar lines, the
‘Economic Freedom of the World’ Index (EFW) assesses the consistency of a
nation's policies and institutions with economic freedom - incorporating
factors such as size of government expenditures and revenue; legal structure &
security of property rights; freedom to trade with foreigners; and regulation of
credit, labour & business.
None of these indicators fully capture the concept of governance though,
focussing on either political freedom or the economy rather than sound public
management or control of corruption. However a somewhat broader
understanding of the concept is employed by the World Bank’s ‘Governance
Indicators’, which score countries according to voice and accountability;
political stability; government effectiveness; regulatory quality; rule of law; and
control of corruption. They are intended specifically for use by the aid
industry rather than foreign investors’ risk assessments, and incorporate data
from the Freedom House, ICRG and BERI indexes, along with 22 other
sources. The World Bank’s Indicators are already used by the US when
allocating funds from the Millennium Challenge Account (see section 1.5) and
provide one of the most widely accepted governance indexes currently
available.
3. DATA AND METHODOLOGY
3.1. Research Hypotheses
Given DFID’s commitment to “encouraging democratic structures which
can hold government accountable and give the poor a voice” (Eliminating
World Poverty: A Challenge for the 21st Century (London: Crown, 1997), p. 32);
its promise to use “resources to proactively promote political stability” (Ibid.,
p. 9); its view that “those [countries] most likely to succeed will have effective
government [and] enlightened legislation” (Ibid., p. 24); and its pledge to
provide “support for good governance and the rule of law and firm action
against corruption” (Ibid., p. 25), it might be interesting to ask how recent UK
aid allocations correlate with the six dimensions of governance measured by
the World Bank’s indicators described above.
Of course, as discussed in the literature review, supporting good
governance does not necessarily imply adopting strict selectivity in aid
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allocations. Aid may still be sent to poorly governed countries in order to help
build better institutions and promote reform - in which case we might not
expect to see a significant correlation between the governance indicators and
aid allocations. However, looking at some of the statements made in the 1997
and 2000 white papers, we can see that DFID is committing itself to at least
some degree of selectivity on the basis of good governance. For example:
“There will be some circumstances under which a government-to-government
partnership is impossible, because the government concerned is not
committed to the elimination of poverty, is not pursuing sound economic
policies or is embroiled in conflict. Where poor countries are ruled by
governments with no commitment to helping the poor realise their human
rights, we will help – where we can do so – through alternative [non-financial]
channels.” (Ibid., p. 41). Whether or not statements such as this constitute an
explicit commitment to selectivity, the ubiquitous pronouncements on the
importance of good governance in DFID’s policy papers imply that an
assessment of what drives UK aid allocations should see governance issues
playing an important role. It is therefore reasonable to expect a degree of
correlation between UK aid and at least some of the aspects of governance
discussed above.
Whilst sending aid to a politically unstable country may help to stabilise it,
it is implausible to argue that sending aid to a corrupt government will help to
reduce corruption. If any lessons have been learnt from past experiences –
such as when millions of pounds of aid were stolen by Zaire’s Sese Seko
Mobutu – pervasive corruption in recipient countries should preclude or at
least significantly reduce aid allocations. The same can be said for
governments which are repressive and unaccountable. It is a commonly
accepted argument that rentier states – those which receive large proportions
of their national income from resources such as oil or gas – are less likely to be
democratically accountable because they do not need to impose heavy taxes
on their citizens and so need not offer representation in return. Similarly, if a
repressive or unaccountable country receives large amounts of aid to
supplement its national income, this will likely have the effect of reducing the
domestic pressure on it to implement reforms. Therefore, if the government’s
rhetoric on governance is really being supported by action we should expect
to see a positive correlation between UK aid allocations and measures of
corruption control and voice and accountability.
Therefore the key research hypotheses for this study are:
Hypothesis 1. The higher the World Bank’s control of
corruption indicator for a country, the more aid it receives
from the UK.
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Hypothesis 2. The higher the World Bank’s voice and
accountability indicator for a country, the more aid it receives
from the UK.
As discussed above, DFID has also emphasised the importance of other
aspects of good governance in its policy statements. It has argued that as well
as having a government which is democratic, accountable, and free from
corruption, factors such as political stability, government effectiveness,
enlightened legislation, and the rule of law are also essential for a country to
experience economic growth and human development. Whilst it might be
expected that sending money to politically unstable or ineffectively governed
countries, unlike sending it to corrupt ones, could improve the quality of
governance, this is challenged by the increasingly accepted view that aid
cannot buy reform and will only be successful in countries which already have
good policy environments. This argument, supported by the World Bank and
adopted by both the US and Dutch aid agencies (see section 1.6), implies that
aid allocations should only be focussed on countries which demonstrate the
qualities described above, because unless reforms are already being
implemented they cannot be successfully induced with aid packages. The
World Bank also believes that aid is fungible and so even if it is allocated
specifically for a project that will clearly benefit a country’s citizens (e.g. better
law enforcement), this will simply allow the country’s government to direct its
resources elsewhere, and thus only has the effect of expanding the
government’s budget. DFID has repeatedly pronounced the importance of all
aspects of good governance if development aid is to be successful, and adopts
much of the rhetoric used by the World Bank. Therefore, this study also
proposes four secondary research hypotheses relating to government
effectiveness, rule of law, political stability, and regulatory quality.
The secondary research hypotheses for this study are:
Hypothesis 3. The higher the World Bank’s government
effectiveness variable for a country, the more aid it receives
from the UK.
Hypothesis 4. The higher the World Bank’s rule of law variable
for a country, the more aid it receives from the UK.
Hypothesis 5. The higher the World Bank’s political stability
variable for a country, the more aid it receives from the UK.
Hypothesis 6. The higher the regulatory quality variable for a
country, the more aid it receives from the UK.
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3.2. Dependent variable
This study uses multivariate regression to analyse the correlation between
the governance indicators for a country and the amount of UK bilateral aid it
receives. Bilateral aid allocations constitute approximately 55% of total DFID
programme
expenditure
(£1813
million
in
2003,
see
http://www.dfid.gov.uk/aboutdfid/statistics.asp) and present an obvious tool
for rewarding or encouraging favourable behaviour by other governments.
They are therefore used as the (ratio level) dependent variable for this analysis.
Data on bilateral aid allocations are taken from DFID’s Statistics on
International Development 1998/99 – 2002/03 (London: Crown, 2002), using
the total DFID bilateral programme value, which includes all project and
programme aid but excludes sums invested by the Commonwealth
Development Corporation and non-DFID relief such as small amounts of drug
related assistance funded by the Home Office and other government
departments.
3.3. Independent variables
The World Bank Governance Indicators provide statistics measuring six
dimensions of governance, as described above. 199 countries and territories
are covered for four time periods (1996, 1998, 2000, and 2002). The indicators
are “based on several hundred individual variables measuring perceptions of
governance, drawn from 25 separate data sources constructed by 18 different
organisations” (D. Kaufmann, A. Kraay, and M. Mastruzzi, “Governance
Matters III: Governance Indicators for 1996-2002”, World Bank Policy Research
Working Paper, no. 3106 (2004): p. 1). These separate data sources are
aggregated using an unobserved components model to produce interval level
point estimates in the range + or – 2.5 (with + 2.5 representing better
performance and – 2.5 representing worse performance) for each governance
dimension and each country. Each of the dimensions of governance is treated
as an independent variable in the regression analysis. For a list of the data
sources used in the construction of the World Bank indicators, see Table 4. in
the appendix.
Although measures of governance based on perceptions rather than hard
data can be criticised for lacking objectivity, this method is generally accepted
as being the only feasible way of producing a full set of data. As pointed out
in the Governance Matters III paper accompanying the World Bank indicators,
dimensions of governance such as corruption “are almost by definition
impossible to obtain, and so there are few alternatives to the subjective data.
Since corruption is by nature an illegal activity, direct measures of its
prevalence do not exist” (Ibid., p. 19). This problem affects many of the
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factors which we would wish to include in the concept of governance and
therefore suggests that a perception based measure presents the best solution.
The World Bank indicators employ a broader concept of governance than
most of the alternative perception-based indexes - some of which are
described in the literature review - partly due to the fact that the indicators
include many of the alternative indexes as data sources but do not rely on
them exclusively. This means that, unlike the other measures, they do not
focus only on political or economic freedom, but on a broader notion of
responsible public management. Furthermore, because the World Bank
carries such international influence and, as mentioned above, the US
government already uses its governance data when allocating funds from the
Millennium Challenge Account, the indicators have therefore automatically
gained currency in the field of development studies. It may be questioned
whether an essentially non-democratic organisation has the authority to define
such a widely used measure of governance (although the fact that it is based
on so many different sources mitigates this criticism), but the salience of the
World Bank indicators is beyond doubt.
3.4. Control Variables
Obviously a key criterion for aid allocation is level of need - therefore the
first control variable is a measurement of the level of development in a
country. The United Nations Development Programme (UNDP) provides an
annual ‘Human Development Index’, ranking countries on the basis of their
GDP per capita, average life expectancy, and national literacy rate and
producing an interval level value between zero and one, with one representing
higher human development. GDP per capita is more commonly used on its
own as a control variable, but by using the HDI index, which includes other
important measures of development in an aggregated value, the analysis
becomes more accurate without introducing any additional variables (HDI
data is available at http://hdr.undp.org/statistics/data/indic_12_3_2.html).
Another factor affecting the amount of aid a country receives is the size of
its population. Therefore this is used (measured in 1000s) as the second (ratio
level) control variable. The World Bank provides data on national populations
and the most up to date figures are for 2003. Because changes in population
year-on-year are small relative to population size, and because of difficulties in
attaining data from the same source for previous years, the 2003 data are used
for all time periods covered by the regression (World Bank statistics on
national populations are available at http://www.worldbank.org/
data/quickreference/quickref.html). A number of previous studies have
included population on the left hand side of the regression equation by using
aid per capita as the dependent variable. However, following in the footsteps
of Zanger (2000), it seems preferable to include population size on the right
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hand side with the other explanatory variables that characterise the recipient
countries.
A third factor influencing aid allocations is whether a country has a history
of colonial links with the UK. Information on the UK’s ex-colonies is taken
from
the
Commonwealth
Secretariat
website
(http://www.
thecommonwealth.org). A country’s history of colonial links with the UK is
included as a dummy variable, coded one if it is an ex-colony and zero if it is
not.
These three control variables are expected to have a significant impact on
the dependent variable. Clearly the higher the level of development in a
country the less aid it needs, and so it is expected that HDI will be negatively
correlated with aid allocation. Equally clearly, the larger the population of a
country the more aid it needs, and so it is expected that population will be
positively correlated with aid allocation. Finally, if a country has a history of
colonial links with the UK then there will be both an element of imputed
responsibility for that country’s development and likely a greater capacity for
the UK to assist. Therefore it is expected that if a country is an ex- British
colony it will be allocated more development aid.
Accordingly, the tertiary research hypotheses for this study are:
Hypothesis 7. The higher the HDI for a country, the less aid it
receives from the UK.
Hypothesis 8. The larger the population of a country, the
more aid it receives from the UK.
Hypothesis 9. If a country has a history of colonial links with
the UK, it receives more UK aid.
3.5. Operationalisation
3.5.1. Time Dimension
This paper is investigating allocations of development aid under the current
Labour government. Because the regression analysis is based upon the World
Bank indicators, it is carried out only for the years which are covered by the
indicators - 1998, 2000, and 2002 (leaving out 1996 as this is before Labour
came to power or DFID was created). Three regressions are run, firstly using
1998 values for the independent variables (except population, for which the
2003 values are used throughout) and the 1998/99 financial year values for the
dependent variable; secondly using the 2000 values for the independent
variables (except population) and the 2000/01 financial year values for the
independent variables; and thirdly using the 2002 values for the independent
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variables (except population) and the 2002/03 financial year values for the
dependent variable.
3.5.2. Population
The population or universe with which this study is concerned includes all
possible recipients of UK aid. Although efforts have been made by DFID to
focus aid on the poorest countries (with 80% of bilateral aid (excluding
humanitarian assistance) flowing to low income countries in 2002/3, see
http://www.dfid.gov.uk/aboutdfid/statistics.asp), middle-income states still
receive financial assistance and therefore need to be included in the analysis.
In order to avoid employing unnecessary definitions of developed or
developing country, the population is taken to consist of every independent
state in the world. This set includes all the recipients of UK bilateral aid listed
by DFID apart from six UK overseas territories (Anguilla, British Virgin
Islands, Gibraltar, Monsterrat, St. Helena, and Turks and Caicos), which are
acceptably excluded because they are not classified as independent states, and
the Windward Islands in the Caribbean (a group of small independent islands
and French overseas territories) which have small populations and receive no
project or programme aid and only very limited amounts of technical
cooperation.
3.5.3. Missing values
When measures of governance in developing countries are required,
missing values can present serious problems because there is likely to be a
degree of correlation between quality of governance and availability of
government statistics. One of the main advantages of using a perceptions
based measure such as the World Bank indicators is that, regardless of the
quality of governance in a country, external organisations should nevertheless
be able to provide a subjective assessment. Therefore, although there may still
be some missing values, they will not be significantly correlated with quality of
governance and so present a much less serious problem for the analysis.
Admittedly, the less objective data there is available on a country, the more
difficult it will be to form subjective opinions about it, but the impact of this
is dramatically reduced by relying on a perceptions based measure.
However, this does not apply to the Human Development Index control
variable, which is based on national literacy data, life expectancy data, and
GDP per capita. Missing values for this variable will be correlated with
quality of governance, as poorly governed countries are less likely to keep
accurate records of these statistics. However, the dimensions of HDI are such
that they undergo only gradual changes. Even drastic changes in governance
cannot have much effect on these measures in the space of one or two years.
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Therefore, changes in HDI between the time periods used in this study will be
small relative to the HDI statistics and so an educated guess for missing values
can be made on the basis of data for previous or subsequent years. The
problem of missing data for the HDI variable can be significantly reduced by
inserting average values wherever data is available for two out of the three
time periods being assessed. This procedure is therefore adopted: for example,
as most of the missing HDI values happen to occur in the 2000 data, averages
of the 1998 and 2002 HDI variable are inserted wherever the value for 2000
HDI is missing.
Missing values do not present a problem for the other two control
variables (history of colonial links and population).
3.5.4. Running the Regression
Three regressions were run, one for each of the time periods under
investigation, and the ‘Enter’ method in SPSS was selected over ‘Stepwise’ in
order to ensure that a coefficient is generated for all the variables, rather than
just the most influential ones. In 1998, after missing values had excluded some
cases, the value of N = 153, in 2000 N = 151, and in 2002 N = 167. In each
time period this exceeded the minimum recommended value of N, given by
N = (5 x no. of independent variables) + 80. I.e. N exceeded 120 in each
period.
It should be noted that values for the dependent variable (aid in £s) have
not been controlled for inflation (which has had an underlying rate of between
two and three percent since 1998) and so, although the results will not be
significantly affected, they should be interpreted with this in mind.
4. RESULTS
4.1. Impact of Governance Variables
In the regression for the first time period (1998), the value of R Square
was 0.514 and the Adjusted R Square was 0.483. In the second time period
(2000), the values of R Square and Adjusted R Square were 0.451 and 0.416
respectively, and in the third time period (2002), the R Square and Adjusted R
Square values were 0.554 and 0.528 respectively. These values imply that the
variables operationalised in this study explain approximately 50% of the
distribution of the dependent variable.
The empirical results show that good governance has had an inconsistent
impact on UK aid allocations during the period under investigation. In 1998
and 2000, only one of the governance variables – voice and accountability had a statistically significant coefficient. By 2002, four of the governance
variables were significant – voice and accountability; government effectiveness;
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regulatory quality; and control of corruption. Of the significant correlations,
those for voice and accountability and government effectiveness are consistent
with the research hypotheses, whilst the correlations for regulatory quality and
control of corruption imply a relationship contrary to those which were
hypothesised.
Of the governance variables, voice and accountability (V&A) has had the
most consistent impact on UK aid allocations. In 1998 it was positively and
significantly correlated with the dependent variable and its coefficient implies
that an increase of one unit in the V&A variable (e.g. from -0.5 to +0.5) was
matched by an increase of approximately £2.4 million in aid from the UK.
The size of the coefficient increased in 2000, when a one unit increase in the
V&A variable correlated with a £4.1 million increase in aid allocations, and
again in 2002, when a one unit increase in V&A correlated with a £5.5 million
increase in aid. This is consistent with Hypothesis 2 (one of the key research
hypotheses), which predicted that the higher the V&A variable for a country,
the more UK aid it would receive, and implies that DFID has paid increasing
attention to factors such as democratic elections and levels of repression allocating more aid to countries whose governments are elected by and
accountable to their citizens.
Political stability (PS) and rule of law (RL) did not show statistically
significant correlations with the dependent variable in any of the time periods
being analysed, but both coefficients were more significant in 2002 (when
their significance statistics were 0.204 and 0.174 respectively) than in 1998
(when their significance statistics were 0.946 and 0.669 respectively). The PS
coefficient was negative in all the time periods and increased in magnitude
between 1998 and 2002, whilst the RL coefficients changed from being
negative to positive between 1998 and 2000, and, staying positive, increased in
magnitude between 2000 and 2002. This implies that, if anything, the
relationship between political stability and aid allocation is contrary to that
which was hypothesised (see Hypothesis 5) but the relationship between rule
of law and aid became consistent with Hypothesis 4 between 1998 and 2002.
The government effectiveness (GE) variable was not statistically
significant in 1998 or 2000, but by 2002 it had a positive and significant
coefficient, implying that a one unit increase in the GE variable correlated
with a £9.3 million increase in UK aid. This is consistent with Hypothesis 3
which predicted that the higher the GE variable for a country, the more UK
aid it would receive. It is also noticeable that between 1998 and 2002, the GE
coefficient consistently increased, suggesting that progress was being made
towards allocating more aid to countries with effective governments.
The regulatory quality (RQ) variable was also only statistically significant
in 2002, when its coefficient implies that a decrease of one unit was associated
with a £6.8 million increase in aid. This implies a relationship contrary to that
predicted by Hypothesis 6. The coefficient for RQ was positive but
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insignificant in 1998 and 2000, becoming statistically significant and negative
in 2002 – implying a general increase in the amount of aid DFID sent to
countries with poor regulatory quality over the three time periods.
Finally, the control of corruption (CC) variable also had a negative
coefficient which showed increasing significance in 1998 and 2000 and became
statistically significant in 2002. By 2002, the correlation between control of
corruption and aid allocation implied that a decrease by one unit in the CC
variable would see an increase of £11.6 million in UK aid. This clearly
contradicts Hypothesis 1 (one of the key research hypotheses) which
predicted that the higher the CC variable for a country, the more UK aid it
would receive. The result is also inconsistent with the argument laid out in
section 3.1, which points out it is implausible that a corrupt government will
use extra resources to reduce corruption. Therefore a negative correlation
between the CC variable and the dependent variable suggests that DFID is not
paying enough attention to this important aspect of good governance.
4.2. Impact of Control Variables
In all three of the time periods being analysed a country’s level of human
development (measured by the HDI index) has significantly affected the
amount of aid it receives, with more aid flowing to less developed countries.
The coefficients imply that in 1998, a 0.1 unit increase in HDI (e.g. from 0.65
to 0.75) correlated with £2.1 million decrease in aid from the UK, in 2000, a
0.1 increase in HDI correlated with a £3.4 million decrease in aid, and in 2002,
a 0.1 increase in HDI correlated with a £4.1 million decrease in aid. These
findings are consistent with Hypothesis 7, which predicted that the higher a
country’s HDI, the less aid it receives from the UK. The increasing impact of
HDI levels between 1998 and 2002 implies that DFID’s promises to direct
more financial assistance to the least developed countries have been backed up
with action. In fact, the significant effects on the dependent variable caused
by a small change (of 0.1) in HDI show it to be one of the most influential
factors driving UK aid allocation.
The population variable was also statistically significant in all three time
periods, but the coefficients were relatively small. An increase of 1 million in
the population of a country correlated with increases in aid of £52,000 in 1998,
£54,000 in 2000, and £73,000 in 2002. These findings are consistent with
Hypothesis 8, but the fact that they are so small suggests that aid flows
disproportionately to countries with small populations – leading to lower
levels of aid per capita as a country’s population increases.
Finally, a country’s colonial history was also statistically significant in all
three time periods, with the data showing a significant increase in aid to
countries which used to be British colonies, consistent with Hypothesis 9.
The coefficients show that in 1998 being an ex- British colony was correlated
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with an increase of £9.7 million of aid, in 2000 it was correlated with an
increase of £12.2 million, and in 2002, with an increase of £10.5 million.
4.3. Summary of Results
In 1998 and 2000 the most influential factors driving UK aid allocation
were colonial links, HDI, and voice and accountability. Countries which used
to be British colonies and were less developed but more democratic and
accountable received the most aid, confirming key Hypothesis 2, and tertiary
Hypotheses 7 and 9. A larger population also led to more aid being allocated,
but the coefficients were relatively small and suggest that having a large
population, although increasing the total aid allocation, actually reduces the
amount of aid per capita. Political stability, government effectiveness,
regulatory quality, rule of law, and control of corruption did not have
statistically significant effects on aid allocation in 1998 or 2000 and so in those
time periods no support was provided for key Hypothesis 1 or secondary
Hypotheses 3-6. In fact, the evidence suggested that, if anything, less political
stability and more corruption resulted in increased financial assistance.
In 2002, aid allocation was still driven by colonial links, HDI, and voice
and accountability, but government effectiveness, regulatory quality, and
control of corruption also had a very significant impact. Countries which used
to be British colonies, were less developed but more democratic and
accountable, and which had more effective governments received the most aid
allocation. However the impact of these factors was reduced because both
regulatory quality and control of corruption were strongly negatively
correlated with the dependent variable, meaning that in 2002, corrupt
countries which had poor regulatory quality received large increases in UK aid.
The results again confirm key Hypothesis 2, and tertiary Hypotheses 7 and 9.
They also confirm secondary Hypothesis 3 (regarding government
effectiveness) but refute both secondary Hypothesis 6, which predicted that
better regulatory quality would lead to an increase in aid allocation and, most
significantly, also refute key Hypothesis 1, which predicted that better control
of corruption would lead to an increase in aid allocation.
These results imply that, whilst some aspects of good governance are
having the desired effect on UK aid patterns, others seem to be influencing aid
in a way contrary to that we would hope for. Whilst the rising levels of aid
sent to democratic and accountable countries with effective governments and
DFID’s increasing focus on the least developed countries (i.e. those with low
HDI levels) is laudable, the fact that more financial assistance is being sent to
countries with poor regulatory quality and minimal control of corruption is
cause for serious concern. These results suggest that DFID is worryingly
unconcerned about some essential dimensions of governance and that its
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INTERNATIONAL PUBLIC POLICY REVIEW
attempts to reward responsible governments are being undermined by the
adverse influence of corruption and poor regulation.
5. CONCLUSION
This research paper set out to empirically analyse the impact that good
governance has had on the allocation of UK development aid since the present
Labour government gained office in 1997. It follows in the tradition of work
by Alesina and Dollar (1998) and Alesina and Weder (1999), and in particular
in the footsteps of a paper by Zanger (2000), which assessed how good
governance affected UK, French, German, and EU aid allocations between
1980 and 1995. Zanger concluded that the aid patterns of these donors show
little consideration was being given to the quality of governance in recipient
countries, but she suggested that “foreign aid donors have only started to make
political conditionality an official guide for their aid allocation. Future
research might show whether the adoption of this concept changed long-term
ODA [official development assistance] distribution in the late 1990s and the
following century” (“Good Governance and European Aid: The Impact of
Political Conditionality”, European Union Politics 1, no. 3 (2000): p. 311).
Focussing solely on UK aid allocation, this paper has attempted to provide
some of the future research to which Zanger alluded.
By utilising the World Bank’s Governance Indicators - measuring voice
and accountability; political stability; government effectiveness; regulatory
quality; rule of law; and control of corruption - the analysis has tried to
employ a wider concept of good governance than that used in previous
studies, including Zanger’s. This avoids the limited focus on political freedoms
or economic openness that occurs in some of the previous studies, and
therefore might provide a more informative analysis of the way aid is
allocated. The distinction that has been made between key and secondary
research hypotheses reflects the fact that two dimensions of governance –
control of corruption and voice and accountability – seem particularly unlikely
to be improved with development aid. It is argued that rentier states, which
receive large proportions of their national income from resources such as oil or
gas, are less likely to be democratically accountable because they do not need
to impose heavy taxes on their citizens and so need not offer representation in
return. Similarly, it is implausible to suggest that financial assistance to
corrupt or unaccountable governments will reduce corruption or increase
accountability. Therefore a negative correlation between aid allocation and
either the control of corruption or voice and accountability variables suggests
that not enough attention is being paid to these essential elements of good
governance.
However, this distinction does not imply that the other four dimensions of
governance are unimportant. The World Bank’s argument that aid cannot buy
VOL. I,
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reforms and will only work in countries which demonstrate good governance
applies to all aspects of governance. Therefore if DFID has been pursuing a
fully selective aid policy, we would expect political stability, government
effectiveness, regulatory quality, and rule of law also to be positively correlated
with UK aid allocations.
The statistical results show that between 1998 and 2002, DFID paid
increasing attention to voice and accountability and government effectiveness
when allocating financial assistance. However the results also show that
regulatory quality and control of corruption were increasingly negatively
correlated with aid allocation over the three time periods, implying that DFID
was allocating more and more money to poorly regulated and corrupt
countries. This seems to contrast with the promises to fight corruption made
in its policy statements (“In all regions, to varying degrees, we need to work
to… combat corruption and promote honest and accountable government”
(Making government work for poor people: building state capacity (London:
Crown, 2001), p. 31)) and calls into question DFID’s commitment to its
professed policy objectives.
The finding that corrupt countries receive more development aid is not
unprecedented. As mentioned in the literature review, Alesina and Weder
(1999) find there is also a positive correlation between corruption and aid
allocation when all the major OECD donors are taken together. Given the
strength of argument against sending aid to corrupt countries, it is regrettable
that this effect seems so pervasive. Further research into the factors that
influence aid allocation may help to explain why corruption seems to
persistently attract development aid and, crucially, what can be done to tackle
this.
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INTERNATIONAL PUBLIC POLICY REVIEW
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A. Singh, “Aid, Conditionality and Development”, Development and Change 33, no.
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Oxford University Press, 1998).
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Conditionality”, European Union Politics 1, no. 3 (2000): pp. 293-317.
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http://www.worldbank.org/data/quickreference/quickref.html
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APPENDIX
Table 1. Regression output: UK bilateral programme aid 1998
N = 153
Constant
HDI
Colonial Links
(dummy variable)
Population (1000s)
Voice and
Accountability
Political Stability
Government
Effectiveness
Regulatory Quality
Rule of Law
Control of
Corruption
R = 0.514
Adjusted R Square = 0.483
Unstandardised Coefficients
Beta
Std. Error
T-value
Significance
14923.530**
4628.688
3.224
.002
-20694.021**
6505.877
-3.181
.002
9678.444***
1855.508
5.216
.000
0.05159***
.006
9.098
.000
2359.386*
1351.085
1.746
.083
-95.885
1408.685
-.068
.946
-1257.259
2719.286
-.462
.645
1984.346
1613.760
1.230
.221
-1343.283
3131.372
-.429
.669
-702.337
3049.368
-.230
.818
Notes: *p < 0.1, **p < 0.05, ***p < 0.01
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Table 2. Regression output: UK bilateral programme aid 2000
N = 151
R = 0.451
Adjusted R Square = 0.416
Unstandardised Coefficients
Beta
Std. Error
T-value
Significance
Constant
24506.899***
6635.266
3.693
.000
HDI
-33902.131***
9231.862
-3.672
.000
Colonial Links
(dummy variable)
-2832.032***
2639.948
4.623
.000
Population
(1000s)
0.05410***
.008
6.691
.000
Voice and
Accountability
4136.373**
1891.011
2.187
.030
Political Stability
-2736.429
2045.769
-1.338
.183
Government
Effectiveness
1700.107
4024.026
.422
.673
Regulatory
Quality
1327.868
2572.580
.516
.607
Rule of Law
117.137
4196.475
.028
.978
Control of
Corruption
-2832.032
3603.033
-.786
.433
Notes: *p < 0.1, **p < 0.05, ***p < 0.01
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Table 3. Regression output: UK bilateral programme aid 2002
N = 167
R = 0.744
Adjusted R Square = 0.528
Unstandardised Coefficients
Beta
Std. Error
T-value
Significance
Constant
30389.331***
6364.506
4.775
.000
HDI
-40830.468***
8673.560
-4.707
.000
Colonial Links
(dummy variable)
10460.969***
2365.229
4.423
.000
Population
(1000s)
0.07337***
.008
9.208
.000
Voice and
Accountability
5542.247***
2080.097
2.664
.009
Political Stability
-2308.804
1811.480
-1.275
.204
Government
Effectiveness
9320.826**
4669.079
1.996
.048
Regulatory
Quality
-6832.891*
3628.260
-1.883
.062
Rule of Law
7220.995
5285.410
1.366
.174
Control of
Corruption
-11613.900***
4034.845
-2.878
.005
Notes: *p < 0.1, **p < 0.05, ***p < 0.01
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Table 4. Sources of data used by the World Bank to produce aggregated governance
indicators
Source: D. Kaufmann, A. Kraay and M. Mastruzzi, “Governance Matters III: Governance
Indicators for 1996-2002”, World Bank Policy Research Working Paper, no. 3106 (2004),
appendix.
THE EXTERNAL ACCOUNTABILITY GAP OF
PRIVATE REGULATORS: ACCOUNTABILITY
PARADOXES AND MITIGATION STRATEGIES
The Case of Credit Rating Agencies
Marc Robi Das Gupta‡
ABSTRACT
This paper analyses the external accountability gap of private regulators
based on a case study of credit rating agencies (CRAs). It firstly outlines the
history of the rating industry as well as the developments in private authority that
led to the regulatory function of CRAs. The paper will then describe and analyse
the external accountability gap, that arises due to the inherent conflict between
their status as private, non-majoritarian profit seeking entities and the status the
Securities and Exchange Commission (SEC) forced upon them, namely that of a
quasi-public and choice determining regulator. The paper utilises principal-agent
theory and has moreover developed and formalised a triadic external principaltrustee-stakeholder relationship model, which explains the external accountability
gap and which may be a contribution to the principal-agent literature in general.
The paper will distinguish between regulatory uses, specifically between that
of national securities laws and that of international banking supervision. In the
former setting it will be difficult to fully substitute CRAs with a full merit
analysis by government, and thus with a government provision of the CRAs`s
function. Nonetheless reintroducing reputation as the main accountability
mechanisms may mitigate the external accountability gap. This may be achieved
‡
M.Sc. (International Public Policy), School of Public Policy, University College London
(November 2004); Contact with questions/comments: marcdasgupta@hotmail.com.
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005): 37-92. [ISSN 1748-5207]
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
37
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INTERNATIONAL PUBLIC POLICY REVIEW
by increasing competition in the nationally recognised statistical rating
organisations (NRSROs) market.
Using CRAs` output for banking supervision is not advisable, as the
rationale (namely efficient reduction of information asymmetry) does not hold in
an international context. Thus CRAs should not be used in banking supervision
as it is inefficient and displays negative consequences. Moreover most banks have
the opportunity to use their own internal rating systems, which based on the fact
that they use a different rating methodology, may be superior for their specific
purposes anyway. The paper also demonstrates how, theoretically and
practically, attempts to overcome the accountability gap result in an
accountability paradox. Firstly, CRAs` performance would be reduced and
secondly, constitutional obstacles would not allow holding CRAs accountable for
their actions.
1.
INTRODUCTION
The aim of this paper is to describe and analyse the external
accountability gap in the credit rating markets. The former occurs, as national
regulators substitute their own actions with external credit ratings provided by
private profit-seeking and non-majoritarian agencies. Firstly, the paper
describes the history of credit rating agencies and the regulatory use of the
former. The paper then discusses the developments of private authority in the
process of globalisation and disintermediation and goes on to analyse the
advantages compared to public authority and the reasons for the recent
growth of private authority. Moreover the paper highlights the distinct
features of private agents and the rationale of governments to provide them
with a quasi-regulatory authority. The paper uses principal-agent theory to
explain and the relationships between private and public bodies as well as the
external accountability gap. From the former analysis the author of the paper
formalises a new triadic principal-agent relationships. The paper then
continues to explore and evaluate several strategies to overcome the
accountability gap. Lastly, the paper proposes several remedies to mitigate the
consequences of the external accountability gap.
2.
THE CREDIT RATING INDUSTRY AND MARKET SUPERVISION
“A credit rating is an opinion of the general creditworthiness of an obligor,
or the creditworthiness of an obligor with respect to a particular debt security
or other financial obligations, based on relevant risk factors”1. It is thus only an
Standard and Poor`s (2003) “Concept Release: Rating Agencies and the Use of Credit Ratings
under the Federal Securities Laws”, http://www.standardandpoors.com
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opinion on the debtor’s ability to make timely payments of principal and
interest, and not a recommendation to sell, buy or hold a security, as only the
creditworthiness of an investment is assessed, not its economic desirability to
investors2.
Credit rating agencies (CRAs) rate corporations, banks, municipals, federal
states and sovereigns and their rating designations have a considerable impact
on debt issuers, concerning the availability and price of debt securities. There
are currently two major credit rating agencies, namely Standard and Poor`s and
Moody`s Investors Service, both with their headquarters in New York, which
dominate the market and make judgements on approximately US $30 trillion
of securities each3.
Moody`s first published bond ratings in the US in 1909 for railroad bonds.
Poor`s started issuing ratings in 1916, and Standard Statistics and Fitch
Publishing issued their first ratings in 1922 and 1924 respectively. Standard
Statistics and Poor`s merged in 1941 into Standard & Poor`s (S&P). Moody`s
was sold by Dun and Bradstreet (which owned it since 1962) as a separate
corporation and S&P has been a subsidiary of publishers McGraw-Hill since
1966.
The rating business accelerated after the Glass-Steagall Act of 1933, which
separated banking and securities businesses and institutionalised the latter one.
Originally all the CRAs revenue came from charging the potential investors for
their published ratings. In the late 1960s and early 1970s Moody`s and S&P
began charging fees to bond issuers for their ratings because it became a
growing collective action problem to co-ordinate potential investors to pay the
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
University Of Illinois Law Review 1(2002): 1-28.
3
M. R. King and T. J. Sinclair. “Private Actors and Public Policy: A Requiem for the New
Basel Capital Accord.” International Political Science Review 24, no. 3 (2003): 345-362.
2
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INTERNATIONAL PUBLIC POLICY REVIEW
fee, especially in the light of new technologies that could quickly diffuse
information all over the world.
Moody`s and S&P moreover distinguish themselves by the fact, that they
rate all taxable corporate bonds publicly issued in the US, regardless of
whether the rating has been solicited or not. This policy has been questioned,
as critics allege that unsolicited ratings are artificially low, so that companies
are forced to request a (better) solicited rating. It has also been claimed that
the former two agencies have sent bills for unsolicited ratings to issuers of
bonds.
The rating process of solicited rating incorporates both public and private
quantitative and qualitative data input and may thus generally be regarded to
be more accurate than a rating solely based on public information. A solicited
rating incorporates information on quantitative data provided by the issuer on
its financial position, as well as data gathered by the agency on the industry,
competitors and the economy.
Moreover, legal advice relating to the specific issue, qualitative data
provided by the issuer on management, business outlook, accounting practices
etc and qualitative data gathered by the agency on competition position, longterm industry prospects and economic environment are considered. However,
the CRAs do not conduct independent audits themselves and the quality of
the rating is largely dependent on the information provided by the issuer at
hand4. The final rating is determined by a rating committee and is subject to
appeal by the issuer (in the case of solicited ratings). S&P and Fitch IBCA use
the same basic set of rating symbols, Moody`s uses a slightly different scale
(Appendix 2).
In the last thirty years, regulators have considerably increased the usage of
credit ratings to help monitor the investment risk regulated entities hold and
to provide “an appropriate disclosure framework for securities of differing
risk”5. There are three broad types of regulatory use, namely for capital
requirements, for disclosure requirements and for investment prohibitions.
The regulators implicitly assume that all ratings from different CRAs are
equivalent. Bottini6 states, that the SEC relies too heavily on unregulated
CRAs to determine what type of security may be offered to the public.
Rating agency judgements are not regulated, but there is a formal
recognition of the activities by government regulators, in such places as the
US, France and Japan. There are another two CRAs (besides Moody`s and
T. J. Sinclair. “Global Monitor Bond Rating Agencies.” New Political Economy 8, no.1
(2003): 147-161.
5
US Securities and Exchange Commission ‘Report on the Role and Function of Credit
Rating Agencies in the Operation of the Securities Markets’, as required by Section 702(b) of the
Sarbanes-Oxley Act of 2002, Washington D.C., 2003
6
P. Bongini, et al. “How good is the market at assessing bank fragility? A horse race
between different indicators.” Journal of Banking & Finance 26(2002): 1011-1028.
4
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S&P), which are officially recognised by the Securities and Exchange
Commission (SEC) as nationally recognised statistical rating organisations
(NRSROs), FitchIBCA and Dominion Bond Rating Service. Nevertheless,
there are another thirty-five to forty domestically oriented CRAs in OECD as
well as in emerging countries.
Since 1975 the SEC recognises “nationally recognised statistical rating
organisations” (NRSROs) through a no-action letter process. Originally only
S&P, Moody`s and Fitch were recognised. Ever since then the SEC recognised
five new rating agencies: Duff and Phelps, McCarthy Crisanti and Maffei,
IBCA, Thomson BankWatch and Dominion Bond Rating Service. The former
four have subsequently merged with Fitch, which hence leaves four NRSROs.
Some authors have expressed concern about the fact that the rating industry
increasingly concentrates, as more and more small competitors are being
acquired by or merge with the major players.
The NRSRO concept was originally introduced by the SEC to determine
capital charges on different grades of debt securities under the Net Capital
Rule, which requires broker-dealers to deduct certain percentages from the
net worth of the market value of their proprietary securities positions when
computing net capital. The sole purpose of the former exercise was to use
these “haircuts” as margins of safety against losses incurred as a result of market
fluctuations in the prices of or lack of liquidity in, their proprietary positions7.
The NRSRO designation is supposed to ensure that the ratings are credible,
reliable and accepted by the market.
The reliance on credit ratings in the marketplace as well as in regulation
increased and nowadays ratings are employed in federal and state legislation to
distinguish among grades of creditworthiness. Since 1975 the SEC has also
incorporated the NRSRO concept into other areas of the federal securities law.
The term NRSRO is being applied with a cross-reference to the Net Capital
Rule in the Securities Act of 1933 and the Exchange Act and the Investment
Company Act of 1940. In Rule 2a-7 of the Investment Company Act NRSRO
ratings are being utilised as benchmarks for establishing minimum quality
investment standards8. The NRSRO concept has also been utilised by Congress
for financial regulation, e.g. in the Secondary Mortgage Market Enhancement
Act of 1984 and in the Federal Deposit Insurance Act of 1989 etc.
7
8
SEC, report
SEC, report
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The Basel Committee of Banking Supervision (BCBS), which works under
the sponsorship of the Bank for International Settlements (BIS) also wants to
use CRAs` ratings for banking supervision. It has introduced the first Basel
Accord for its (then) ten member countries (G 10) in 1988, in order to
harmonise bank capital adequacy standards. This international convergence of
supervisory regulators governing the capital adequacy of international banks9 is
aimed to adopt capital to assets ratios that have been risk weighted. Thus the
amount of capital that a bank needs to hold is a function of the riskiness of its
assets portfolio. The Accord contains three pillars, covering capital adequacy,
supervision and disclosure and the revised Accord II aims to incorporate CRAs
ratings for the former purpose.
3. CONTEXT
Traditionally banks acted as intermediaries between borrowers and lenders
of funds, borrowing money in the form of deposits and, at their own risk,
lending it to borrowers. Lenders of funds could rely on the prudential
behaviour of regulated banks. The increasing importance of CRAs ratings in
private, as well as regulatory and bank utilisation can be explained by the
phenomenon of disintermediation.
On both sides of the balance sheet the emergence of the “new global
finance”10 has led to a disintermediation process. Depositors invest their money
in more attractive mutual funds, which put their money straight into the
financial markets. The proportion of households owning mutual funds rose
from 6% to 28% in the period between 1980 and 1994 and the proportion of
household assets held in bank deposits fell from 1980 to 1990 from 46% to
38%. By the mid-1990s, mutual funds contained around US$ 2 trillion in assets,
compared to US$ 2.7 trillion held in US bank deposits. Commercial borrowers
on the other side increasingly obtain their finance directly in the financial
markets through debt securities. In 1970 commercial bank lending made up
65% of commercial borrowing needs of corporate America, by 1992 the share
had fallen to 36%11.
The above developments are strongly linked to the globalisation process in
the international political economy, especially in the financial markets, as well
as to the fact that bank intermediation constitutes high overhead costs due to
E. Kapstein, Governing the Global Economy (London: Harvard University Press,1994)
Sinclair, T. J. “Between state and market: Hegemony and institutions of collective action
under conditions of international capital mobility.” Policy Sciences 27 (1994): 447-466.
11
T. J. Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.” Environment and Planning C: Government and Policy 2000 (18) (2000): 487-502
9
10
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the credit monitoring function12. This is because banks lend to borrowers at
their own risk; borrowers and lenders of funds do not establish a contractual
relationship in this scenario13. CRAs on the other hand only risk their
credibility and reputation, but not their balance sheet while conducting their
business. Therefore their only interest is to make an accurate rating, and not to
identify credits that enhance their own balance sheet14.
Disintermediation changes the roles of banks and creates an information
problem for suppliers and users of funds. Suppliers cannot rely on the prudent
behaviour of banks and have to make their own judgements about the
likelihood of repayment from borrowers. The latter on the other hand now
have to signal their ability to repay principal and interest in a timely manner,
so that risk associated with the borrower, and consequently interest rates
charged to him, are low. The process of disintermediation has thus disempowered traditional intermediating institutions and empowered other
institutions such as CRAs15.
4. LITERATURE REVIEW
4.1. Private Authority
Cutler16 describes three trends in governance. Firstly, law is employed to
legitimise more varied claims of authority (such as CRAs), which leads to a
juridification of social, political and economic life. Secondly, there is a trend
towards a pluralism of and heterogeneity in forms of regulation and
governance. Lastly, privatised governance arrangements experience enhanced
significance.
The development of CRAs as a regulatory authority is due to a process of
three interrelated developments. Firstly, the structural power of
internationalisation and disintermediation has led to a challenge of commercial
positions of banks by cheaper and more efficient capital markets. Secondly,
innovations in financial instruments (e.g. derivatives, structured finance) stress
the analytical system and output of CRAs, which in reply develop new
Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.”
13
T. J Sinclair. “Passing Judgement: credit rating processes as regulatory mechanisms of
governance in the emerging world order.” Review of International Political Economy 1, no. 1
(1994): 133-159.
14
Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.”
15
Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.”
16
C. Cutler. Private Power and Global Authority (Cambridge: Cambridge University
Press,2003).
12
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INTERNATIONAL PUBLIC POLICY REVIEW
expertise and rating scales. Lastly, competition and specialisation in the rating
industry accelerated17.
CRAs possess a specific form of social authority, based on public
acknowledgment of their track record and their image of being disinterested
experts. This makes them in the eyes of market participants, a legitimate and
endogenous (not externally imposed) authority.
Their authority consists of four elements. The first element is the social
context, within which they represent certain social interests, specifically global
elites, and help to obstruct competing logics, these elites are hostile to.
Therefore they amplify the dominance of a narrow assumption about market
efficiency, in which state intervention is regarded as negative, and which
neglects transition costs, such as unemployment18.
The second element is the epistemic authority, based on expert and local
knowledge. Through the knowledge structure they exercise authority over
market transactions in two ways. Firstly, they shape behaviour through control
over what is regarded as an acceptable possibility. This form of authority is
largely consensual. Secondly, they can rule by sanctioning deviant behaviour
(e.g. through downgrades), in order to bring it back in line with the acceptable
behaviour of conduct. This is a more coercive form of authority19.
The third element of their authority rests on their coordination function.
Lastly, their authority is based on the quasi-regulatory function the
government has accredited to them as a substitute for their own action20.
The private authority of CRAs has implications for investment, for policy
choices, management style and for national determination. Firstly, they possess
structural as well as behavioural power over investment decisions of market
participants. US agencies dominate the global market, and local CRAs have
been bought up and infused with the practices and rating processes of the
headquarters. Knowledge based on history, location and tradition gives way to
abstract, verifiable and transparent knowledge forms21.
Secondly, they have an impact on policy choice. The desire to obtain
finance in the securities market, and the correspondent need to obtain a
favourable rating, forces many federal states and municipals in the US to
T. J. Sinclair. “The Infrastructure of Global Governance: Quasi-Regulatory Mechanisms
and the New Global Finance.” Global Governance 7 (2001): 441-451.
18
Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.”
19
Sinclair. “The Infrastructure of Global Governance: Quasi-Regulatory Mechanisms and
the New Global Finance.”
20
Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.”
17
21
Sinclair. “Passing Judgement: credit rating processes as regulatory mechanisms of
governance in the emerging world order.”
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practice fiscal austerity, as Sinclair22 and Hackworth23 impressively document.
The former phenomenon is rooted in new constitutionalism, which urges the
state to reduce social policy expenditures and to enlarge the influence of the
private sector in the provision of services. Hence CRAs` view of appropriate
management style and public policy can have implications for the mixture of
public and private goods provided locally24.
CRAs conduct a fundamental analysis, which integrates not only financial
data (focusing on the entity), but also, economic ones (focusing on the
collective situation). Therefore the “through the cycle” ratings of CRAs may
differ substantially from the “current condition” rating banks conduct
internally. The implications of this sort of conduct are an internationalisation
of forms of knowledge associated with fundamental analysis. The former also
assumes that all states are the same, as they are all driven by the same
dynamics. Therefore the emphasis is on universally applicable financial
principles. Sinclair25 states, that this assumption is at odds with the
development view of the world, which asserts that, societies are quantitatively
and qualitatively different from one another.
Thirdly, countries willing to issue securities have to rely on the few US
rating agencies with a NRSRO designation. The former have the tendency to
rate countries with a different societal set up than the Anglo-Saxon one, e.g.
countries with a corporatist or trade union tradition, less favourably26, a home
bias well documented in the financial literature.
The mounting significance of CRAs is in line with other global
developments in forms of authority. Ever more the framework for
international economic transactions is created and maintained by the private
sector. This global trend corresponds to current domestic developments,
specifically those of privatisation, reliance on market forces and regulation by
industries. Although it is not clear that market oriented sources of authority
are the most desirable alternative, the modern state is unable to cope with the
demands of the global order, and thus gives private authority legitimacy in
exercising authority over economic transactions. Another source of legitimacy
for private authorities is specialised expertise27; CRAs for example are
regarded as endogenous and neutral participants in the securities market.
Sinclair. “Passing Judgement: credit rating processes as regulatory mechanisms of
governance in the emerging world order.”
23
J. Hackworth. “Local Autonomy, Bond Rating Agencies and Neoliberal Urbanism in the
United States.” International Journal of Urban and Regional Research 26. no.4 (2002): 707-725.
24
Sinclair. “Passing Judgement: credit rating processes as regulatory mechanisms of
governance in the emerging world order.”
25
Sinclair. “Passing Judgement: credit rating processes as regulatory mechanisms of
governance in the emerging world order.”
26
Sinclair. “Passing Judgement: credit rating processes as regulatory mechanisms of
governance in the emerging world order.”
27
Cutler et al. “The Contours and Significance of Private Authority in International
22
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CRAs constitute a form of private authority, as subjects view them as
being legitimate. Moreover they are able to foster a high degree of compliance
and most importantly, they have been empowered by the government
(through the regulatory use of NRSROs ratings) to exercise authority. Hence,
private authority emerges both due to interfirm interaction as well as statefirm interaction28.
The shift in authority from states to markets has made political players
out of these private, non-majoritarian profit-seeking entities. Consequently
politics is not confined to politicians and officials anymore; the state ceases to
be the sole vehicle of public policy. The authority of the state has been
weakened by the overlapping trends of technological and financial changes, as
well as by the expansion of market forces, which accelerated the integration of
national economies into a single global market. In this scenario power over
outcomes is often exercised impersonally by markets, often unintended by
those who participate in the market transactions29.
4.2. Efficiency
Due to the high costs to gather (lenders) and signal (borrowers)
information on creditworthiness, institutions developed that captured
economies of scale, provided centralised judgments on creditworthiness and
gained expertise through specialisation30. Rating agencies facilitate the flow of
information by processing public (and sometimes private) information and
packaging it into a useful and standardised format at far lower costs than
individual investors would face.
Efficiency approaches, based on new institutional economics, explain the
authority in terms of enhanced efficiency in the market due to reduced
transaction costs and uncertainty as well as due to information provision.
CRAs improve transparency and comparability of financial assets from
different markets and are therefore generally welfare enhancing in terms of
efficiency. Thus in theory, as well as in practice, states delegate regulatory
functions to a more efficient private sector31. Another advantage of CRAs is
that research is not wastefully duplicated32.
Affairs.” In Private Authority and International Affairs, edited by A. C. Cutler, V. Haufler and T.
Porter, 333-377. Albany: State University Press of New York, 1999.
28
Cutler et al. “The Contours and Significance of Private Authority in International
Affairs.”
29
Strange, S. The Retreat of the State. (Cambridge: Cambridge University Press,1996)
Sinclair. “Reinventing authority: embedded knowledge networks and the new global
finance.”
31
Cutler et al. “The Contours and Significance of Private Authority in International
Affairs.”
32
G. Husisian. “What Standards of Care Should Govern the World`s Shortest Editorials?
30
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The normative rationale for regulation appropriate for the rating industry,
is that of (improving) efficiency and not that of distributional considerations,
as the regulatory scheme closest to it, namely securities law, is evaluated
according to the same rationale and has the same function: to reduce
information asymmetry. In case of a market failure one can improve efficiency
in two ways: firstly, one can improve the performance. Secondly, one can limit
negative consequences33.
H1a: CRA are more efficient at coordinating the securities market than
government action, and outcomes should be judged as with securities laws
in terms of efficiency only, if no other negative consequences arise.
H1b: If the regulatory use of CRAs is inefficient and displays negative
consequences other alternatives should be utilised
4.3. The External Accountability Gap
Kerwer34 regards CRAs as non-majoritarian regulators (NMR), facing a
(democratic) accountability problem. In principal-agent theory the
accountability problem arises due to an information asymmetry between a
principal seeking to control a self-interested agent. But in a classic
accountability relationship the principal has to be able to control the agent,
who is supposed to act on the principal’s behalf. This may only happen, if the
principal delegates authority or gives financial support to the agent. This
narrow focus neglects external accountability relationships, where the
principal is not hierarchically superior to the agent, does not transfer decisionmaking rights and does not grant material support.
Two types of external accountability relationships exist. Firstly, in the
principal-trustee relationship, the principal (SEC) authorises the trustee
(NMR/CRA) to act on his behalf in order to signal a credible policy
commitment and avoid political manipulation35. The principal does not
control the trustee, as to enhance his own preferences. Thus by definition
there is no accountability relationship. Accountability is ensured through
public and expert scrutiny, as well as through reputation36.
An Analysis of Bond Rating Agency Liability.” Cornell Law Review 75, no.2 (1990): 411-461.
33
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
University Of Illinois Law Review 1(2002): 1-28.
34
Kerwer (2005 forthcoming) Holding Global Regulators Accountable: The Case of Credit
Rating Agencies
35
. Majone and Giandomenico. “Two Logics of Delegation. Agency and Fiduciary Relations
in EU Governance.” European Union Politics 2, no.1 (2001): 103-122.
36
Kerwer, Holding Global Regulators Accountable: The Case of Credit Rating Agencies
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INTERNATIONAL PUBLIC POLICY REVIEW
Secondly, in the stakeholder-agent relationship, the former (e.g. a
borrower) is a modified principal, as the agent exercises a choice determining
impact on the stakeholder37. Through the regulatory application of CRAs
ratings by the SEC and other government bodies, the opinions on an entity’s
creditworthiness, which are not a recommendation to sell or buy, become a
mandatory and coercive investment standard. Neo institutional theory
confirms, that third party enforcement of voluntary expertise based on
standards, converts the former into coercive rules38. Investors and borrowers
therefore have to utilise the ratings and cannot exit.
A pension fund manager has to sell a security, if it has been downgraded
to a “speculative-grade”; he consequently only has to reallocate his investment,
possibly to his advantage. But borrowers are much more affected by CRAs
ratings, for them a downgrade may have severe consequences, and accordingly
they would be the prime would be principals among the stakeholders.
Nonetheless, they are not internal principals, although most of them pay fees
to obtain a rating, but this is, as mentioned in the introduction, an anomaly
due to a collective action problem39.
Therefore stakeholders, with an external accountability relationship
experience severe difficulties in sanctioning the agents and thus often politicise
the formerly economic issue. The former is also true for national governments,
which are penalised by CRAs (via lower ratings) for (so they claim) having
different societal set-ups40. As the above discussion demonstrates, the external
accountability gap in the CRAs market is an unsolvable problem, as long as
coercive regulators make these voluntary standards mandatory.
H2: Third party enforcement makes CRAs choice determining, as it
changes the original principal-agent relationship between CRA and market
participants and thus it creates an accountability gap.
In the case of standards, quality considerations are more important than
price considerations. In theory, if quality deteriorates, customers can firstly use
the economic exit option and stop buying the product, that is, when demand
is sufficiently elastic and supply is sufficiently competitive. Secondly,
customers can express their dissatisfaction with the political voice options.
R. Keohane “Global Governance and Democratic Accountability.” In Taming
Globalisation Frontiers of Governance by Held, et al, 2003
38
Kerwer, D. (2002) ‘Standardising as Governance: The Case of Credit Rating Agencies’, in:
Heritier, Reinvesting European and International Governance, Lanham: Rowman and Littlefiled
39
Kerwer, Holding Global Regulators Accountable: The Case of Credit Rating Agencies.
40
Kerwer, Holding Global Regulators Accountable: The Case of Credit Rating Agencies
37
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However one has to give the entity in question enough time to respond to the
pressure41.
Thus the solution is not more accountability, but more market control.
The market is however highly concentrated, with Moody`s and S&P holding
80-90% of the market share and moreover there are substantial entry barriers.
If one considers, that for many regulatory purposes two ratings are required,
one realises that the choice is severely limited.
H3: The external accountability gap cannot be overcome through
regulation and thus one needs to improve the exit option and competition in
order to utilise reputation as an accountability mechanism
Although borrowers cannot use the fee payments to influence the rating,
Kerwer is wrong when he states that CRAs refuse any communication or
advice. Solicited ratings are being discussed with the borrower before the
publication (Appendix 3). If a rating is unfairly low, the company has the
opportunity to provide additional information to correct the mistake. CRAs
also provide ancillary services, in which the possible rating outcomes of certain
strategic business decisions are being examined. However, this may pose a
conflict of interest, which will be discussed later.
Standards are often closely associated with expertise, and the reference to
expert knowledge provides standards with legitimacy (see Sinclair’s embedded
knowledge networks). But as Brunsson et al.42 stress, there is a danger that
expert knowledge becomes a substitute for ethical and political discourses, a
phenomenon many critics of CRAs point out. This leads to a depoliticisation
and technicalisation of the issues at hand, and thus regulation without
responsibility emerges. Therefore one should consider whether the goals of
these standards (market efficiency) are desirbale for all the regulatory
purposes, i.e. whether the appropriate goal of these regulatory purposes is
efficiency only (e.g. in international banking supervision). One should also
consider whether there are better ways to achieve the goals stipulated in
regulation (even if it is only efficiency), which may decrease the accountability
gap, without having to increase voice mechanisms and/or regulatory oversight.
4.4. Private Public Dichotomy
In liberal theory only the public sphere is empowered to prescribe
behaviour, as only the public sphere is accountable through political
institutions; private authority lacks this accountability. Conceptualising private
international authority faces however an additional obstacle, specifically that
41
42
2000)
. A. Hirschman. Exit, Voice and Loyalty (London: Oxford University Press, 1970)
N. Brunsson and B. Jacobsson. A World Of Standards (Oxford: Oxford University Press,
52
INTERNATIONAL PUBLIC POLICY REVIEW
of theorising about international governance in the absence of a (world)
government43.
Accountability has many inter-linked meanings. It can refer to greater
transparency in a world of hierarchy and bureaucracy. It may also denote the
access to an impartial arena where abuse of authority can be challenged and
judged. Moreover accountability may occur in the form of pressure and
oversight that will lead to an appropriate behaviour44. Coercive decisionmakers may be held accountable democratically, hierarchically, horizontally or
via transparency.
But increasing oversight, and thus accountability, would interfere with the
independence of CRAs, and moreover it would reduces the incentive to
innovate and improve quality45. Increasing transparency of rating processes and
output, as well as increasing legal liability, poses constitutional as well as
economic problems, as will be discussed in section 5.3. Promoting a
professional self-regulatory system, as it exists in accounting, also faces severe
obstacles, based on the same rationales.
Liberal, democratic and representative law making and enforcement as a
state held monopoly, is a concept that does not integrate well with the
concept of private law making. This is mainly due to the dichotomous
distinction liberalism draws between the public and the private sphere, as well
as between the state and the market. But Gramsci argues46 that the privatepublic distinction is not organic, but methodological. Laissez-faire liberalism,
“is a deliberate policy, conscious of its own ends and not the spontaneous,
automatic expression of economic facts”47. Thus one should challenge, and
critically scrutinise distinctions that separate domains, such as public-private,
political-apolitical and economic-political. Cutler48 moreover argues that one
should be cautious of privileging private legal regulation and subordinating
domestic policy concerns to neo-liberal market discipline and the interests of
society to those of capital.
This paper thus challenges the increasing usage of private bodies for public
law enforcement, which are, solely based on the liberal (methodologically
constructed) dichotomy between public and private spheres, free from any
accountability.
The relationship between accountability and performance is apart from
the above not entirely apparent. If in the case of CRAs, the aim of increased
43
Cutler et al. “The Contours and Significance of Private Authority in International
Affairs.”
44
M. Dubnick (2003) Accountability and the Promise of Performance: In Search of the
Mechanisms, Annual Meeting of the American Political Science Association.
45
Kerwer, Holding Global Regulators Accountable: The Case of Credit Rating
46
Cutler. Private Power and Global Authority
47
Cutler. Private Power and Global Authority
48
Cutler. Private Power and Global Authority
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accountability is to enhance performance, paradoxically the opposite effect
might occur. There is an inherent tension between performance and
accountability on an operational as well as on a logical level. Increasing
accountability may decrease the overall level of performance, a phenomenon
called the accountability paradox49.
This is due to the performative nature of account giving in the form of
reporting, mitigating and reframing. It requires attention and consumes energy
and time of the account giver, all resources that could otherwise be deployed
for more desired forms of performances, for example increased accuracy of
ratings in the case of CRAs50. Therefore a well functioning and competitive
market may hold CRAs accountable more effectively via reputation and
competition.
H4: Attempts to increase accountability lead, due to the liberal publicprivate dichotomy, to a two-folded accountability paradox: They decrease
performance and face constitutional obstacles
H4: Attempts to increase accountability lead, due to the liberal
public-private dichotomy, to a two-folded accountability paradox: They
decrease performance and face constitutional obstacles
5. ANALYSIS
5.1. Efficiency
If dissatisfied with the actions of the trustee (CRAs), the SEC could
abolish the regulatory use and the NRSRO designation. This however would
harm the market and the SEC much more than the CRAs, especially without
any viable alternative in sight to protect investors and reduce the systemic risk
of capital markets.
A full merit analysis (for disclosure requirements and investment
decisions) conducted by the government itself would be time consuming,
costly and most likely less flexible and responsive to changes, as well as less
accepted by the market. Thus instead the SEC requires full disclosure of
information so that investors can conduct their own merit analysis; or as it is
costly and time consuming for individual investors, they can pass that analysis
on to CRAs51.
The SEC utilisation of external ratings shows a credible commitment, is
less prone to political manipulation and additionally more effective and
Dubnick Accountability and the Promise of Performance: In Search of the Mechanisms
Dubnick Accountability and the Promise of Performance: In Search of the Mechanisms
51
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
49
50
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INTERNATIONAL PUBLIC POLICY REVIEW
efficient. Schwarcz52 argues for the use of external ratings, as this organisational
form of regulation is preferable over transactional regulation, if the
organisation operates in the commercial, financial sphere where protecting
state’s legitimacy is not a primary goal. Additionally rules set by organisational
regulation are optimal in the light of the costs of the rules because
organisational regulation relies on a simple commitment mechanism such as
reputation.
Brunsson et al.53 point out that most standards are set by the private sector
and that they are especially common on the global stage, where there is less
competition from other rule setters. CRAs` output proliferated in response to
disintermediation and the corresponding need to reduce uncertainty and
information asymmetry in a diverse and varied transnational environment.
Standards are an effective way of transmitting information and thus result in
simplification, as fewer options have to be considered.
Olegario54 points out that CRAs are much better able to communicate
private information about the borrower to the market, than the borrower
himself. Private information, incorporated into a rating, can be communicated
without a danger that it will fall into competitors` hands; thus a potential
competitive advantage can be preserved. This process increases borrowers`
accountability and aids to route capital to the best investments55. Without
CRAs information costs would be enormous, and investors would be reluctant
to conduct research of their own for a marginal increase in interest rates
(compared to government bonds); they would thus invest too conservatively.
Therefore the SEC delegates authority to CRAs and trades off control for
effectiveness, as risk regulation is adequately addressed and more flexible. The
usage of independent, external ratings enhances the credibility of the US
government by avoiding the problems of time inconsistent preferences and illdefined property rights and moreover it improves market efficiency56.
Therefore, as hypothesised, in H1a CRA are more efficient at
coordinating the securities market than government action, and outcomes
should be judged as with securities laws in terms of efficiency only as no
other negative consequences arise.
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
Brunsson and B. Jacobsson. A World Of Standards
54
R. Olegario. Credit Reporting Agencies: Their Historical Roots, Current Status, and Role
in Market Development (University of Michigan Business School, 2004)
55
Husisian. “What Standards of Care Should Govern the World`s Shortest Editorials? An
Analysis of Bond Rating Agency Liability.”
56
Majone and Giandomenico. “Two Logics of Delegation. Agency and Fiduciary Relations
in EU Governance.” European Union Politics 2, no.1 (2001): 103-122.
52
53
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5.2. The Triadic Principal-Trustee-Stakeholder Relationship and the External
Accountability Gap
However it should be noted CRAs initially coordinated the market,
without state enforcement. They are not equity analysts or investment
advisers, as they do not make a recommendation to sell or buy a security. They
normally rely on public as well as on private information provided to them
and they do not independently seek to verify the information.
Thus coordination service firms have the primary function of coordinating
markets and setting standards of behaviour, not to prescribe behaviour, as they
are less institutionalised as well as less standardised than other forms of private
cooperation such as cartels or private regimes57.
One may view CRAs as agents for the market as a whole, and borrowers
as well as investors as principals. Although Kerwer`s description and analysis
of the external accountability relationships are correct, he neglects one
important aspect: namely the triadic relationships and causal link between the
two external accountability relationships of principal (SEC), trustee (CRAs)
and stakeholder (borrower). CRAs only have a choice determining impact on
borrowers (and thus make them stakeholders) due to the trustee status the
SEC forced upon the CRAs. The SEC forces itself onto the CRAs as a
principal and therefore alters the original principal-agent relationship between
market participants and CRAs.
Diagram 1: Triadic External Principal-Trustee-Stakeholder Relationship
57
Cutler et al. “The Contours and Significance of Private Authority in International
Affairs.”
56
INTERNATIONAL PUBLIC POLICY REVIEW
The formerly cooperative relations are transformed into authoritative relations as
they become infused with an obligatory quality, i.e. the authority generated from
58
expertise becomes binding, e.g. through regulatory usage . The CRAs now have a
59
choice determining impact .
CRAs ratings are voluntary standards that do not possess hierarchical
authority or the ability to sanction and are designed to coordinate the market.
Standards are a form of social coordination and control distinct from markets
and hierarchies. Therefore standardisation presupposes that the adopter can
act independently. Due to the former assumption, the allocation of
responsibility is different to hierarchies, the standard follower not the issuer is
responsible for using the standard60.
Therefore it is difficult to hold CRAs accountable. As standards are not
designed to be compulsory, no efficient feedback mechanism or an ability to
exercise a voice option exist. Feedback in theory occurs by standard adopters
using the exit option to signal that they are not satisfied with the quality of the
standards. This however is not possible due to the third party enforcement of
the standards by the SEC and the lack of NRSRO alternatives to choose from.
Cutler et al. “The Contours and Significance of Private Authority in International
Affairs.”
59
G. Kaminsky and S. Schmukler “What triggers market jitters? A chronicle of the Asian
crisis.” Journal of International Money and Finance 18 (1999): 537-560.
60
Brunsson and B. Jacobsson. A World Of Standards
58
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Third party enforcement can also amplify a lock-in effect. Thus once a
standard has been adopted, and in the case of CRAs even been
institutionalised, it can inhibit innovation, competition and quality
improvements61.
The SEC makes the CRAs` opinions mandatory and choice determining
for borrowers, but (rightly so) does not hold them accountable themselves.
Accountability may still be accomplished, although the impact of CRAs is
choice determining for borrowers, and although there is no possibility for
borrowers to hold CRAs accountable in a hierarchical way, as no feedback
mechanisms or enforceable liability standard exists.
Voice as a feedback and accountability mechanism, as pointed out above,
comes not naturally to the credit rating market, as its organic roots are that of
a voluntary standard. Nonetheless the exit option cannot be implemented at
the moment, as demand is highly inelastic due to the regulatory use of CRAs
and an NRSRO designation process, which creates high entry barriers for new
competitors. The non-existence of the exit option drives market participants
to utilise the voice option, which due to the external accountability gap is
ineffective as well.
Therefore, neither exit nor voice is a feasible option and the delinquent
management will never experience revenue loss due to deteriorating quality62.
If the SEC however would increase the exit option, market participants will
be less likely to use the voice option. At the moment however, the exit
options carries with it a high penalty; namely the exclusion from the
international (securities) capital markets.
Therefore, as hypothesised, in H2 Third party enforcement makes CRAs
choice determining, as it changes the original principal-agent relationship
between CRA and market participants and transforms it into a triadic
external principal-trustee-stakeholder relationship and thus it creates an
accountability gap.
5.3. Inefficiencies and Negative Consequences in Banking Supervision
The revised Basel Accord II proposes to use external ratings by CRAs for
the capital adequacy standards of international banks. Once the new Accord
has been adopted, it is likely that the usage will spread to more countries and
international institutions. However, as many critics point out, external ratings
only cover a small proportion of a bank’s portfolio and are unresponsive to the
61
Brunsson and B. Jacobsson. A World Of Standardsand R. Cantor “Moody`s investors
service response to the consultative paper issued by the Basel Committee on Bank Supervision
‘A new capital adequacy framework’.” Journal of Banking & Finance 25(2001): 171-185.
62
Hirschman. Exit, Voice and Loyalty
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INTERNATIONAL PUBLIC POLICY REVIEW
unique needs of individual banks. This disadvantages SMEs and other bank
customers. As the use in market supervision also causes an external
accountability gap governments should reduce the reliance on the securities
market by preserving other financing possibilities available that may mitigate
the adverse effects. But this can only happen if banking supervision and thus
banking as a financing possibility is free from credit rating agency influence.
SMEs and private borrowers cannot issue securities and have to rely on
commercial banks to obtain loans. But banks will be reluctant to give out loans
to firms which do not possess a rating, as they would have to keep more
capital reserves for loans given to unrated companies, compared to companies
with a rating. Moreover will it be even more difficult for stakeholders of
different nations to overcome the external accountability gap and hold US
CRAs accountable.
The author has argued that generally no rationale exists to increase the
regulation of CRAs in order to improve efficiency in national securities
markets, as this (efficiency) would be the only legitimate rationale to increase
regulation of CRAs. However neither in this nor in another context will
regulation increase efficiency or accuracy. But this does not imply that using
CRAs` output for capital requirements of banks is efficient.
For some regulatory purposes no real alternative exists to the usage of
CRAs` ratings, but most banks have the facilities to conduct their own
internal risk assessments, based on a current condition rating approach, which
suits the purposes of banks much better than the through the cycle approach
of CRAs. “When the objective is to allocate economic capital, monitor loans
and establish loan reserves, the point in time approach is more appropriate”63.
Furthermore using CRAs` output in international bank regulation will
display negative distributional consequences, will undermine democratic
control and will effectively bar small companies all over the world from
obtaining loans. Thus using CRAs output for the regulation of capital
standards is inefficient and inappropriate. The desire to create efficiency only
materialises if ratings are of homogenous quality across markets and borrowers.
But it has been proven that CRAs lack the accuracy they display at rating US
corporations, when they assess sovereigns, foreign banks or foreign
corporations. Moreover it has been suggested that they display a home bias64.
63
47-95.
M. Crouhy et al. “Prototype risk rating system.” Journal of Banking & Finance 25 (2001):
64
R. Cantor and F. Packer “Sovereign Credit Ratings.” Current Issues In Economics and
Finance 1, no.3 (1995): Federal Reserve Bank Of New York R. Cantor and F. Packer.
“Differences of opinion and selection bias in the credit rating industry.” Journal of Banking &
Finance 21(1997): 1395-1417. J. Ammer, and F. Packer, “How Consistent Are Credit Ratings? A
Geographical and Sectoral Analysis Of Default Risk.” International Finance Discussion Papers,
no.688, (2000). R. Cantor, “Moody`s investors service response to the consultative paper issued
by the Basel Committee on Bank Supervision ‘A new capital adequacy framework’.” Journal of
Banking & Finance 25(2001): 171-185. G. Ferri et al., “The role of rating agency assessments in
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Thus in this scenario, the premises of reducing information asymmetry is
not given anymore, and therefore the rationale for using CRAs` output in
regulation diminishes as well. Utilising CRAs` ratings for a global scale
regulation will be costly and impractical in a “primitive” system of
international law65. The reputational constraint or accountability mechanism
will not work on a global scale, as the reputation is only relevant to a subset of
the globe’s population. Many stakeholders of this additional choice
determining impact of CRAs will not participate in the reputational feedback
mechanism.
The triadic principal-trustee-stakeholder relationship explains this
phenomenon. The principal (SEC) who empowered the trustee (CRA) and
who is an agent of all market participants in the national securities market, is
not a legitimate principal to empower trustees for international bank
regulation, as he is not empowered by all those stakeholders it may affect.
Thus in this scenario, the premises of reducing information asymmetry is
not given anymore, and therefore the rationale for using CRAs` output in
regulation diminishes as well. Utilising CRAs` ratings for a global scale
less developed countries: Impact of the proposed Basel guidelines.” Journal of Banking & Finance
25 (2001): 115-148. Bongini et al. (2002), Y. Shin, and W. Moore. “Explaining credit rating
differences between Japanese and U.S. agencies.” Review of Financial Economics 12 (2003): 327344
65
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
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INTERNATIONAL PUBLIC POLICY REVIEW
regulation will be costly and impractical in a “primitive” system of
international law66. The reputational constraint or accountability mechanism
will not work on a global scale, as the reputation is only relevant to a subset of
the globe’s population. Many stakeholders of this additional choice
determining impact of CRAs will not participate in the reputational feedback
mechanism.
The triadic principal-trustee-stakeholder relationship explains this
phenomenon. The principal (SEC) who empowered the trustee (CRA) and
who is an agent of all market participants in the national securities market, is
not a legitimate principal to empower trustees for international bank
regulation, as he is not empowered by all those stakeholders it may affect.
Moody`s also endorses to use internal risk assessments in sophisticated
banks, as the regulatory use of external ratings undermines the quality of credit
rating over time by increasing rate shopping, decreasing CRAs` independence
and reducing incentives to innovate and improve quality of the ratings67.
Regulators fundamentally change the nature of the CRAs` output. Issuers
not only pay a rating fee to access capital markets, but to purchase a privileged
status for their securities from the regulator. Therefore CRAs have a product
to sell regardless of the accuracy and quality of the rating and regardless of
market credibility and acceptance68.
For those banks that cannot use internal ratings at the moment, external
ratings should only be used in a transitional period. The Basel Committee of
Banking Supervision (BCBS) launched a Financial Sector Reform and
Strengthening (FIRST) initiative, which will provide technical assistance
grants to developing countries, so that these can improve their internal risk
assessment capacities69.
The adverse consequences of using CRAs in bank regulation are
numerous. Firstly, the meaning of ratings may vary across CRAs, as no single,
universally accepted measure exists70.
Regulators however regard ratings as interchangeable71, despite the fact
that Moody`s includes considerations of recovery in corporate ratings, and S&P
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
Cantor, “Moody`s investors service response to the consultative paper issued by the Basel
Committee on Bank Supervision ‘A new capital adequacy framework’.”
68
Cantor, “Moody`s investors service response to the consultative paper issued by the Basel
Committee on Bank Supervision ‘A new capital adequacy framework’.”
69
International Monetary Fund and World Bank (2002). “Implementation of the Basel Core
Principles for Effective Banking Supervision, Experiences, Influences, and Perspectives.”
http://www.imf.org
66
67
M. Crouhy et al. “Prototype risk rating system.”
Cantor and F. Packer. “Differences of opinion and selection bias in the credit rating
industry.”
70
71
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only measures the relative likelihood of corporate default. Cantor and Packer72
confirm that the same letters in the rating scale of different CRAs describe
different default risks.
Secondly, their analysis shows that DCR (now Fitch) and Fitch rate
systematically higher than Moody`s and S&P, which therefore might lead to
rating shopping.
Rate shopping in turn undermines rating accuracy. McNamara and
Vaaler73 show in their study, that the competitive positioning of a CRA as
either an incumbent or an insurgent significantly influences the sovereign risk
ratings of emerging market participants. Cantor and Packer74 confirm that third
ratings obtained by bond issuers are normally higher than the first two ratings
(issued by incumbents, see Appendix 7).
Thirdly, it seems that CRAs` ratings are not better able to reduce systemic
risk or assess bank fragility than other indicators. Bongini et al.75 found that
ratings are not better able to assess bank fragility than historical accounting
Cantor and F. Packer. “Differences of opinion and selection bias in the credit rating
industry.”
73
G. McNamara and P. Vaaler. “The Influence of Competitive Positioning and Rivalry on
Emerging Market Risk Assessment.” Journal of International Business Studies 31, no. 2 (2000):
337-347
72
Cantor and F. Packer. “Differences of opinion and selection bias in the credit rating
industry.”
74
75
Bongini, P, et al. “How good is the market at assessing bank fragility? A horse race
between different indicators.”
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INTERNATIONAL PUBLIC POLICY REVIEW
data; to the contrary, they exhibited the lowest discriminatory power between
sound and insolvent banks. CRAs are able to distinguish “good” from “bad”
countries, but due to the doctrine of sovereign ceiling, which states that no
entity can have a higher rating than the sovereign it is situated in, they are not
able to distinguish “good” from “bad” banks76.
Thus although non US banks have been found to be particularly safe in a
study by Ammer and Packer77, their ratings might still be considerably lower
than that of US banks, which “ have been overrated by about one rating notch
relative to US non financial firms. Moreover Bongini et al.78 find that, being
rated has no disciplinary effect on the conduct of banks, as banks are often
considered to be too big to fail. The authors conclude that CRAs may even
increase systemic risk, as they downgrade late and more severely than
fundamentals would require. King and Sinclair79 confirm that CRAs ratings are
procyclical.
Another negative effect of the Basel Accord II would be that it raises the
cost of capital in developing countries80 (see Appendix 8). The increase in the
costs of capital in developing countries is due to the sovereign ceiling as well
as due to the fact that non-rated assets would receive a higher risk rating. Bank
ratings in these countries are strongly linked to the sovereign rating, whereas
this is not the case in OECD countries. Moreover developing countries
sovereign rating downgrades by CRAs have been excessive in the past81.
Ratings are less spread in these countries, and CRAs would be insensitive to
improvements in the quality of assets. The gap between two equally strong
banks in two countries would therefore widen.
76
Bongini, P, et al. “How good is the market at assessing bank fragility? A horse race
between different indicators.”
77
J. Ammer, and F. Packer, “How Consistent Are Credit Ratings? A Geographical and
Sectoral Analysis Of Default Risk.”
78
Bongini, P, et al. “How good is the market at assessing bank fragility? A horse race
between different indicators.”
79
M. R. King and T. J. Sinclair. “Private Actors and Public Policy: A Requiem for the New
Basel Capital Accord.”
80
M. R. King and T. J. Sinclair. “Private Actors and Public Policy: A Requiem for the New
Basel Capital Accord.” . G. Ferri et al., “The role of rating agency assessments in less developed
countries: Impact of the proposed Basel guidelines.”
81
R. Cantor and F. Packer “Sovereign Credit Ratings.”
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Thus especially in a crisis, this unfairly asymmetrical treatment leads to
procyclical swings, which worsens the availability and cost of credits (credit
crunch) and would display negative effects on the level of economic activity in
less developed countries82.
Therefore, as hypothesised in H1b, International Banking regulation in
terms of capital standards should not utilize external ratings as it is
inefficient and displays negative distributional consequences
5.4. Accountability Paradoxes
Some authors have suggested increasing regulation e.g. via statutory
oversight, disclosure or standards for minimum requirements. It has also been
proclaimed to heighten the liability standard (from recklessness to negligence)
of CRAs due to their choice determining impact83. Hypothesis H4 in section
4.4 states that: Attempts to increase accountability will lead to a two-folded
accountability paradox. Firstly, in economic terms performance will decrease.
82
. G. Ferri et al., “The role of rating agency assessments in less developed countries: Impact
of the proposed Basel guidelines.”
83
Francis A. Bottini. “An Examination of the Current Status of Rating Agencies and
Proposals for Limited Oversight of Such Agencies.” San Diego Law Review 30, no. 3 (1993): 579620.
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INTERNATIONAL PUBLIC POLICY REVIEW
Secondly, due to the third party enforcement of ratings and the liberal public
private dichotomy, it will be unconstitutional to increase accountability.
Theory on negligence standards states that the former will be inefficient in
terms of precaution taken, if both parties (in this case CRAs and
investors/borrowers) can influence the harm caused. If at all, the principal
that makes CRAs` output coercive (the SEC) should internalise precaution
and injury costs. This is a highly unlikely scenario and thus the tort law should
ensure that overall social costs are at a minimum. A negligence standard would
increase administrative costs, due to a flood of court cases, would raise the
sum of precaution above the social optimum (as CRAs would be overly
cautious) and most likely would not reduce the costs of harm incurred.
As securities laws, CRAs ratings should be evaluated according to their
efficiency in reducing information asymmetry. One could improve efficiency
by increasing rating accuracy or by limiting negative consequences.
Improving performance through cost reduction or increased reliability
does not seem possible. Fees are market based and not excessive. Moreover
the CRAs` track record for corporations is outstanding.
Reputation ensures that CRAs` ratings are accurate. On the other hand
regulation might impair reliability and diminish the importance of reputation.
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Negative consequences include the lacking democratic accountability,
which however does not seem to undermine the CRAs rating accuracy,
Therefore reputation may be regarded as a normative complement to
democratic accountability. Possible conflicts of interest due to the fact that the
bond issuer pays for ratings (a collective problem that cannot be overcome),
are of minor concern, as fees are independent of actual rating outcomes84.
A further potentially negative consequence, precisely the issuance of
artificially low unsolicited ratings (which are only based on incomplete
information) in order to make bond issuers pay for a (better) solicited rating, is
only of concern if used for regulatory purposes, but more importantly, it has
not be proven. Moreover 1st amendment protection of CRAs makes them
immune to interference in their publication strategies. Again, reputation may
solve the problem, as Moody`s started to indicate which ratings are
unsolicited85 because they felt their customers would value this service.
Market forces should ensure a proper level of care. Competition and the
strife of individual CRAs to obtain a competitive advantage increase accuracy.
Additionally there are several close substitutes in place and market
participants (principals) can monitor CRA (agents) through the simple
monitoring of their historic track record86.
The rationale for a negligent standard is that it will increase rating
accuracy. The costs of negligence will be internalised by the CRAs and thus a
higher standard of due care should be reached. Moreover it is believed that
CRAs can avoid mistakes at least cost, as they posses more expertise than the
investors. Furthermore they are better able to spread the risks of mistakes.
But CRAs would have to charge higher prices, incorporating mandatory
negligence insurance, in order to compensate innocent parties. If demand is not
elastic (which it currently is not), they will pass on the costs to all consumers
and issuers of ratings.
Thus a negligence standard drives up costs, without improving rating
accuracy. To show that they did not act negligently, CRAs will have to spend
time and resources on documenting their work, which however does not
improve the product, and is therefore social waste. Additionally, as the
negligent costs will be passed on to all consumers equally, small customers will
cross subsidise big ones, as their costs will raise more than their expected law
suit costs. As a result the number of large subscribers will increase, whereas
the number of small subscribers will reduce; the latter ones however are the
ones that do not have the alternatives major subscribers have.
R. Lemke, Haftungsrechtliche Fragen des Ratingwesens- ein Regulierungsproblem?,
Frankfurt
84
85
86
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
Schwarcz, S. “Private Ordering Of Public Markets: The Rating Agency Paradox.”
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INTERNATIONAL PUBLIC POLICY REVIEW
Furthermore, a negligent standard raises the variable costs and thus
decreases the number of small and risky entities rated, as they have the highest
marginal variable costs. Therefore only save, big and established companies are
rated for which it is least relevant.
A negligence standard is costly, does not improve accuracy, leads to
defensive rating, disadvantages small investors and borrowers, encourages free
riders of ratings to become potential plaintiffs and is difficult to determine
judicially, as the ratings are based on a high level of expertise. Therefore an
economic analysis favours the recklessness standard87.
Constitutional problems, which stem from the first amendment
protection of CRAs as members of the press, prohibit raising the level of
liability and/or the level of regulatory oversight through specific standards of
diligence, rating disclosure mandates, record keeping requirements,
government inspection, capital and other financial resource requirements and
limitations on communications with subscribers88.
Additionally this would sharply compromise the independence of CRAs,
would deter innovation in credit analysis and methodologies and would “result
in homogenisation of credit ratings analyses through government prescribed
minimum or uniform standards.”89 Thus it would undermine the logic of using
a trustee to establish a credible commitment and to insulate their activities
from political manipulation.
The courts in the past applied the Jaillet Rule, which states that
newspaper publishers are not liable to members of the public for nondefamatory negligent misstatements; they are only liable in a case of
recklessness of falsity. Courts view CRAs occupying a space between that of a
publisher of a general interest newspaper and an advisory newsletter making
specific investment recommendations. Most importantly, the CRAs` ratings
are an opinion and raise issues of public concern, and are thus protected by the
first amendment from burdensome state regulation (see Dun & Bradstreet, Inc.
v. Greenmoss Builders, Inc.).
The court applies this rule, as the benefits of information available to the
public exceed the protection of private persons, a right covered by defamation
cases. Moreover the Supreme Court stated that society should not depend on
courts for the correction of false information, but rather on the market place
of ideas90.
. Husisian. “What Standards of Care Should Govern the World`s Shortest Editorials? An
Analysis of Bond Rating Agency Liability.” R. Lemke, Haftungsrechtliche Fragen des
Ratingwesens- ein Regulierungsproblem?
88
US Securities and Exchange Commission (2003) ‘Concept Release: Rating Agencies and
the Use of Credit Ratings under the Federal Securities Laws’, Release Nos. 33-8236, Washington
D.C.: http://www.sec.gov/rules/concept/33-8236.htm
89
Id.
90
Husisian. “What Standards of Care Should Govern the World`s Shortest Editorials? An
Analysis of Bond Rating Agency Liability.”
87
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Table 5. Court Cases
Court Case
Lovell v. Griffin (1938)
Passaic Daily News v. National
Labor Relations Board (1984)
Lowe v. SEC (1985)
Pacific Gas & Electric Co. v.
Public Utilities Comm. Of Cal.
(1986)
First Equity Corp. of Florida v.
Standard and Poor`s Corp. (1988)
Riley v. National Federation of
the Blind of North Carolina
(1988)
In Re Scott Paper (1992)
Pan Am Corp. v. Delta Airlines
(1993)
Jefferson County School District
v. Moody`s Investors Services,
Inc. (1995)
Orange v. McGraw Hill (1999)
In Re Fitch (2003)
Ruling
Liberty of press not confined to newspapers
and periodicals
Government regulation of the material to go
into a newspaper is not consistent with First
Amendment guarantees of a free press
Publication protected by 1st amendment,
CRAs are not investment advisers
State cannot tell newspapers what it can
print and what it cannot
No sufficient evidence to permit the
conclusion that the defendant in fact
entertained serious doubts as to the truth of
his publication
Mandating speech that a speaker would not
otherwise make necessarily alters the
content of the speech: First Amendment
scrutiny
S&P does not have to publicise internal
operating procedures and deliberations
S&P functions as a journalist, when gathering
information
No defamation: defendant did not allege a
specific false statement: only opinion
relating to matters of public concern
No liability for false statement unless made
with actual malice
Fitch only covers own clients and aided in
deciding how to structure investment (thus
no public concern, no mere opinion)
Source: Bottini, 1990, Lemke, 2000, S&P, 2003
Not only is it impossible to increase the liability standard; increased
oversight, including regular Commission inspections and examinations to
determine compliance with the appropriate regulatory regime for NRSROs91,
US Securities and Exchange Commission ‘Concept Release: Rating Agencies and the Use
of Credit Ratings under the Federal Securities Laws’,2003 Release Nos. 33-8236, Washington D.C.:
http://www.sec.gov/rules/concept/33-8236.htm
91
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“would likely run afoul of fundamental First Amendment principles”92, as
CRAs are not investment advisers93 (see Investment Advisers Act of 1940).
Additionally it is also impossible to make CRAs comply with the recordkeeping and inspection requirements of the IAA as a precondition to receiving
NRSRO status94, because the doctrine of unconstitutional conditions states
that the government may not deny a benefit (even if a person is not entitled to
that benefit) because the person refused to forfeit or waive a constitutionally
protected interest95.
For the same reasons, it will be impossible to make requirements that
ratings and commentary contain disclosures about the analytical base, or that a
minimum standard for training and qualifications exists. This holds, even if the
legislation would be designed to increase the flow of information and benefit
the public at large.
Therefore, as hypothesised in H4, attempts to increase accountability
lead, due to the liberal public-private dichotomy, to a two-folded
accountability paradox: they decrease performance and face constitutional
obstacles
Nonetheless with an enforcement investigation the SEC may review the
CRAs` records and operations. The former may arise, out of good faith, belief
or credible allegations that the securities laws may have been violated96, but
still a random and frequent inspection regime would be unconstitutional.
However, there does seem to be a breach of the antitrust laws and the
Sherman Act, as anti-competitive behaviours in respect of the quasi duopoly,
has been reported, but not yet established in a recent ENRON related
Congress hearing97.
Some hearing participants declared that the large CRAs have abused their
dominant positions by engaging in certain aggressive competitive practices.
Fitch accused S&P and Moody’s of notching, i.e. they lower their ratings or
refuse to rate securities issued by asset pools (e.g. collateralised debt
obligations), unless they rated a significant fraction of this pool. This would
Standard and Poor`s (2003) “Concept Release: Rating Agencies and the Use of Credit
Ratings under the Federal Securities Laws”, http://www.standardandpoors.com
93
S&P,“Concept Release: Rating Agencies and the Use of Credit Ratings under the Federal
Securities Laws”
94
SEC, concept release
95
S&P,“Concept Release: Rating Agencies and the Use of Credit Ratings under the Federal
Securities Laws”
96
S&P,“Concept Release: Rating Agencies and the Use of Credit Ratings under the Federal
Securities Laws”
92
97
SEC, concept release
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clearly be an anti-competitive action and should be investigated jointly be the
SEC and the Federal Trade Commission.
The CRAs also offer consulting and other advisory services to issuers.
Although currently these ancillary services make up a marginal portion of the
CRAs` business, they create a potential conflict of interest similar to that of
accounting firms offering consulting and auditing services to the same
company. The latter recently have become subject to extensive independence
rules98. CRAs point out that they have substantial firewalls that separate rating
businesses from the influence of ancillary businesses. Rating analysts do not
participate in the marketing of ancillary services, and their compensation is not
dependent on the performance of ancillary services99. Nonetheless regulators
should closely follow developments in this area.
5.5. Mitigation Strategies: Exit, Choice and Accountability through Reputation
CRAs used to enhance the accountability of borrowers, who trusted the
former with the task of enhancing their accountability based on their
reputation. Now borrowers are not able choose whom to trust to enhance
their accountability, they are forced to select from a limited pool. Thus the
members of the severely limited NRSRO market have customers irrespective
of the fact, whether the customers would choose them based on their
reputation. Moreover borrowers do not choose someone to enhance their
accountability in order to obtain access to finance per se, but someone to clear
a regulatory threshold. Thus the SEC has strictly speaking made the NRSROs
market a (different) sub-market to the credit rating market, in which
reputation as accountability does not work, in which entry barriers are high
and in which competition is severely limited.
Although they are external principals, borrowers can utilise their
practically internal principal position by sanctioning the CRAs via exit, which
is similar to withdrawing financial support. The stakeholders can choose who
will have a (choice determining) impact on them. This however is only
possible if the SEC realises its crucial role in this triadic relationship and
increases the number of trustees, so that like in the market setting without
regulatory use, reputation may act as the main accountability mechanism of
CRAs.
CRAs generally are only accountable to investors. But the third party
(SEC) enforcer of these ratings (the SEC) has to be accountable to borrowers
as well. In the absence of a direct (internal) accountability mechanism
between borrowers and CRAs and in the absence of uniform rules, the SEC
SEC, concept release
S&P,“Concept Release: Rating Agencies and the Use of Credit Ratings under the Federal
Securities Laws”
98
99
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should ensure that borrowers have a meaningful choice and are able to exit
the choice determining impact of a particular CRA.
As a public body that makes (even if it is through delegation to a trustee)
choice determining decisions, the SEC is accountable to all the participants in
the securities market. The SEC is in its relationships to
borrowers/stakeholders an agent, and the latter ones are, as a member of a
democratic society who delegated authority to a public body (the SEC), the
principals.
The responsibility to offer choice to borrowers derives from the fact that
CRAs` ratings are voluntary standards and not coercive rules. Coercive rules
are uniform in application as well as in their content. But CRAs` output, as a
form of private authority is not standardised enough to be treated uniformly
(see Section 5.3). Their rating symbols differ, their input and the weights given
to various elements differ as well. Hence, if the SEC wants to utilise CRAs`
ratings on the grounds of superior efficiency in co-ordinating the market, it has
to leave stakeholders with a choice. The SEC has to realise that CRAs` output
is not interchangeable.
Therefore, according to the author’s analysis, extended principal-agent
theory would suggest to use exit, competition and reputation as an
accountability mechanism for trustees that have, through third party
enforcement, a choice determining impact on stakeholders.
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As the above analysis demonstrated, CRAs have reached their prominent
position in the capital markets through enhancing efficiency by reducing
information asymmetry and by improving the accountability of borrowers;
they have been regarded as endogenous actors and were held accountable
through the reputation mechanism.
Therefore, as hypothesised in H3, the external accountability gap
cannot be overcome through regulation and thus one needs to improve the
exit option and competition in order to utilize reputation as an
accountability mechanism.
The external accountability gap cannot be overcome via increased
regulation and oversight and the regulatory use can at the moment only be
limited, but not abandoned. The solution is thus more market control, so that
one can utilise reputation as an accountability mechanism, i.e. the SEC has to
provide users of ratings with a meaningful choice, so that they can utilise the
exit option and thus can increase accountability via the reputation mechanism.
The SEC proposes in its 2003 concept release, alternatives to some of the
regulatory uses of CRAs. Rule 15c3-1 under the Exchange Act could allow
broker-dealers to use internally developed credit ratings for purposes of
determining the capital charges on different grades of debt securities under the
Net Capital Rule. Strict firewalls between those responsible for revenue
production and those who develop internal credit ratings, could prevent
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INTERNATIONAL PUBLIC POLICY REVIEW
conflicts of interest. Moreover, they could be required to get regulatory
approval of their internal rating system.
Rule 2a-7 under the Investment Company Act, which limits institutional
investors to purchasing “investment grade” securities, could be altered so that
subjective, internal credit ratings are sufficient to determine the quality
standard of securities. Again, these internal rating systems can be made subject
to regulatory approval. In this way, it may be possible to keep the high levels
of efficiency, but at the same time the accountability gap may be overcome, as
the SEC can easily prescribe the above agents (who work under the
Investment Advisers Act), which rating system to use etc. Basically all the
problems in increasing oversight, standards of diligence, and disclosure
requirements are not an issue in this context, as investment advisers have a
different legal status to CRAs (who are members of the free press). Thus one
could overcome the accountability problem by exiting the whole market.
Therefore each regulatory use of CRAs should be reviewed and possibly
replaced.
Within the market, the NRSRO designation process is still an indirect
form of merit regulation, as the designation itself is based on a merit analysis of
rating agencies. The current NRSRO designation processes by the SEC sets
high barriers to entry and thus reduces competition and inhibits quality
improvements. The major CRAs thus have business whether the quality of
their rating is good or not.
The single most important criteria are whether the CRAs are “nationally
recognised” by market participants, and whether the ratings are credible and
reliable. For new agencies however it is impossible to achieve market
acceptance without a NRSRO designation, as this in turn will not be granted
without the former. Kerwer thus describes the process as a “catch 22”, the SEC
report100 has described it as a “chicken and egg problem”, and the Department
of Justice states that the national recognition requirement creates a “nearly
insurmountable barrier to new entry into the market for NRSRO services101.
Designation criteria based on measures such as financial resources,
revenue, capital, number and training of analysts, rating methodologies or
process and performance standards102 would not effectively assure the
credibility and reliability of ratings, and contrary to the proposed aim, it would
increase entry barriers.
Nonetheless, one needs to balance the need to stimulate competition and
the protection of the NRSRO designation, so that the aims of the regulatory
use (increase efficiency, reduce systemic risk and information asymmetry,
US Justice Department (1998) DOJ urges sec to increase competition for securities
ratings agencies. Press release
(http://www.usdoj..gov/atr/public/press_releases/1998/1596.htm)
101
SEC, concept release
102
SEC, concept release
100
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73
protect investors) are not compromised by a sub-optimal rating quality. “A
closer examination of market structures and regulations applied to the
NRSRO agencies (is necessary) to see how they may be carefully revised to
promote competitive markets for ratings services without also distorting the
ratings themselves”103.
Firstly the SEC should develop a formal and transparent process with clear
and specific criteria for the NRSRO designation, so that recognition of
NRSROs occurs through action (and not through a no action letter). Criteria
might include attestations from authorised officers of users of securities ratings
that the ratings are credible and reliable and statistical data demonstrating
market reliance on the applicant’s rating, as well as the correlation between
predicted and actual defaults104.
Additionally credit rating affiliates of established, well capitalised firms
that have a reputation for quality financial analysis in the investment
community (such as commercial and investment banks, insurance companies,
accounting/consulting firms), may be given provisional NRSRO status.
Table 7. Other Resources Used to Make Investment Decisions
(Percentage of Respondents)
Corporate
Practitioners
26
4
Financial Industry
Service Providers
22
4
A.M. Best Company
Dominion Bond Rating
Service
Dun & Bradstreet
48
Egan-Jones Rating
1
Company
KMV
1
Lace Financial
3
Other CRAs
1
Internal research
42
Research from
36
investment banks
Other
7
No other sources
17
Source: The Association For Financial Professionals (AFP)
78
3
13
4
3
68
17
6
3
G. McNamara and P. Vaaler. “The Influence of Competitive Positioning and Rivalry on
Emerging Market Risk Assessment.”
104
SEC, concept release
103
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This may be so, even if these ratings are based on purely quantitative
rating models or if they deploy the current condition and not through the
cycle approach, which according to Loeffler “is clearly superior in predicting
defaults”105. However it would have to be assured that no conflicts of interest
arise and that appropriate firewalls are in place.
Moreover foreign CRAs as well as niche specialist may be granted
provisional NRSRO status if they comply with the recognition criteria. This
would allow them to demonstrate their sectoral or regional rating expertise
and would thus stimulate competition.
6. CONCLUSION
The paper firstly established that CRAs are generally more efficient in coordinating the securities market than a government body would be.
Nonetheless in international banking supervision CRAs are inefficient due to
lacking expertise in rating all assets in a bank’s portfolio, especially in emerging
markets where ratings are less spread. Therefore the use in banking
supervision would lead to many negative consequences, one of which is
increased capital costs in emerging markets and thus increased systemic risk
and negative pro-cyclical swings.
The external accountability gap arises due to the triadic external principaltrustee-stakeholder relationship the SEC creates through forcing themselves
onto the agencies as principals and thus turning CRAs` opinions into coercive
rules. Due to the liberal public-private dichotomy and the fact that CRAs are
designed as voluntary standards a two folded accountability paradox arises.
Attempts to increase accountability via oversight, industry regulation,
disclosure requirements or increased levels of liability thus results in decreased
performance and moreover faces constitutional obstacles.
Therefore the solution is to mitigate the negative consequences of the
external accountability gap. Firstly, if not clearly advantageous and if
reasonable alternatives exist, CRAs output should not be utilised in regulation.
Secondly, deploying reputation as an accountability mechanism can mitigate
the external accountability gap. For the former to work, competition, choice
and exit options have to be enhanced by reducing entry barriers to the
NRSRO designation.
Besides making recommendations concerning the regulating of CRAs and
on how, if at all, to use them in securities and banking market supervision, this
paper also attempts to make a contribution to the principal-agent literature by
establishing and formalising a principal-agent model (diagrams 4 & 9) that
explains the external accountability gap (the triadic external principal-trustee105
G. Loeffler “An anatomy of rating through the cycle.” Journal of Banking & Finance 28
(2004): 710
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75
stakeholder relationship). Further research is necessary to verify the triadic
model through comparing the credit rating agency case with other forms of
private authority in which accountability gaps are an issue.
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Appendix 1. Moody`s Rating Analysis of an Industrial Company
Issue
Structure
Company Strucutrue
Operating/Financial Position
Management Quality
Industry/Regulatory Trends
Sovereign/Macro-Economic Analysis
Source: Crouhy et al. (2001)
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Moody
`s
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa
Ca
D
Appendix 2. Long-term Debt Rating Symbols
S&P,
Interpretation/Investment Grade
FitchIB
CA,
DCR
AAA
Investment Grade
Highest credit quality: highly unlikely to be adversely
affected by foreseeable events
AA+
Very high credit quality: not significantly vulnerable to
foreseeable events
AA
AAA+
High credit quality: May be more vulnerable to changes
in circumstances or in eco. Conditions than in the above
cases
A
ABBB+
Good credit quality: Adverse changes in circumstances
and eco. Conditions are more likely to impair
commitments
BBB
BBBBB+
Speculative Grade
Speculative: Possibility of credit risk developing, esp. as a
result of adverse eco. Changes, however business and
financial alternatives may be available
BB
BBB+
High Speculative: Significant credit risk, current
commitments met but need favourable business and eco.
Environment to ensure continued payment
B
BCCC+,C
High default risk: Default is probable
CC,CCC
C
Default: Extremely speculative securities worth cannot
exceed recovery value in any liquidation or
reorganisation of the obligation
D
Actual default occurred
Source:Maltzan-Pacheco, J. von (2000)
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Appendix 3. Standard and Poor`s Debt Rating Process
Request
rating
Assign analytical
team and conduct
basic research
Meet
Issuer
Rating
committee
meeting
Issue
rating
Appeals
process
Source: Crouhy et al. (2001)
Surveillance
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Appendix 4. Moody`s Rating Accuracy
Source :Cantor (2001)
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Appendix 5. Distribution of Ratings of 92 Japanese Firms by JCR, R&I,
Moody`s, S&P
Summary of
assigned ratings
Rating agency
AAA
JCR
R&I
Moody`s
S&P
11
8
0
1
AA
A
BBB
BB
B
30
38 11
1
1
23
32
24
3
2
14
23
34
15
5
15
12
27
24
12
Source: Shin and Moore (2003)
CCC and
below
0
0
1
1
Total
92
92
92
92
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Appendix 6: Average Differences in Ratings between Moody`s and Other
Agencies in 1990
Source: Cantor (2001)
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Appendix 7. Results of Ordinal Logistic Regression Analysis
Source: McNamara and Vaaler (2000)
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Appendix 8. CRAs in Banking Supervision and the Impact on the Cost of
Capital
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Source: Ferri et al., 2001
91
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Appendix 9. Current Condition’s and Through-the-cycle Approach’s
Ability to Predict Default
Source: Loeffler (2004)
FORM VS. FUNCTION: PROSPECTS FOR GLOBAL
CONVERGENCE IN CORPORATE GOVERNANCE
REGIMES
Jonathan C. Bond‡
1.
INTRODUCTION
At the intersection of two crucial threads of the economics of transition
literature—legal reform, and restructuring via privatisation—lies the same
phenomenon which has vexed and divided the leading lights of the
mainstream economics and management disciplines for decades. This puzzle
is the nature and future of global corporate governance, a conundrum which,
despite its deceptive appearance of simplicity, remains at the centre of a
heated debate which transcends disciplinary boundaries and which has only
grown more intense with time. The persisting diversity of corporate
governance regimes in polities around the globe begs a number of questions:
Why did the distinctive German-Japanese and Anglo-American paradigms
arise? What is preserving them now, and how long will the divergence
continue? Will the Anglo-American perspective eventually come to dominate
‡
M.Sc. candidate (Public Policy), School of Public Policy, University College London
(expected November 2005); 2004/05 US-UK J. William Fulbright Postgraduate Scholar.
Contact with questions/comments: jonathan@jonathancbond.com.
I wish to thank the UK Fulbright Commission (London) for funding and other support. I
am also grateful to Prof. Tomasz Mickewicz (School of Slavonic and Eastern European Studies,
UCL) for his patient guidance and insightful suggestions, Prof. David Coen (School of Public
Policy, UCL) for his persistent encouragement, as well as two anonymous referees for their
helpful comments. Responsibility for all remaining errors is solely my own.
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005): 93-110.
[ISSN 1748-5207]
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
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its opponents? Perhaps most controversial of all, which system, if any, ought
to dominate on efficiency or on normative grounds?
In their now-classic survey of corporate governance around the world,
Andrei Shleifer and Robert Vishny endeavoured to disarm those who dispute
the prospects of international convergence and/or the comparative merits of
the two dominant paradigms of corporate governance—the dispersedownership, shareholder-driven Anglo-American model or the concentratedownership, bank-centred German-Japanese template.1 The defining feature
of a system of corporate governance is not the way it is dressed up, but what it
accomplishes: so long as it provides an effective mechanism, legal or otherwise,
to protector investors’ holdings and thus foments efficient allocation of
invested savings.2 Such a theory would seem to pre-empt the entire debate
over whether the extant systems of corporate governance should or will
converge.
Yet the debate rages on. And well it should, for a number of reasons.
After first identifying why the question of the future of corporate governance
ought to remain at centre-stage, this essay will proceed by: first, sketching out
the essentials of the global convergence-divergence debate as it has been
framed in the economics and legal literature; second, exploring the underlying
forces which each side of the dispute has tried to account for; and finally, by
evaluating the strengths and weaknesses of one of the most novel approaches
in the literature—the ‘functional convergence’ hypothesis. It will be argued
that this functional theory of corporate governance, and the view of the future
it generates, offers on balance the most comprehensive and persuasive
perspective on corporate governance’s prospects as well as its past.
2.
WHY CONVERGENCE MATTERS
Given Shleifer and Vishny’s aforementioned observation, however, why
should comparison or progressive global convergence between differing
governance regimes be of interest? Seven reasons suggest themselves. First,
1
A. Shleifer, and R. Vishny, “A survey of corporate governance,” Journal of Finance 52, no. 2
(June 1997): pp. 737-783. Other ways of characterising the distinction include that noted by R.
Morck, and L. Steier, “The global history of corporate governance: an introduction,” National
Bureau of Economic Research Working Paper #11062 (2005). In Morck and Steier’s work, the
Anglo-American system is identified as an “exit”-based system of governance (i.e. dispersed,
small-stake shareholders vote ‘with their feet’ as it were), while the German-Japanese model
(and particular extensions of it, such as the principle of ‘codetermination’ in France and
Germany) is identified as “voice”-based (i.e. bank shareholders, as well as customers, suppliers,
and employee groups each hold stable stakes in a given firm—upon which they do not seek to
gain from speculation, but rather as a means to remain informed and to have a channel by which
to express their interests and concerns directly to the firm’s management). Ibid., pp. 3-4.
2
Shleifer and Vishny, “A survey,” p. 739.
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many discount or even deny the validity of Shleifer and Vishny’s proposition.3
Second, the assertion of the two dominant systems’ relative equivalence fails to
explain why they arose and persisted.4 Third, these continuing differences
have important consequences for ownership structure—a point which Shleifer
and Vishny themselves helped to bring to light in their work with La Porta
and Lopez-de-Silanes,5 which in turn affects aspects from firm performance to
corporate responsiveness to stakeholders. Fourth, equivalence in the abstract
is far removed from context-specific operation. In other words, for a
multitude of reasons—from institutional environment to cultural
adaptiveness—one system may prove far superior in a given scenario.6
Fifth, even if Shleifer and Vishny are correct and the systems are in some
broad sense equivalent, the mechanisms by which the two paradigms converge
or remain divergent may be instructive for other similar areas of regional and
global public policy, such as pan-EU and transatlantic securities and exchange
harmonization. Sixth, the literature on the past and future of corporate
governance has splintered in too many ways to be of no concern: rightly or
wrongly, much has been attached to the debate, and thus much now hinges on
its outcome. Finally, as indicated at the outset, corporate governance and its
prospects lie right at the heart of the economics of transition and
3
See, e.g., B. McDonnell, “Convergence in corporate governance: possible, but not
desirable,” Villanova Law Review 47 (2002): pp. 341-385.. McDonnell also notes his reservations
concerning the extended work of La Porta, Lopez-de-Silanes, Shleifer, and Vishny, whom he
refers to as the “Gang of Four.”
4
S. Jacoby, “Corporate governance in comparative perspective: prospects for convergence,”
Comparative Labor Law and Policy Journal 22 (2000): pp. 5-32.
5
R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Corporate ownership around the
world,” Journal of Finance 54, no. 2 (April 1999): pp. 471-517; R. La Porta, F. Lopez-de-Silanes,
A. Shleifer, and R. Vishny, “Legal determinants of external finance,” Journal of Finance 52, no. 3
(1997): pp. 1131-1150; R. La Porta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Law and
finance,” Journal of Political Economy 106, no. 6 (December 1998): pp. 1113-1155. R. La Porta, F.
Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Investor protection and corporate governance,”
Journal of Financial Economics 58 (2000): pp. 3-27; see also Morck and Steier, “The global
history,” pp. 2-4. [Following the convention in the literature (to which McDonnell’s appellation
is the exception; see note 3 supra), the collective work of these four authors will be referred to
as “LLSV”. See M. Ayyagari, “Does cross-listing lead to functional convergence?: Empirical
evidence,” World Bank Policy Research Working Paper #3264 (April 2004), p. 1.] Specifically,
though the literature as a whole does not yield a complete consensus on the determinants of
dispersed vs. concentrated ownership are, LLSV have persuasively established the link between
Anglo-American and common law systems with dispersed ownership, and vice versa. See
LLSV, “Legal determinants,”; LLSV, “Law and finance,”; LLSV, “Investor protection.”
McDonnell, once again, disagrees with LLSV’s attribution of causality. See McDonnell, op cit.,
at note 38.
6
M. Guillen, Corporate governance and globalization: arguments and evidence against
convergence. Reginald H. Jones Center Working Paper [no number available], The Wharton
School, University of Pennsylvania (1999). This is the heart of the complementarities/pathdependency argument which has filled so much of the literature. This is discussed in much
greater depth below.
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development.
Both legal reform and corporate restructuring through
privatisation are all closely connected via the same fundamental principalagent dilemma. Moreover, the aspects described above are amplified in a
transition or development context.7
3. A DEBATE IN DISARRAY
Despite the critical importance of the issue of corporate governance and
its future, the debate which has developed especially in the last fifteen years
now sits in an unfortunate state. Participants from all sides acknowledge (and
lament) the degree to which the dispute has remained one of theory, opinion,
and often mere conjecture rather than robust empirical inquiry.8 Specifically,
there is precious little hard evidence testifying to the actual convergence of
legal rules or the absence of such convergence. In fairness, some noteworthy
empirical results have been gathered—again, most notably in the area of legal
transformation in transitioning economies.9 For example, in her study of the
change in legal regimes in twenty-four transition countries from 1990 to 1998,
Katharina Pistor identifies a very strong trend of convergence toward the
Anglo-American model of corporate law, regardless of the legal family to
which each country belonged prior to the imposition of socialism.10 As Pistor
acknowledges, much of this convergence is “largely the result of an external
supply of legal solutions,”11 and yet this explanation is not incompatible with
the general convergence thesis.
Additionally, whether as a cause or effect of the generally poor state of
empirical investigation to-date (with the exception of Pistor’s study, supra),
the debate is inundated by myriad theories (and variations upon those
theories) of how the paths diverged and where they are now headed. Brett
McDonnell, for instance, offers a typology of sixteen past-present theory pairs,
A. Durnev, and E. H. Kim, “To steal or not to steal: firm attributes, legal environment
and valuation,” University of Michigan-Ann Arbor Working Paper [no number available] (2002).
8
The most vitriolic expression in this vein is that offered by D. Branson, “The very
uncertain prospect of ‘global’ convergence in corporate governance,” Cornell International Law
Journal 34 (2001): pp. 321-362. Arguing vehemently against the convergence hypothesis in all its
forms (including Coffee’s functional convergence theory, which Branson appears to entirely
misunderstand; see Branson, “The very uncertain,” pp. 329), Branson declares that his opponents
are guilty of “pontificating” without any appeal to evidence, and rather cite their own prior
work as sufficient authority. Branson goes on to assert that aside from quoting themselves, such
authors cooperatively quote one another in what he terms “inbred scholarship.” Ironically,
Branson himself makes no appeal to empirical evidence. Ibid., pp. 332-34.
9
“Transitioning countries” here refers to the successor states of both the Former Soviet
Union (FSU) and soviet-type regimes in Central and Eastern Europe (CEE)
10
K. Pistor, “Patterns of legal change: shareholder and creditor rights in transition
economies,” European Bank for Reconstruction and Development Working Paper #49 (May
2000), pp. 21-22.
11
Ibid., p. 27.
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and yet even this is far from a complete representation of the landscape.12
McDonnell’s typology aside, the core of the debate is on its face a five-way
contest between: those stressing neoclassical efficiency and institutional
competition,13 those emphasising rent-seeking by politicians and other key
actors,14 scholars focused on path-dependency and static complementarities
between governance and institutional environment,15 others stressing the
importance of culture,16 and finally those who argue that convergence should
be seen (and forecast) in functional, as opposed to formal, terms.17
4. WHAT LIES BENEATH: FORCES OF CONVERGENCE AND DIVERGENCE
Beneath all the nomenclature, however, each of the positions championed
in the debate over convergence in corporate governance merely reflects each
author’s attempt to portray the balance which is or will be struck between the
pressure toward convergence and the barriers against it. In short, the debate
has become a question of emphasis or weighting the forces which interact, not
a contest between mutually exclusive alternatives. Thus, before one can
understand both where the debate stands today and which position is
comparatively superior, one must first understand the forces which nearly all
the contestants agree are at work. To that end, both the pressures pushing in
McDonnell’s typology is helpful to a point, though (as noted supra) it patently fails in its
chief purpose of representing the range of perspectives one could logically hold concerning
corporate governance. See Tables 1 and 2 in the Appendix, infra, for a reconstruction of his
typology. Among other things, McDonnell entirely fails to account in his systematization for
the entire concept of functional convergence; accounting for this could easily multiply his entire
outcome range by a factor of two, if not much more. McDonnell himself argues that the
combination of P3:F3 in his Table 2 is the most likely pairing.
13
See, e.g., H. Hansmann, and R. Kraakman R., “The end of history for corporate law,”
Georgetown Law Journal 89 (2001), pp. 439-468.
14
See, e.g., M. Roe, “A political theory of American corporate finance,” Columbia Law
Review 91 (1991), pp. 10-67; M. Roe, “Some differences in corporate structure in Germany,
Japan, and the United States,” Yale Law Journal 102 (1993), pp. 1927-1997.
15
See, e.g., L. Bebchuk, and M. Roe, “A theory of path dependence in corporate ownership
and governance,” Stanford Law Review 52 (1999), pp. 127-170.
16
Branson, “The very uncertain.”
17
J.C. Coffee, Jr., “The future as history: the prospects for global converge in corporate
governance and its implications,” Northwestern University Law Review 93 (1999): pp. 641-706;
J.C. Coffee, Jr., “The rise of dispersed ownership: the roles of law and the state in the separation
of ownership and control,” Yale Law Journal 111 (2001): pp. 1-82; J.C. Coffee, Jr., “Racing
towards the top?: The impact of cross-listings and stock market competition on international
corporate governance,” Columbia Law Journal 102 (2002): pp. 1757-1831; J.C. Coffee, Jr., “Law
and regulatory competition: can they co-exist?,” Texas Law Review 80 (2002): pp. 1729-1736. R.
Gilson, “Corporate governance and economic efficiency: when do institutions matter?,”
Washington University Law Quarterly 74 (1996): pp. 327-345; R. Gilson, “Globalizing corporate
governance: convergence of form or function,” American Journal of Comparative Law 49 (2001):
pp. 329-357.
12
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favour of convergence and the forces preserving divergence will be
enumerated and illustrated before the landscape of the present debate is
portrayed in greater detail.
Why should one expect corporate governance practices around the world
to converge in the first place? The strongest answer is also the most obvious:
economic efficiency. The conventional (if stylised) argument runs as follows:
First, competitive pressure operates at the level of the firm with respect to its
suppliers of external finance. There exists, ex hypothesi, some optimal package
(given some array of investor preferences, etc.) of residual claim rights and
control rights which firm managers will yield to investors, and thus
competitive pressure will pull all firms which survive to this optimal
package.18 Firms which fail to conform to the optimal level will face higher
costs of finance and will thus, ceteris paribus, be forced out of the
marketplace.19 Increasing mobility of capital and plummeting costs of
communication mean that this abstract model applies, it is argued, on a global
scale, such that investors will have their choice of rights packages offered by
firms soliciting capital.
An important objection immediately arises, however: the foregoing
simplistic scenario assumes (arguendo) that firms are the only actors who
directly choose which governance practices will apply to their relationships
with their suppliers of external finance, but clearly this is untrue in the real
world. Instead, continues the objection, corporate governance is intricately
controlled in any given polity by a web of government, quasi-government, and
private actors above and beyond the firm and its investor. Thus, if corporate
governance is a matter of law, not merely of what rituals businesses privately
observe, how does efficiency yield convergence?
Proponents of convergence offer several responses. First, explicit,
deliberate efforts by any of the aforementioned involved actors to ‘harmonise’
the corporate governance regime may take place, such as standardization
across the EU.20 Second, a further simple explanation is that either firms or
shareholders will directly lobby their respective polities to mimic the more
efficient practices of a jurisdiction whose example they have witnessed.21
Third, the experience of U.S. states’ corporate laws may be replayed (writ
large) on the international stage: namely, if firms are relatively uninhibited
from reincorporating in more favourable jurisdictions (i.e. those whose formal
corporate governance requirements more closely match the optimal
arrangement vis-à-vis the firm in question), they will do so.22 Jurisdictions
Hansmann and Kraakman, “The end of history,” p. 449.
Coffee, “The future as history,” p. 646.
20
Hansmann and Kraakman, “The end of history,” p. 454.
21
Ibid., p. 455.
22
Ibid., pp. 454-55.
18
19
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which lose corporate charters will either conform or, perhaps, become
irrelevant.23
Two further explanations are offered by those who emphasise functional
over formal convergence in corporate governance, such as John Coffee, Jr.,24
and Ronald Gilson.25 The functional hypothesis, which will be treated in
greater detail below, primarily asserts that rules ‘on the books’—which may
take a long time to reach a common global midpoint—are far less significant
than the actual practices used by firms in the face of formal legal requirements.
Thus, they argue, convergence can take place despite the fact that corporate
governance is often a matter of legislative prerogative. First, even firms which
cannot reincorporate can list themselves on a foreign stock exchange and thus
bind themselves to a more stringent set of rules than those in force in their
home jurisdiction.26 Second, given a business climate saturated with mergers
and acquisitions activity [“M&A”], one might argue, as Coffee does, that better
corporate governance will yield higher equity values for a firm, thus giving a
firm which makes use of superior governance a strategic advantage in M&A
transactions (i.e. since the value of its shares is higher, it has a stronger
bargaining position in a stock-for-stock deal).27
Given these accounts of the pressures towards international convergence
in corporate governance standards (of varying degrees of plausibility), what is
to stand in the way of the march toward a single, universally-employed,
globally-optimal governance regime? Among the barriers identified by
sceptics of convergence, at least three broad categories stand out: pathdependency (and static complementarities), rent-seeking, and multiple
equilibria.28 The first barrier, path dependency, is also the broadest and most
Viz. In maximic form, Quae neminem constringat lex non est. (lit. “A law which binds no
one is no law.”) (Original to the author.)
24
Coffee, “The future as history”; Coffee, “The rise of dispersed ownership”; Coffee,
“Racing towards the top?”; Coffee, “Law and regulatory competition.”
25
Gilson, “Corporate governance”; Gilson, “Globalising corporate governance.”
26
Coffee, “The future as history,” pp. 648-49.
27
Ibid., p. 649.
28
Numerous other specific hypothetical barriers to convergence could be named, though
few if any are the subject of anything near a consensus in the literature. One less-frequentlycited, yet still somewhat persuasive, example is that of control premia identified by Coffee,
“The future as history,” pp. 658-59: The argument is premised upon what is already accepted
about the nature of concentrated ownership structures—viz. the value of the control block need
not be identical to the proportional value of the other shares which trade on the open market.
Thus, while increased corporate governance may result in higher share values on the market,
these higher prices reflect the value of shares which are being or are offered for sale—which are
ex hypothesi the non-control-block, i.e. minority, shares. (This makes intuitive sense as well,
since improved corporate governance may be more important to minority shareholders than
control-block-holders, given the minority owner’s fear of expropriation by the majority owners.)
The price of the control-block is likely to remain constant or decrease, however, with
improvements in corporate governance (as the ability to expropriate decreases). As their
interests will suffer from this likely drop in their equity holding’s value, the controlling
23
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amorphous. To be sure, its elementary logic is intuitively persuasive: prior
choices, actions, or accidents have predestined a certain actor, jurisdiction, or
even society to a particular outcome, even if it is not the most efficient as
viewed from the present.29 However, it is the application of the notion to the
global development corporate governance which has yielded difficulty. For
instance, Mark Roe, among its chief heralds, argued in a number of articles
that although the German-Japanese model of concentrated, bank-centred
governance was more efficient, the United States remains unlikely to adopt
such a model because of a series of events and popular attitudes in America
traceable to at least the mid-nineteenth century.30 Yet, in later work, Roe
along with others (e.g. Bebchuck and Roe 1999) argues that path-dependent
features in Germany, Japan, and in other concentrated-ownership jurisdictions
are at least equally to blame for the lack of convergence.
The path-dependency argument is very closely linked to the issue of rentseeking behaviour by political, economic, or other categories of actors which
yields barriers to particular jurisdictions arriving at the most efficient outcome.
However, discussions of “rent-seeking” as a barrier to convergence in corporate
governance have moved beyond the classic case of profit-maximising
behaviour by elected or appointed political officials. At present, the term is
applied in general terms to the barriers which arise due to the mismatch of
those with political power over a particular firm’s legal environment and those
with control of the firm itself (both managers and owners). A variety of
scenarios falls under this heading in its present usage, common examples
including that in which a jurisdiction implements restrictions on hostile
takeovers, which may not benefit any or a majority of shareholders of a given
firm whose owners are mostly non-citizens, but does benefit the majority of
shareholders will attempt to avoid changes to corporate governance. Thus, the argument
identifies a weak link in the traditional case that increased share value will induce controlling
owners to adopt better governance as a matter of efficiency. See Coffee, op cit.
29
Coffee, “The future as history,” pp. 660-62. When the time dimension is removed from
the basic path-dependency model, it is often labelled as the issue of “complementarities.” Like
path-dependency, “complementarities” signifies a wide array of forces at work, but most
basically refers to the static compatibility of particular legal, regulatory, or other institutions
with other political or social apparatuses and attitudes in society. Ibid., pp. 660ff. Thus, the
concept is closely tied to the demand-for-law literature, discussed below in relation to the
functional convergence hypothesis.
30
Roe, “A political theory”; Roe, “Some differences.” Specifically, runs one version of the
argument, as reconstructed by Coffee, the general public and political distrust of concentrated
financial power led to both statutory and market pressures towards the proliferation of small
intermediaries (for instance, banks were limited to operations within a single state, etc.).
Coffee, “The future as history,” pp. 660ff. Consequently, the banking sector’s growth was
presumably stunted, and the banks which did grow and prosper on their limited scale were far
too small and/or geographically constrained to serve as effective monitors of multi-state
enterprises.
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those shareholders who are also voting citizens of the jurisdiction.31 As with
path-dependency, the predominance of rent-seeking as a reason for continued
divergence is likely due more to its intuitive appeal than to any systematic
evidence demonstrating its validity.
Finally, opponents of convergence have repeatedly argued that the
convergence thesis is flawed because its ‘motor’—the dominant pressure
towards ‘the’ efficient arrangement—is premised on the faulty assumption that
a single system exists or could exist which is optimal relative to all contexts.
Two forms of this argument can be formulated. In its stronger form, the
argument merely asserts that no single microeconomic model of corporate
governance can be ‘superior’ in any meaningful sense.32 In its weaker form, the
argument asserts that the superiority of a governance model is always contextspecific.33 The inference in either case is that multiple equilibria may exist in
the arrangement of corporate governance apparatuses, such equilibria
presumably rendered stable either by economic forces or by pathdependencies. Thus, one could conclude, the pertinent pressure acting on a
particular country’s corporate governance system are not pushing it towards a
single global equilibrium, but towards a more localised point of stasis.
Given, then, both the pressures towards and barriers against convergence
as summarised above, it appears that the convergence debate has become a
metaphor for the state of its own subject: just as the diverging systems of
governance have arisen, persisted, and now seem to be intermingling while yet
maintaining considerable distinctness, so too the scholars most concerned have
developed starkly different perspectives, which have survived more than a
decade, and yet a limited degree of intermingling among their key ideas is
observable. As it stands, the debate is primarily a contest between those
believing Anglo-American corporate governance is superior and thus favoured
by institutional evolution34 and those who believe convergence towards that
system will not take place.35 Attempts at a middle-position (via reframing the
question at issue) include those like McDonnell’s, which views convergence as
31
Coffee, “The future as history,” p. 654. Implicit in this type of scenario is some
presumption that shareholders taken as a whole mirror Mancur Olson’s model of the “inchoate
group.” See M. Olson, The logic of collective action (Cambridge, MA: Harvard Univ. Press,
1999).
32
Jacoby, “Corporate governance,” pp. 21-25.
33
Branson, “The very uncertain,” pp. 347ff.
34
Hansmann and Kraakman, “The end of history.”
35
See, e.g., Branson, “The very uncertain”; Jacoby, “Corporate governance”; L. Cunningham,
L. “Commonalities and prescriptions in the vertical dimension of global corporate governance,”
Cornell Law Review 84 (1999): pp. 1133-1194; M. Kissane, “Global gadflies: applications and
implementations of U.S.-style corporate governance abroad,” New York Law School Journal of
International and Comparative Law 17 (1997): pp. 621-672; G. Visentini, “Compatibility and
competition between European and American corporate governance: which model of
capitalism?” Brooklyn Journal of International Law 23 (1998), p. 833ff.; and many others.
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unlikely but normatively undesirable.36 As noted earlier, however, the general
dearth of credible, systematic empirical evidence on either side threatens to
ossify the divide, as neither side can persuade the other on the merits of their
intuition and conjecture alone.
5. ‘CONVERGENCE BY ANY OTHER NAME’: THE FUNCTIONAL THEORY
It is precisely this gridlock which one more recent theory—the “functional
convergence” hypothesis extolled by both Coffee and Gilson—is designed to
solve. While by no means perfect, it is this functional view which represents
the best hope of understanding corporate governance as it operates in the
present and how it is likely to evolve in the future. The theory is premised
upon the seemingly elementary distinction between “formal” corporate
governance and “functional” governance. In short, corporate governance law as
it exists ‘on the books’ in any given jurisdiction is related to but distinct from
the ways in which firms are actually governed in practice.37 Applying this
distinction to global convergence, Coffee and Gilson assert that while the laws
on paper may be quite slow to change, governance in practice can adapt to
some degree around the laws as they exist on paper. Two of the mechanisms
by which this could occur were discussed above: firm migration, and M&A
activity. The more central point to the argument is that while systems of
governance can remain divergent in name, entrepreneurial actors can (and, it is
asserted, will) drive the two systems towards the optimum governance
arrangement.38
Though participants in the convergence debate who stand firmly on one
side or the other may on occasion dismiss the functional convergence
hypothesis as an attempt to “predict global convergence through ‘the
backdoor’”,39 there are at least three broad reasons to prefer the functional
view over and against any other theory yet on offer. First, precisely by
36
McDonnell, “Corporate governance,” pp. 382-84. McDonnell’s arguments against the
desirability of convergence include, in addition to a vague and generic appeal to equality of
resources for all, a rather peculiar additional rationale: McDonnell argues that given our great
uncertainty as to what the business environment and needs of the future will look like, it may
be that a system of corporate governance being employed today but which is not optimal given
today’s parameters may be exactly what is needed in (say) fifty years. Consequently, the
knowledge and expertise already built up in this given system should be preserved, in case
entrepreneurs and policymakers of the future need to call upon it. Thus, McDonnell concludes,
convergence today is undesirable, as it means the all-but-theoretical extinction of potentially
quite valuable systems. McDonnell explicitly compares this to preventing the extinction of
biological species, “which do not seem to add much to the world at this point, because at some
point in the future those species may become more valuable, for example, by becoming the
source for a cure to a new disease.” Ibid., pp. 382-83.
37
Coffee, “The future as history,” pp. 652ff.
38
Ibid., pp. 649ff.
39
Branson, “The very uncertain,” p. 329.
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distinguishing between the formal and functional dimensions, it allows one to
accept the merits of both sides of the convergence debate. On the one hand, if
one sets the political and path-dependent barriers aside, the pressure of
efficiency driving toward the most efficient governance practices available is
difficult to challenge. On the other hand, the political—as well as social and
cultural—barriers to efficiency-driven institutional evolution are just as
intuitively appealing. Moreover, to construct a theory which merely staked
out a middle ground between these two opposing forces without providing a
substantive explanation would be futile. Yet the functional theory avoids this
in that it is not merely a synthetic summary of the “inevitability of the
tradeoffs and tensions”,40 but instead proffers an independent, substantive
argument which explains the development of corporate government while
accounting for both the pressures for and barriers to convergence. This
argument, resting on the formal-functional distinction, asserts that companies
will voluntarily find ways to bring upon themselves the most efficient
governance regimes, regardless of the limitations of their formal environment.
Second, as part of this substantive argument, Coffee in particular offers a
plausible prima facie case for how this functional convergence would come
about. As noted above, the process of cross-listing and M&A activity both
describe feasible mechanisms by which the statutory differences between
jurisdictions become less relevant while firms either deliberately or
inadvertently bring their transactions under the scope of the most efficient
governance arrangements. In the case of cross-listing in particular, firms which
voluntarily list themselves (directly or indirectly) on a foreign stock
exchange—most notably for Coffee’s argument the New York Stock
Exchange—actually bind themselves to a particular set of securities and
governance rules and at the same time trigger an important signalling
mechanism to would-be investors.41 There are, to be sure, important
empirical challenges to these mechanisms on the horizon, but the explanations
themselves are in many ways convincing.
Third, the functional hypothesis is the best available to-date in terms of
compatibility with the theory of the demand-for-law. The theory, as best
elucidated by Pistor,42 corroborates the formal-functional distinction in relation
to legal rules, both explicitly and implicitly. Indeed, except when applied in
very narrow cases, the demand-for-law concept is precisely concerned with
economic actors’ demand for particular functions of contract-enforcement and
monitoring to be carried out, whether by legal institutions or by private
means. The functional view of corporate governance has, moreover,
Coffee, “The future as history,” p. 648.
Ibid., pp. 657ff.
42
K. Pistor, “Supply and demand for law in Russia. East European Constitutional Review 8,
no. 4 (Fall 1999), n.p., available online: <http://www.law.nyu.edu/eecr/ >; K. Pistor, “The
demand for constitutional law,” Constitutional Political Economy 13 (2002), pp. 73-87.
40
41
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attempted to apply the demand-for-law insights in the effort to demonstrate
that formal legal rules very often follow, rather than create, the functional or
practical governance systems with which they are concerned. Specifically, in
analysing the aforementioned study by Pistor of the shift towards AngloAmerican corporate law in transition economies from 1990 to 1998,43 Coffee
argues that even here, where the proximate cause of such a shift was the
involvement of many Western expert advisors, there is still evidence of form
following function.44 In particular, argues Coffee, the usual (LLSV-inspired)
sequencing of strong shareholder protections driving dispersed ownership was,
of necessity, turned on its head. It is at least a defensible reading of the
transition experience, he maintains, that mass privatisation created dispersed
ownership very rapidly, thus generating a constituency demanding some level
of investor protection.
Thus, in the absence of clear evidence supporting either of the standard
positions in the convergence debate, the functional theory seems at present to
be in a class by itself. However, caution is certainly warranted: despite both
Gilson’s and Coffee’s repeated claims that the empirical evidence clearly
supports the functional theory, this evidence has been slow in coming.45 More
disconcertingly, at least one recent study explicitly attempting to test one part
of the functional convergence hypothesis found little to support the intuitively
appealing thesis. Meghana Ayyagari, in a study published by the World Bank,
specifically investigated whether firms which cross-listed onto a U.S. stock
exchange experienced a decrease in the concentration of ownership.46
Following the general functional theory and the LLSV conclusion that the
extent of minority shareholder protection is the key determinant of dispersed
ownership,47 one expects firms that cross-list into a system where minority
protections are stronger to eventually witness greater dispersion in ownership.
However, the results are disappointing: only a small, short-lived decline in
concentration of ownership appears after firms cross-list, and many crosslistings are clearly designed for the sale of control blocks, not to raise capital
from new minority shareholders.48 There are several non-trivial shortcomings
in Ayyagari’s empirical investigation, however—the most obvious of which is
Pistor, “Patterns of legal change.”
Coffee, “The rise of dispersed ownership.”
45
Coffee, “The future as history”; Coffee, “Racing towards the top?”; Coffee, “Law and
regulatory competition.”
46
Ayyagari, “Does cross-listing lead.”
47
LLSV, “Law and finance.”
48
Ayyagari, “Does cross-listing lead,” pp. 3ff. Additionally, many which do cross-list onto
U.S. exchanges do so using American Depositary Receipts (ADRs), negotiable instruments
which represent claims to shares, fractions of shares, or blocks of shares on deposit at a bank or
other institution. These are much better suited to marketing entire control blocks for sale on a
foreign exchange, and there are severe limitations on the extent to which those who cross-list
via ADR actually bind themselves to stricter rules. Ibid., pp. 5-6.
43
44
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the time-span of her study: some firms were observed only in the year before
and the year after cross-listing, and the entire sample is derived from the 1990
to 2002 period.49 Given the gradual nature of the effects—and moreover the
perceptions—of improved governance, these time limitations may yield
considerably understated results. Thus, while Ayyagari’s findings represent an
important challenge to the functional hypothesis, they are not as fatal as they
at first appear.
6. CONCLUSION
It is evident that the debate over global convergence has relevance for
both legal and economic investigations into corporate governance. This
relevance is only heightened when the focus is narrowed to transitioning
economies. While the debate is and is likely to remain unresolved in the
literature for years to come, the breakthrough reflected by the functional
thesis (as propounded by Coffee and Gilson, supra) must be acknowledged.
Though even the functional thesis is vulnerable to empirical critiques, it is this
framework which identifies the right empirical questions to ask. Given this, in
conjunction with its uncontroversial policy recommendations50 and its ability
to meaningfully and substantively integrate of the other prevailing theories, it
is not unlikely that the competing frameworks themselves will converge
towards the theory which distinguishes form from function.
Ibid., pp. 12-13.
Generally, these including making more transparent and straightforward the processes
and legal ramifications of cross-listing; see Coffee, “The future as history.”
49
50
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International and Comparative Law 17 (1997): pp. 621-672.
Klapper, L. and Love, I. “Corporate governance, investor protection and
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Paper #2818 (April 2002).
La Porta, R., Lopez-de-Silanes, F., and Shleifer, A. “Corporate ownership
around the world.” Journal of Finance 54, no. 2 (April 1999): pp. 471-517.
La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. “Legal
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———. “Law and finance.” Journal of Political Economy 106, no. 6
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———. “Legal plug-ins: cultural distance, cross-listing, and corporate
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McDonnell, B. “Convergence in corporate governance: possible, but not
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Morck, R., and Steier, L. “The global history of corporate governance: an
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Working Paper #49 (May 2000).
———. The demand for constitutional law. Constitutional Political
Economy 13 (2002): pp. 73-87.
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corporate law: a cross-country comparison.” University of Pennsylvania
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———. “Some differences in corporate structure in Germany, Japan, and the
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APPENDIX
Table 1. McDonnell’s “Summary of Possible Stories” of Corporate
Governance
Stories of the Past:
P1
P2
P3
P4
The United States has evolved optimally; Japan and Germany have
not
Japan and Germany have evolved optimally; the United States has
not
The United States has taken a different path than Japan and
Germany, but neither path is clearly superior
The United States, Germany and Japan are roughly similar
Stories of the future
F1
F2
F3
F4
Japan and Germany will move toward the path currently followed
by the United States
The United States will move toward the path currently followed by
Japan and Germany
The United States, Japan and Germany will converge to a hybrid
form
The United States might remain, or become, distinct from Japan
and Germany
(Source: McDonnell, “Convergence in Corporate Governance,” p. 368, Table 1)
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Table 2. McDonnell’s “Summary of Possible Outcomes” of Corporate
Governance
Summary of Possible Outcomes
P1
P2
P3
P4
F1
American
Triumphalist
Convergence
F2
Converge to
inferior
JapaneseGerman
System
F3
Superior
American system
and inferior
Japanese-German
system converge
to hybrid
F4
Inferior
JapaneseGerman system
remains on
separate path
Convergence to
Inferior
American
System
Converge to
superior
JapaneseGerman
System
Superior
Japanese-German
system and
inferior American
system converge
to hybrid
Inferior
American
system remains
on separate path
Converge to
American
System though
not clearly
superior
Converge to
Japanese
German
system
though not
clearly
superior
Two noncomparable
systems converge
to hybrid
Noncomparable
systems remain
on separate
paths
Japan, Germany
and the United
States remain on
same path
Currently
similar systems
diverge or,
United States
stays ahead of
others though
on same path
Japan and
Germany,
already on same
path as United
States, catch up
Japan,
Germany and
the United
States remain
on same path
(Source: McDonnell, “Convergence in Corporate Governance,” p. 369, Table 2)
SECULARISM: LIBERALISM’S ACHILLES HEEL AT
THE ‘END OF HISTORY’
Ploutarchos Evlogimenos ‡
In his 1989 article and in a book in 1992, Fukuyama indicated that we
have reached the end of history. Written in the euphoric time which saw the
retreat and fall of communism, and thus signalling the end to the Cold War,
Fukuyama’s thesis claimed the “unabashed victory of economic and political
liberalism”1 and that “the ideal of liberal democracy could not be improved
on.”2 Fascism and communism (liberalism’s two beaten opponents) may not
yet be six feet under, but it would be hard to make the case they are not at
least terminally ill. With the latter out of the way Fukuyama suggests two
other possible rivals; religion and nationalism.3 However, they are both
dismissed as assailable by the liberal project.
Several criticisms and even outright refutations of Fukuyama’s thesis have
appeared ever since the 1989 article was published, many expanding on the
potential of religion and nationalism as rivals to liberalism. My discussion will
also challenge the ‘end of history’ by considering one of the aforementioned
rivals: religion. My aim is not to relentlessly criticize or refute Fukuyama’s
claim, but add a mark of caution to the general debate concerning the global
spread of liberalism and liberal democracies. My contention is that religion
must not be underestimated as it has the potential to rock the roots of
liberalism. Fukuyama’s argument will be used as a starting and reference point
‡
M.Sc. candidate (International Public Policy), School of Public Policy, University College
London (expected November 2005). Contact with questions/comments:
ploutoe@yahoo.co.uk.
1
Francis Fukuyama, “The End of History?” The National Interest, no. 16, summer, (1989),
p. 3.
2
Francis Fukuyama, The End of History and the Last Man (London: Penguin Books, 1992),
p. ix.
3
Fukuyama, The End of History, p.14.
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005): 111-120. [ISSN 1748-5207]
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
111
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for my discussion. I will argue that the secular, a pillar for modern liberalism,
can be an inherently intolerant principle thus compromising the whole liberal
democracy project. This contradiction leaves the promises of liberalism and
specifically liberal democracy exposed to an internal identity crisis but also
external criticism. To illustrate my discussion I will use the case of French
secularism and the possible challenge posed to it by French-Muslims. I will
start my discussion by defining liberalism. I will then outline Fukuyama’s
thesis and consider some problems facing the global spread of liberalism. I will
then move on to the French secularism illustration, first introducing a
definition and discussion on secularism and its roots. If we are at the end of
history, one would expect the prevailing and universal ideology to be free of
contradiction. I label my discussion as a caution because even though I indicate
a contradiction in liberalism which may hinder it global assurgency, I do not
believe that it is an irreconcilable one.
Generally liberalism is based on the primacy of an individual’s freedom to
develop one’s self and cultivate their capacities. Liberalism also comes to be
associated with toleration, be it of religious, political, gender or racial concerns
etc. Liberalism also bears definitional connections to societies which are
organised around a free market. Fukuyama identifies political liberalism as “the
rule of law that recognises certain individual rights,” which he classes into the
three general groups of civil rights, religious rights, and political rights.4 He
defines liberal democracy, the form of government which will prevail at the
end of history, as “the doctrine of individual freedom and popular
sovereignty.”5 It must be noted that when trying to define liberalism one is
confronted with the array of variations and meanings attached to it. For the
purposes of my discourse it is not necessary to explore all of these; the above
summary will suffice.
Inspired by the eminent collapse of communism in 1989, Fukuyama’s
version of the ‘end of history’ - indicating an end to ideology not of events –
stops at liberalism and the universalization of that notion. Following Hegel
and, to some extent, Plato’s notion of thymos (spirit and desire) he states that
the progression of history was not predominantly situated in material forces
(as in Marxism) but in “in the realm of human consciousness.”6 Material or
economic interpretations of history are deficient as man is not simply an
economic animal.7 The claim is that all ideologies which have challenged
liberalism have failed: nationalism and fascism (e.g. Nazi Germany),
communism (Soviet bloc) and religion (at least in the predominantly secular
West) have failed to take precedence over liberal values. However, the end of
Fukuyama’s article on the end of history (1989) and his book (1992) leave the
Fukuyama, The End of History and the Last Man, p.43
Ibid. p.42
6
Fukuyama, The End of History, p.5.
7
Fukuyama, The End of History and the Last Man, p. xvi.
4
5
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future open; not to a new ideology but to the reoccurrence of an old one. The
thymos and megalo-thymia which characterise and drive man find temporal
appeasement in liberal societies.8 The stark acknowledgment at the end of
both his article and book (more so in the latter case) is that further ideological
revolution, generated from the inability of liberalism to constantly satisfy
everyone will always provide the setting for someone “to go back and restart
history.”9
Fukuyama’s attempt to present us with end of history and the
“universalization of Western liberal democracy as the final form of human
government,”10 invokes the debates on globalization, specifically those centred
on the discourse of a ‘global culture.’ Is it possible to claim singularity in
‘culture?’ As Antony Smith points out, it is not.11 Despite the defined and
regular patterns of interconnectedness and global exchange entailed by
globalization, it is not possible to claim more than the existence of a trend
towards the existence of some features that are shared nevertheless by many
different cultures. An interconnected world may facilitate and normalize the
exchange of cultural influences yet “cultural traditions do not derive from or
descend upon, mute and passive populations on whose tabula rasa they
inscribe themselves.”12 It follows that liberalism (a Western construct) may be
resisted by some as being foreign to their culture. To enforce it on those
would contradict liberalism itself and tend towards a 19th century European
imperialist drive, a point which Fukuyama recognizes.13
To Fukuyama’s admittance liberalism is vulnerable to thymos14 due to
gaps in liberalism’s ability to satisfy certain desires. One of these desires is that
for recognition, which can be satisfied by religion and nationalism.15
Recognition leads to the matter of the Other. This Other does not denote a
sophisticated academic or ideologically laden term. It signifies alternative and
difference. In the parlance of the anthropology discipline, the Other is what
defines the ‘us VS them’ division.16 To declare the undisputed end of history
arguably the Other must be decisively dealt with and the aforementioned
division ubiquitously resolved. Dealing with the Other does not mean
eliminating it. In terms of religion and thymos it would imply creating
religious ’iso-thymia;’ an appeasement of human spirit which religion evokes.
Ibid. p. 329.
Ibid. p. 334.
10
Fukuyama, The End of History, p. 4.
11
Anthony D. Smith, “Towards a Global Culture”, in The Global Transformations Reader,
(eds.) D. Held & A. McGrew (Padstow : Polity Press 2000), p. 245.
12
Ibid. p. 45.
13
C.f. Fukuyama, The End of History, p.16.
14
Fukuyama, The End of History and the Last Man, p. 334.
15
Ibid. p. 238.
16
C.f. Clifford Geertz, Local Knowledge, (London, Fontana Press1983).
8
9
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Fukuyama implies that liberalism finds appeasement of religion in secularism;
(although he does not explicitly use that term):
modern liberalism itself was historically a consequence of religious
based societies which failing to agree on the nature of the good life,
could not provide even the minimal preconditions of peace and
stability.17
Secularism must deliver the promise of religious iso-thymia every time if
liberalism is to become a truly global ideal. Secularism is generally taken to
express the attitude that religion should have no place in civil affairs.18 Modern
secularism is liberal democracy’s attempt to make citizenship to one’s state the
primary principle of identity: it is “an enactment by which a political medium
(representation of citizenship) redefines and transcends particular and
differentiating practices of the self that are articulated through class, gender,
and religion.”19 However, by denoting the existence of these “practices” the
secular becomes a notion defined by its opposition to something. Furthermore,
by trying to create an identity by asserting the primacy of one principle of
identity (e.g. citizenship) over the rest (e.g. religion) “secularism arrogates to
itself the right to define the role of religion in politics,” thus closing up the
political space and acting like a faith intolerant of other faiths.20
Historically secularization originates from the West as an “interpretive
paradigm which allows us to discuss and comprehend the interrelated themes
of social and religious change,” within the region in respect to Christianity.21
The Peace of Westphalia introduced the principles of territorial sovereignty,
established the independence of states and gave strength to the concept of
sovereign states, thus overthrowing the notions of a universal religious
authority acting as final arbiter of Christendom. Then the argument can be
that secularism is the teleological development of Christianity’s role in the
public sphere; “secularization, in other words, remains situated within the
broader Christian context.”22” Fukuyama concedes liberal democracy emerged
first in the Christian West and that the universalism of democratic rights can
be seen “in many ways as a secular form of Christian universalism.”23 In this
Fukuyama, The End of History, p. 14.
Heiner Meulemann, “Enforced Secularisation – Spontaneous Revival?” European
Sociological Review, Vol. 20, no. 1, February (2004), p. 47.
19
Talal Asad, Formations of the Secular: Christianity, Islam, Modernity, (Stratford, Stratford
University Press, 2003), p.5 – emphasis added.
20
Elizabeth S. Hurd, “The Political Authority of Secularism in International Relations,
European Journal of International Relations,” vol.10(2), (2004), p. 237 and 256.
21
Stephen J. Hunt, Religion in Western Society, (Basingstok: Pelgarve, 2002), p. 15.
22
Hurd, The Political Authority of Secularism in International Relations, p. 241.
23
Francis Fukuyama, History Is Still Going Our Way: Liberal democracy will inevitably
prevail, Friday, 5th October 2001:
http://chnm.gmu.edu/ematters/issue6/911exhibit/emails/fukuyama_wsj.htm.
17
18
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regard, liberalism is rooted in a secular tradition which defines and establishes
itself in respect to a Christian morality. The suggestion is that the secular in
this case separates the role of Christianity from civil affairs; “secularism is a
unique Western achievement (and) it follows that (…) those who are not
Western cannot be secular.”24 Secularism is designed to confine the Christian
element. Liberalism is the post-Christian Church de facto organizing order of
society, but although it may keep the Christian Church authority away from
civil affairs it does not necessarily do the same for the Christian Ethic.25 Then,
how does secularism, and consequently liberalism, fare in regards to other
religions? To investigate this I will use the case of French secularism and
French-Muslims. I will mainly do this through a discussion using the ‘headscarf
affair’26 as it can be seen as epitomizing the challenges and discourses Islam
poses to French secularism and liberalism.27
In France the notion of secularism is tantamount to laicite, a constitutional
definition describing the neutrality of the state towards religious and other
convictions, in order to build a state for all. In terms of the French state this
dates back to 1905 when a law separating church and state was passed by the
French parliament, Terminating Napoleon’s Concordant of 1801 with the
Vatican. “In the French Republic, religion cannot, must not be a political
project… It [is] necessary to preserve the national principle of secularity separating religion and state.”28
The following literature review aims to highlight aspects of the headscarf
affair in France, revealing the clashes of Islam and secularism. By this I want to
demonstrate a certain intolerance inherent in secularism and how this may
obstruct the universalization of liberalism. Emmanuel Terray finds the debate
on secularism and the hijab (headscarf) underscored by matters of immigrants’
cultural integration and gender concerns.29 His findings are a result of a critical
study of Bernard Stasi’s report Laicite et Republique. The report was ordered
by a Presidential Commission in July 2003 (headed by Stasi in his capacity of
Hurd, “The Political Authority of Secularism in International Relations,” p. 251.
C.f. Madeleine Bunting, “Secularism gone mad: Chirac's determination to ban Muslim
headscarves from schools will cause years of confrontation,” The Guardian, Thursday 18th
December 2003: http://www.guardian.co.uk/comment/story/0,3604,1109242,00.html, Hurd,
“The Political Authority of Secularism in International Relations,” p. 248, Max Weber, The
Protestant Ethic and the Spirit of Capitalism, in Political Writings, (Cambridge, Cambridge
University Press, 1994).
26
This originates in a long debate over headscarves that has divided France since 1989,
when l'affaire du foulard ("the headscarf affair") saw two young Muslim girls expelled from
their school in Creil, near Paris, for wearing headscarves, thus going against the French secular
tradition.
27
Arun Kapil, “On Islam in the West and Muslims in France: Views from the Hexagon,”
Third World Quarterly, vol.18(2), (1997), p. 383.
28
Sentiments of French Government as expressed by Prime Minister Jean-Pierre Raffarin –
source: BBC news-online 03/02/04
29
Emmanuel Terray , “Headscarf Hysteria,” New Left Review (26) March/April (2004).
24
25
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Mediator of the Republic) and it is on this reports recommendation that the
National Assembly voted favourably on a religious symbols ban in February
2004. Terray concludes that the effects of the report will be the exclusion and
not - as claimed by the report - the republican and egalitarian inclusion of all
in the French state. The reason for this exclusion is the fact that the French
government underplays the role of the cultural and gender contentions,
covering them with rhetoric of secularism. Antoine Boulange argues that the
French government has misguidedly put “abstract” idea of secularism above
the civil rights of Muslims30. Boulange, writing from a modern-Marxist
perspective, identifies problems of Muslim-immigrant integration and gender
concerns behind the French government’s calls of secularity. His focus is to
demonstrate how this post-9/11 Islamophobia and thus ‘demonization’ of the
French-Muslim population leads to a weakening of the working class in
France.31
Lina Liederman conducts a comparative study of the attitudes towards the
headscarf in the UK and France in her research of pluralism in education in
these two countries.32 Through her study she identifies and compares the
primary issues in each country. Liederman identifies some of the latter as
“women’s issues (and) discrimination.”33 Moreover and similarly to Terray,
Liederman finds that these issues are shrouded by a republican, secular
rhetoric; “the absence of consistent references on (…) race relations in the
French Islamic headscarf debate implies a particular French dislike or
uneasiness with the notion of race.”34 Soysal explores the compatibility of
notions of (Western) European citizenship with organised Islam within
Europe.35 She writes on the hijab case in France in terms of human and
citizenship rights. In brief the argument is that the prevalence of Universal
Human rights has come to somewhat diminish claims to national citizenship
in the European domain. Thus the integration of Islam in Europe, Islam being
a borderless sense of identity, is hard to address simply through the means of
secular rhetoric, without addressing specific issues of culture. All these studies
criticise to some extent France’s strong secular beliefs as counter productive.
Secularism as presented by the French authorities in the hijab affair will have
30
(2004).
Antoine Boulange, “The Hijab, Racism and the State,” International Socialism, Spring
Boulange, “The Hijab, Racism and the State” p. 23.
Lina M. Liederman, “Pluralism in Education: the display of Islamic affiliation in French
and British schools,” Islam and Christian-Muslim Relations, Vol.11, no.1, (2000).
33
Liederman, “Pluralism in Education: the display of Islamic affiliation in French and British
Schools,” p. 109.
34
Liederman, “Pluralism in Education: the display of Islamic affiliation in French and British
schools,” p. 110.
35
Yasemin N. Soysal, “Changing Parameters of Citizenship and Claims-Making: Organised
Islam in European Public Spheres,” Theory and Society Vol. 26/4, (1997).
31
32
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the effect to “ban and exclude36” or oppress Islam in France.37 Such oppression
undermines the liberal notions of toleration and freedom to cultivate one’s full
capacities.
Boulange evokes elements of Huntington’s ‘clash of civilizations’38 which
has generated a perception of Islam as a threat to Western civilisation. In a
post-9/11 world Boulange sees France as acting in a way which exemplifies
Western Islamophobia. Soysal argues that symbols such as the hijab seize
being religious symbols and become means of cultural and political expression.
Thus their bearers defend them on the grounds of human rights.39 Miriam
Feldblum argues on the grounds of Soysal’s reasoning that there are two levels
to the hijab affair.40 On the grounds that it evokes universal human rights, it is
an attack on the French notion of secularity and also a threat to the French
model of national integration which eschews ethnic related rights. In such a
case secularism creates a politics of exclusion situation. It thus undermines the
project of liberal democracy. “Individuals and groups who dissent from secular
transcendental/temporal delineation are shut out of public deliberation before
it begins;” secularism runs the risk of “shutting down new approaches to
negotiations between religion and politics.”41
The survival of liberalism and its universal spread is only possible if its
baseline, secularism, manages to take a neutral stance, not one of exclusion.
Thus, taking the French example, secularism antagonises the non-Christian,
and undermines liberalism. The secular project should create a basis for the
political which whilst preventing the religious from taking over civil affairs it
should not exclude it as an identity. “Exclusion of something from the political
is the political gesture par excellence.”42 Secularism should define the limits of
the game and liberalism should be the political mediator between the different
identities. In its expansion over the globe liberalism will encounter many
identities, some of which will be contained within the same political space
(e.g. French-Muslims VS other French citizens in France). “Each identity is
fated to contend – in various degrees in multifarious ways – with others it
depends on to enunciate itself; that politics the issue is not if but how.”43
Terray , “Headscarf Hysteria,” p. 127.
Boulange, “The Hijab, Racism and the State,” p.23.
38
See Samuel P. Huntington, “The Clash of Civilisations,” Foreign Affairs v. 72, no.
Summer, (1993) and Samuel P. Huntington, The Clash of Civilization and the Decline
Religion, (New York: Simon and Schuster, 1996).
39
Yasemin N. Soysal, Limits of Citizenship: Migrants and Postnational membership
Europe, (Chicago, University of Chicago Press, 1994) and Soysal, “Changing Parameters
Citizenship and Claims-Making: Organised Islam in European Public Spheres”.
40
Miriam Feldblum, Reconstructing Citizenship: Politics of Nationality Reform and
Immigration in Contemporary France, (New York, State University of New York Press, 1999)
41
Hurd, “The Political Authority of Secularism in International Relations,” pp.239-241.
42
Slavoj Zizek, The Ticklish Subject, (London, Verso, 1999), p. 82.
43
William E. Connolly, The Augustinian Imperative, (London, Sage Publications, 1993)
36
37
3,
of
in
of
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INTERNATIONAL PUBLIC POLICY REVIEW
France and generally European societies are not prone to acknowledging some
legitimate role for religion in public life and in the organization of collective
group identities. “Muslim organized collective identities and their public
representations become a source of anxiety not only because of their religious
otherness as a non-Christian and non-European religion, but more importantly
because of their religiousness itself as the other of European secularity.”44
The liberal democracy project tries to propagate iso-thymia through a
series of institutional arrangements: popular sovereignty, rights separation of
powers and the rule of law.45 As a notion it is not inherently global but it is
rooted in Western Europe and the secularization of Christianity. It therefore
runs the risk of isolating its Other religions (i.e. the ones it defines itself
contrary to), proliferating thymos and exasperating differences. This is
exemplified by the case of the French Muslims. Thus secularism is not always
democratic and neutral.46 A possible way to change this is if secularism
redefines itself thereby incorporating more religions so that it is not solely
situated within a Christian context. Secularism rooted in Christianity provides
the liberal democratic project a false sense of certainty and triumph. This
becomes its Achilles heel, leaving it vulnerable to self-contradiction of its
tolerance and individual freedom ideals. “The two-sided tragedy of liberalism is
that it doesn't know its own limits, and neither does it know its own strength.
If it knew both of these, it would find the self-confidence and humility to
understand and learn from those who challenge it.”47
44
Jose Casanova, The New Religious Pluralism and Democracy, Panel Discussion, George
University, April 21-22, 2005:
http://64.233.183.104/search?q=cache:LcLz5wOgExsJ:irpp.georgetown.edu/agenda.doc+secular
ism+casanova&hl=en
45
Fukuyama, The End of History and the Last Man, p.333.
46
Hurd, “The Political Authority of Secularism in International Relations,” p. 240.
47
Bunting, Secularism gone mad: Chirac's determination to ban Muslim headscarves from
schools will cause years of confrontation.
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REFERENCES
Asad, T. Formations of the Secular: Christianity, Islam, Modernity. Stratford:
Stratford University Press, 2003.
BBC news-online 03/02/04: http://news.bbc.co.uk/1/hi/world/europe/
345863.stm
Boulange, A. “The Hijab, Racism and the State.” International Socialism, Spring
(2004).
Bunting, M. “Secularism gone mad: Chirac's determination to ban Muslim
headscarves from schools will cause years of confrontation.” The Guardian,
Thursday 18th December 2003:
http://www.guardian.co.uk/comment/story/0,3604,1109242,00.html
Casanova, J. “The New Religious Pluralism and Democracy” Panel Discussion,
Georgetown University, April 21-22, 2005:
http://64.233.183.104/search?q=cache:LcLz5wOgExsJ:irpp.georgetown.ed
u/agenda.doc+secularism+casanova&hl=en
Conifer, P. “Accounting for Islamism”, 2003:
http://www.culturewars.org.uk/2003-02/islamism.htm
Connolly, W.E. The Augustinian Imperative, (London, Sage Publications, 1993).
Feldblum, M. Reconstructing Citizenship: Politics of Nationality Reform and
Immigration in Contemporary France. New York, State University of New
York Press, 1999.
Fukuyama, F. “The End of History?” The National Interest, no. 16, summer,
(1989).
———. The End of History and the Last Man. London: Penguin Books, 1992.
———. “History Is Still Going Our Way: Liberal democracy will inevitably
prevail, Friday,” 5th October 2001:
http://chnm.gmu.edu/ematters/issue6/911exhibit/emails/fukuyama_wsj
.htm
Geertz, C. Local Knowledge. London: Fontana Press, 1983.
Hunt, S.J. Religion in Western Society. Basingstoke: Pelgrave, 2002.
Huntington, S.P. “The Clash of Civilisations.” Foreign Affairs v. 72, no. 3,
Summer, (1993).
———. The Clash of Civilization and the Decline of Religion. New York:
Simon and Schuster, 1996.
Hurd, E.S. “The Political Authority of Secularism in International Relations.”
European Journal of International Relations, vol. 10(2), (2004).
Kapil, A. “On Islam in the West and Muslims in France: Views from the
Hexagon.” Third World Quarterly, vol.18(2), (1997).
Liederman, L.M. “Pluralism in Education: the display of Islamic affiliation in
French and British schools.” Islam and Christian-Muslim Relations, Vol.11,
no.1, (2000).
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Meulemann, H. “Enforced Secularisation – Spontaneous Revival?” European
Sociological Review, vol. 20, no. 1, February (2004).
Smith, A.D. “Towards a Global Culture.” In The Global Transformations
Reader, eds. D. Held & A. McGrew. Padstow: Polity Press, 2000.
Soysal, Y.N. Limits of Citizenship: Migrants and Postnational membership in
Europe. Chicago: University of Chicago Press, 1994.
Yasemin N. “Changing Parameters of Citizenship and Claims-Making:
Organised Islam in European Public Spheres,” Theory and Society Vol.
26/4, (1997).
Terray, E. “Headscarf Hysteria”, New Left Review (26) March/April (2004).
Weber, M. The Protestant Ethic and the Spirit of Capitalism, in Political
Writings. Cambridge: Cambridge University Press, 1994.
Zizek, S. The Ticklish Subject. London: Verso, 1999.
THE EUROPEAN COMMISSION AS AN AGENDASETTER: LESSONS FROM AND LIMITATIONS OF
FORMAL ANALYSIS
Daniela Ulicna‡
1.
INTRODUCTION
The concept of agenda-setting is used in the literature to describe at least
two different actions within the policy cycle, each taking place at a different
stage. First, Kingdon discusses how an issue becomes a part of the political
agenda, and he defines agenda-setting as a process through which an issue
attracts the attention of policy-makers.1 Building upon the theory of “garbage
cans”,2 he developed concepts of “policy windows” – the opportunity to push a
policy through — and “policy entrepreneurs” – active advocates of particular
solutions who identify and take advantage of policy windows. While these
conceptions will be only marginally used in this essay it is important to know
that they are both applied analyse the decision-making in the EU.3
The second conception of agenda-setting is inspired by the principal-agent
framework where an agent, due to inequality of information, has (to a certain
extent) the power to set the agenda for the principal. Rational-choice analysts
‡
M.Sc. candidate, School of Public Policy, University College London (expected
November 2005); Contact with questions/comments: ulicnadan@yahoo.com.
1
J. Kingdon, Agendas, alternatives and public policies (New York: HarperCollins College
Publishers, 1995).
2
M. Cohen, J. March, and J. Olsen., “A garbage can model of organizational choice,”
Administrative Science Quarterly, 17 (March 1972), pp. 1-25.
3
See, for example, B. Wendon, “The Commission as image-venue entrepreneur in EU
social policy,” European Journal of Public Policy 5, no. 2 (1998), pp. 339-353. See also L. Cram,
Policy-making in the European Union: conceptual lenses and the integration process (London:
Routledge, 1999).
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005): 121-132. [ISSN 1748-5207]
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
121
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conceptualise this agenda-setting power of the agent as the capacity to 1)
choose from a set of alternatives acceptable to the principal the one that is the
closest to the agent’s preferences and 2) to formulate this alternative into a
particular piece of legislation upon which the principal decides.4 Tsebelis
understands the agenda-setting power as the ability to formulate the
legislation, to choose one particular alternative among other acceptable
solutions, and to put it forward, in opposition to the veto-power (the capacity
to reject the legislation).5 This conception is clearly different from the one
held by Kingdon, who considers that this specification and the choice of policy
alternatives is a different process from agenda-setting. Pollack remarks this
variance in the use of the concept and uses the term “informal agenda-setting”
for the definition used by Kingdon and his successors and “formal agendasetting” for the rational-choice understanding of the process.6
Even though the European Commission is mainly understood as the
executive body of the EU, it also has the legislative power to initiate
legislation. For a great part of EU policies the Commission even has the
exclusive right to initiate the legislation. The Council shares this right with the
Commission for policies included in the second and third pillar.7 Therefore,
the Commission appears to be the major formal agenda-setter in the EU.
Section 2 of this essay will analyse under what conditions the Commission can
exercise its agenda-setting powers as it is understood by the rational choice
approach. We will see that the literature concerned with the Commission’s
formal agenda-setting is mostly based on the analysis of formal rules during the
legislation process and the position of different actors in decision-making. We
will examine the bases upon which a number of authors claim that the
Commission can be a powerful agenda-setter. If their claim can be shown
justified, it would constitute an argument in favour of a supra-nationalist
interpretation of EU integration. Section 3 will examine the limits of this
analysis, illustrated both by instances where the Commission failed to use its
agenda-setting power and by those cases where it succeeded due to its
informal agenda-setting. With reference to the principal-agent framework, it
will be shown that the success of the Commission’s agenda-setting power
depends on the willingness of the principal, the Council, and therefore the
member states.
4
B. Tsebelis and G. Garrett, “Legislative politics in the European Union,” European Union
Politics 1, no. 1 (2000), pp. 9-36; C. Crombez, B. Steunenberg, and R. Corbett, “Understanding
the EU legislative process,” European Union Politics 1, no. 3 (2000), pp. 363-381.
5
Tsebelis and Garrett, “Legislative politics.”
6
M.A. Pollack, “Delegation, Agency and Agenda-setting in the European Community.”
International Organization 51, no. 1 (1997), pp. 99-134. M.A. Pollack, The engines of European
Integration: Delegation, Agency and Agenda-setting in the EU (Oxford: Oxford University Press,
2003).
7
See S. Hix,The political system of the European Union (New York: Pelgrave, 1999),
Appendix, pp. 366-375.
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AGENDA-SETTER
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EU COMMISSION AS A FORMAL
The major actors in the legislative process of the EU are the Commission,
the Council of Ministers and the European Parliament (EP). The Commission,
as it was already said, brings proposals of laws. Its agenda-setting power
consists in the possibility to choose among different acceptable alternatives
(i.e. those that would pass through the vote in the Council) the one that is
closest to its ideal policy. The Council is a decisive actor in the adoption of
every piece of legislation. Under certain circumstances, the Council can amend
the legislation and it has the power to veto every piece of legislation. The
impact of the EP varies according to the procedure under which the particular
piece of legislation is adopted. For some types of legislation, the EP is not at all
involved in the adoption process: for instance, it can delay legislation under the
consultation procedure. Under the co-decision procedure, by contrast, it can
also veto legislation and have a significant power to shape it by amendments.8
While in the former case, the Commission, as an agenda-setter, has to consider
only the preferences of the Council and make a proposal that is acceptable by
the Council, in the latter case (i.e. co-decision procedure) the Commission has
to take into account the preferences of the EP as well. This increases the
number of actors who can modify the original Commission’s proposal and
potentially push the proposal further from the Commission’s ideal position.
Thus, the agenda-setting power of the Commission is lesser under the codecision than under the two other procedures.9
Another important factor that influences the agenda-setting power of the
Commission is the decision rules by which the legislation is adopted and
amended.10 The agenda-setting power is important if it is easier for the
decision-makers to adopt the legislation than to amend it. Under the
consultation procedure, where there is only one reading, the Council can only
amend the proposal by unanimity, while for some types of legislation it can
adopt it by Qualified Majority (QMV). Therefore it is easier to adopt the
legislation than to modify it. The Commission has significant discretion if the
legislation is adopted by QMV. In that case the proposal has to satisfy the
To see which type of law is adopted by which procedure see Hix, The political system,
pp. 64-65.
9
G. Tsebelis, “The power of the European Parliament as a conditional agenda-setter” in
The American Political Science Review 88, no. 1 (1994), pp. 128-142; C. Crombez, “The Treaty of
Amsterdam and the co-decision procedure,” in The rules of integration: institutionalist approaches
to the study of Europe, eds. G. Schneider, and M. Aspinwall (Manchester: Manchester University
Press, 2001).
8
10
Pollack, “Delegation.”
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median veto-players; therefore, the Commission can put forward an
alternative closer to its ideal point, while if the Council is to amend the
proposal, the amendment needs the support of all the actors, including the
extreme veto-player closest to the Commission’s position and likely to support
the initial Commission’s proposal. In a case where the decision rule requires a
piece of legislation to be adopted unanimously, the Commission’s agendasetting power is weaker because the proposal has to satisfy the extreme vetoplayer (see Figure 1) and the same condition applies for the amendment put
forward by the Council. It is equally difficult to adopt and to amend a
proposal.
Therefore according to the study of these rules, the Commission’s formal
agenda-setting power should be greatest in cases of legislation adopted by
QMV, under the consultation procedure, or without the involvement of the
EP. Important issues fall into this category, such as the Common Agricultural
Policy, some provisions concerning the Single Market (ex. liberalization of
services) or Competition policy (e.g.. state aid).
Figure 1
XL & XR – veto players in unanimity vote
XQ & XQ* - veto players in QMV vote
Source: Schulz, H.& Konig, T. (2000) “Institutional reform and decision-making efficiency in the
European Union” in American Journal of Political Science 44(4); p. 657. Note: It is assumed that
the position of the Commission is at the side of “more integration” further than the most
integrationist member state.
As was said previously, the Commission’s agenda-setting power is less
under the co-decision procedure. The co-decision procedure, as it is
functioning now (co-decision II), was introduced in the Treaty of Amsterdam.
It was preceded by the co-decision I (Maastricht Treaty) and even before by
the cooperation procedure (Single European Act). While the involvement of
the EP was progressively becoming more important, several authors agree that
the formal agenda-setting power of the Commission has progressively
VOL. I,
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decreased with the institution of each of these three procedures.11 However,
there remains debate about to what extent is it decreasing. Crombez, for
instance, claims that the Commission’s proposals done after the second reading
have become irrelevant in the co-decision procedure: either the “joint text”
is adopted (the result of conciliation between the Council and the EP) or the
status quo remains.12 Even though the Commission issues its opinion, that
either rejects or adopts the EP amendments, in the second reading, this
opinion is not binding.
On the other hand, Burns confirms that even though the Commission’s
power is weakened it can still set the agenda if certain conditions are
satisfied.13 Among the three conditions she formulates, the first is that “the
Commission must share preferences with the majority of both the Council
and the EP, or with a minority of the Council and the majority of the EP.”14
One might object, of course, that it is not clear what the Commission’s
advantage would be if it shared the preferences of the majority in both the
Council and the EP. The rational-choice models are all based on the
assumption that the three actors have different preferences (König and Pöter
2001). If all three actors share the same preferences, there is no conflict, and
therefore no advantage in setting the agenda. Furthermore, it is even less clear
how the preferences shared by the Commission, the majority of the EP and
only a minority in the Council could manage to pass through the legislative
process. Since if the Council does not adopt the joint text by QMV the
legislation fails. Similar objections could be done to the second condition
concerning the levels of “impatience”, if all three actors share the same level of
“impatience” none of them can take advantage of it. Among the three
conditions she lists only the third one concerning the lower likelihood of
Commission’s success when it has a bad relationship with the EP rapporteur
holds. Another reason that makes the Burn’s article less convincing is the fact
that it is based on only one case study (food labelling).
As was noted earlier, rational-choice approaches to agenda-setting is
mainly focused on the analysis of rules. Authors provide few tests and case
studies that would support their results. Among the few authors providing a
test is Tsebelis, who concludes that the Commission’s behaviour (refusal or
adoption of EP’s amendments) predicts the refusal or adoption of 70% of the
11
Tsebelis, “The power”; C. Crombez, “Legislative procedures in the European
Community,” British Journal of Political Science 26, no. 2 (1996), pp. 199-228; C. Crombez, “The
Treaty”; C. Burns, “Co-decision and the European Commission: a study of declining influence?”
Journal of European Public Policy 11, no. 1 (2004), pp. 1-18. For the details of the three
procedures and their differences, see Hix, The political system, pp. 86-87.
12
C. Crombez, “The Treaty.” While in the co-decision I it was the Common Position
adopted by the council on the basis of Commission’s proposal that was adopted in case there is
no agreement about the joint text.
13
Burns, “Co-decision.”
14
Ibid., p. 15.
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legislation under the co-decision procedure, while it was a better predictor
(85%) under the cooperation procedure.15 These results show that in fact the
Commission’s influence was weakened, but not annihilated (as Crombez
suggests), since it well predicts for nearly three-fourths of the legislation, by
the passage from cooperation to co-decision.
Despite the disagreement among authors using different models for the
analysis of the EU decision-making,16 the rational choice literature comes to
the conclusion that the Commission did have a significant formal agendasetting power in the EU decision-making process but that this has weakened
over time. The Commission’s agenda-setting power should be greatest in the
case of legislation adopted by QMV in the Council and through procedures
that do not include the EP. In that case, the Commission should be able to
impose legislation against a minority in the Council. It appears also that while
the EP is pushing for more involvement in the legislative process and since the
co-decision procedure is becoming more used, the formal agenda-setting
power of the Commission might well progressively decrease.17 However even
though there is a substantial literature discussing these various models of
legislative process there is less evidence to support their results.18 In the next
part we will consider concrete examples of agenda-setting in the EU and we
will examine the objections addressed to the rational-choice literature on this
subject.
3. ILLUSTRATIONS OF COMMISSION’S ENTREPRENEURSHIP AND THE LIMITS
OF FORMAL RULES ANALYSIS.
The first objection made to the previously discussed literature has already
been depicted: a lack of empirical evidence.19 The second objection is that
when discussing only the formal decision rules authors do not give account of
the whole decision-making process, they neglect the informal rules that are
significant in the EU as in other polities (Schmidt 2001). According to the
results of the rational-choice theory, the Commission has a significant number
15
G. Tsebelis, C. C.B. Jensen, A., Kalandrakis, and A. Keppel, “Legislative procedures in the
European Union : An empirical analysis,” British Journal of Political Science 31, no. 4 (2001), p.
595.
16
Crombez et al., “Understanding.” P. Moser, “The European parliament as a conditional
agenda-setter: What are the conditions? Critique of Tsebelis,” American Political Science Review
90, no. 4 (1996), pp. 834-838. Tsebelis, “The power.”
17
Crombez, “Legislative procedures.”
18
T. König and M. Pöter, “Examining the EU legislative process: the relative importance of
agenda and veto power,” European Union Politics 2, no. 3, pp. 329-351; S.K. Schmidt, “Only an
agenda-setter? The European Commission’s Power over the Council of Ministers,” European
Union Politics 1, no. 1 (2000), pp. 37-61; Crombez, Steunenberg and Corbett, “Understanding.”
19
S.K. Schmidt, “A constrained Comission: informal practices of agenda-setting in the
Council,” in Schneider and Aspinwall, The rules. Pollack, “Delegation.”
VOL. I,
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of opportunities to push forward its preferred policies. This literature also
understands the Commission as being in conflict with the member states, since
it is assumed to hold a more integrationist position. According to the
principal-agent framework the Commission is seeking for more competences
for itself and therefore more integration.20 However, it will be shown here that
these assumptions have to be nuanced— since the Commission is an efficient
entrepreneur mostly in cases where it has the support of the Council—and
that it is unable to impose its view through an opened conflict with member
states. This argument is also supported by König and Pöter’s analysis, in which
they conclude that the rational-choice models previously discussed overrate
the agenda-setting power of supranational institutions since it is not a very
good predictor of policy change.21
As was mentioned previously, among the areas where the Commission
should have the best chances to exploit its agenda-setting power are the CAP
and the liberalisation of services. Pollack’s analysis an example of the first,22
studying MacSharry’s CAP reform, in which he finds that even though the
Commission was activist during the negotiations it was constrained by the
member states and the use of consensus decision-making.23 Similar analysis is
provided by Schmidt who provides counter-examples of what would be
expected by the formal agenda-setting literature.24 She analyses five examples
of legislation where the Commission should have had (according to the
rational-choice models) taken advantage of its agenda-setting power and it did
not. One of these examples is the liberalisation of electricity services. Policies
concerning the liberalisation of services belong to the category of policies
decided by QMV under the consultation procedure.25 In the case of electricity
services the Commission’s proposal faced severe opposition of France and mild
opposition of Italy and Greece. However, as shown in Figure 2,the
Commission’s proposal could have obtained the majority in the Council at the
expense of a great disproval of the French government. Rather than this, the
Commission eventually accepted several changes to its proposal under the
pressure of various Council presidencies and the version finally adopted
satisfied even the most extreme actor, France. Schmidt explains this outcome
by the informal rule of consensus in the Council.26 Another author who
arrived at similar findings is Thatcher in his analysis of telecommunication’s
Pollack, The engines.
König and Pöter, “Examining.”
22
Pollack, The engines.
23
Ibid., p. 322.
24
Schmidt, “A constrained.”
25
Hix, The political.
26
Pollack underlines the same obstacle to Commission’s agenda-setting in his analysis of the
Working Time directive. Pollack, The engines.
20
21
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liberalisation.27 All these examples show that in cases where the Commission
has the possibility to exploit its agenda-setting power but risks a major conflict
with one or more governments, a consensual solution prevails.
Figure 2. Preference Distribution in the Electricity case
Source : Schmidt, S.K. (2001); p. 134
However this does not mean that the Commission never acts as a policy
entrepreneur. In cases concerning less politically sensitive issues, the
Commission may manage to push through policies in fields where it is
supposed to be disadvantaged according to the rational-choice analysis of
decision rules. The Social policy does not belong among the policies where the
Commission has the greatest chances to exploit its agenda-setting power
(decisions are taken at unanimity in the Council). Despite this initial
disadvantage, Pollack and Hafner-Burton show how the Commission did
significantly influence the legislation in this area.28 The authors analyse gender
mainstreaming policy promoted by the Commission across various other
policy fields. They claim that the condition for the Commission’s success in
this case was careful and strategic formulation of its proposals. They show
how the different “gender mainstreaming officials” in different DGs managed
to introduce this new policy into areas such as Structural Funds, Employment,
Development, Research and Competition, successfully producing regulations,
guidelines and programmes in the first four policy fields. In all the cases the
M. Thatcher, “The Comission and national Governments as partners: EC regulatory
expansion in telecommunications 1979-2000,” European Journal of Political Science 8, no. 4
(2001), pp. 558-584.
28
M.A. Pollack and E. Hafner-Burton, “Mainstreaming gender in the European Union”
European Journal of Public Policy 7, no. 3 (2000), pp. 432-456.
27
VOL. I,
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gender mainstreaming was introduced into existing policy frames of the five
DGs “emphasising efficiency (as opposed to equality)” which made
Commission’s proposals politically more acceptable in the Council.29 It is also
important to mention that originally only a minority of member states (mainly
Scandinavian countries—two of which were new members at the time these
policies started) had a substantive experience with gender-equality policies.
Therefore, we could expect the majority in the Council to be hostile to this
type of policies. When we join to this the fact that the Council is usually
reticent to regulate social policies at the EU level, we can consider that the
gender mainstreaming is a good example of Commission’s leadership and its
informal agenda-setting power. The last was reflected in the fact that the
Commission brought the gender issue to the EU agenda and developed a new
EU policy—gender mainstreaming— with an initial support of only a minority
of member states. On the other hand, this case can not be taken as an example
of Commission’s formal agenda-setting power since the decisions in the
Council were taken at unanimity and the Commission was not taking
advantage of the formal decision rules. What we observe, as Cram underlines,
is rather the ability developed by DG V (Employment, Social affairs, etc.) to
“package issues in the form likely to engender least opposition in the
Council.”30
4. CONCLUSION
This analysis of Commission’s agenda-setting powers reveals that even
though theoretically the Commission could be dictating the agenda under
some conditions, there is little evidence of this really happening. The
Commission does in fact behave as an agent searching to maximise its
preferences, but the agenda-setting power alone does not give it enough
possibilities to overrule the Council. It appears also that the analysis of formal
rules of the legislative process does not explain why the Commission would
not succeed in cases such as Electricity liberalisation (discussed above) or the
Working Time Directive.31 In order to understand the EU decision-making
process other perspectives have to be added, including the study of informal
rules. An issue which was not discussed in this essay, but was touched on in
the introduction, is the rise of issues on the EU agenda rather than their
formulation. The case of gender mainstreaming, exposed above, could raise the
question of whether if the Commission is not an agenda-setter in a sense of
“formulating its preferred policies into legislation,” it could be an agenda-setter
in a sense as Kingdon understands it, bringing in new issues and acting as a
policy entrepreneur. However, such study would involve analysis of other
Ibid.
Cram, Policy making, p.162
31
Pollack, The engines.
29
30
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actors, such as interest groups, and would require more than the space
available here.
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REFERENCES
Burns, C. “Co-decision and the European Commission: a study of declining
influence?” Journal of European Public Policy 11, no. 1 (2004): pp. 1-18.
Cohen, M., March, J. and Olsen, J. “A garbage can model of organizational
choice.” Administrative Science Quarterly, 17 (March 1972): pp. 1-25.
Cram, L. Policy-making in the European Union: conceptual lenses and the
integration process. London: Routledge, 1999.
Crombez, C. “Legislative procedures in the European Community.” British
Journal of Political Science 26, no. 2 (1996), pp. 199-228.
———. “The Treaty of Amsterdam and the co-decision procedure.” In The
rules of integration: institutionalist approaches to the study of Europe, eds. G.
Schneider, and M. Aspinwall (Manchester: Manchester University Press,
2001).
Crombez, C., Steunenberg, B. and Corbett, R. “Understanding the EU
legislative process.” European Union Politics 1, no. 3 (2000): pp. 363-381.
Hix, S. The political system of the European Union. New York: Pelgrave, 1999.
Kingdon, J. Agendas, alternatives and public policies. New York:
HarperCollins College Publishers, 1995.
König, T. and Pöter, M. “Examining the EU legislative process: the relative
importance of agenda and veto power.” European Union Politics 2, no. 3
(2001): pp. 329-351.
Moser, P. “The European parliament as a conditional agenda-setter: What are
the conditions? Critique of Tsebelis,” American Political Science Review 90,
no. 4 (1996): pp. 834-838.
Pollack, M.A. “Delegation, Agency and Agenda-setting in the European
Community.” International Organization 51, no. 1 (1997): pp. 99-134.
———. The engines of European Integration: Delegation, Agency and Agendasetting in the EU Oxford: Oxford University Press, 2003.
Pollack, M.A. and E. Hafner-Burton. “Mainstreaming gender in the European
Union.” European Journal of Public Policy 7, no. 3 (2000), pp. 432-456.
Schmidt, S.K. “A constrained Commission: informal practices of agendasetting in the Council,” In The rules of integration: institutionalist
approaches to the study of Europe, eds. G. Schneider, and M. Aspinwall
(Manchester: Manchester University Press, 2001).
———. “Only an agenda-setter? The European Commission’s Power over the
Council of Minister.” European Union Politics 1, no. 1 (2000), pp. 37-61
Thatcher, M. “The Comission and national Governments as partners: EC
regulatory expansion in telecommunications 1979-2000.” European Journal
of Political Science 8, no. 4 (2001): pp. 558-584.
Tsebelis, B. and Garrett, G. “Legislative politics in the European Union,”
European Union Politics 1, no. 1 (2000): pp. 9-36.
132
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Tsebelis, G. “The power of the European Parliament as a conditional agendasetter.” American Political Science Review 88, no. 1 (1994): pp. 128-142.
Tsebelis, G., Jensen, C.B., Kalandrakis, A. and Keppel, A. “Legislative
procedures in the European Union: An empirical analysis.” British Journal
of Political Science 31, no. 4 (2001): pp. 573-579.
Wendon, B. “The Commission as image-venue entrepreneur in EU social
policy.” European Journal of Public Policy 5, no. 2 (1998): pp. 339-353.
CAN NATIONAL EXECUTIVES USE IMF
CONDITIONALITY AS LEVERAGE FOR DOMESTIC
BARGAINING?
Argentinean National Executive and provincial
negotiations for the IMF’s Financial Shield in
November 2000
Andres Tacsir‡
1.
INTRODUCTION
During the first week of January 2001, Buenos Aires was covered with the
government’s new propaganda slogan: ‘Risk free. Argentina is growing’. After
several months of bargaining, the Argentinean government finally achieved the
Financial Shield (FS), an agreement with the International Monetary Found
(IMF) which would guarantee Argentina’s financing needs for the entire year.
With sovereign bond spreads greater than 10% and the economy in its second
year of recession, the IMF’s offer of US$ 16.3 billon and consequent funding
from different sources (such as the World Bank, the Spanish government and
the Argentinean private bank sector) of US$ 39.7 billon gave the Argentinean
authorities some respite and the hope that the economy would grow again.
The Argentinean National Executive Power (NEP) required several
months to convince the rest of the political actors to commit themselves to
the measures demanded by the IMF. President Fernando De la Rúa and his
cabinet had to implement four demands in order to gain the IMF approval
that would trigger the remainder of the assistance: a reduction in provincial
spending, the approval of the national budget, reform of the social security
scheme, and modification of the health system that was run by trade unions.
The bargaining concerning the National Budget Law and the reforms of both
the social security and health systems required the approval of the National
M.Sc. candidate, School of Public Policy, University College London (expected
November 2005).
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005): 133-150. [ISSN 1748-5207]
‡
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
133
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Congress (NC). By contrast, the cuts in the provincial budgets and the
replacement of the Federal Tax Sharing Mechanism (FTSM) by a new system,
known as Compromiso Federal 2000 (CF2000), involved the head of the
executive in each province.
Although negotiations between the NEP and the provincial governors
lasted only nine days during November 2000, the CF2000 was an important
first step in achieving the IMF conditions that required the full political
resources of the national government. In this essay I analyze the strategy that
the NEP pursued for the signing of the CF2000 in order to obtain IMF
support. As the literature of two-level games postulates, I consider that the
domestic and international levels are linked during international negotiations.
In this sense, my main goal is to analyze whether the NEP used IMF
conditionality as leverage to negotiate with the Provincial Executive Powers
(PEPs). Even though the NEP was urged to secure IMF financial assistance in
order to continue with the Convertibility Plan (CP)1, IMF conditions enabled
the national negotiators to obtain a PEP commitment that was otherwise
unattainable. After the resignation of the vice-president and a near rupture of
the coalition in the government, the NEP needed to restructure its power; in
that situation, the IMF was used as an ally to deal with one of the most
difficult tasks faced by the government: its relationship with the PEPs.
This paper is divided into five sections. In Section II, I describe some of
the main institutional characteristics of the Argentinean political game in order
to understand the importance of the negotiations between the NEP and the
PEPs. In Section III, I turn to my case study and analyse the negotiations
between the NEP and PEPs during November 2002. In Section IV, some brief
conclusions are made. Annex 1 provides an explanation using the rational
choice model of the dynamics of the bargaining between the NEP and the
PEPs concerning the CF2000.
2.
THE INITIAL SITUATION IN THE ARGENTINEAN CASE: GENERAL OVERVIEW
AND INSTITUTIONAL FRAMEWORK
After 10 years of Menem’s Peronist Party (PJ) presidency, UCR’s De la
Rúa led the Alianza coalition that took office in December 19992. Álvarez,
1
The Convertibility plan was a stabilisation programme adopted in 1991. The value of the
domestic currency, peso, was linked to the US dollar with the guarantee that pesos could be
exchanged for dollars at will. The BCRA (Central Bank) was given independence from the NEP
and received the mandate to maintain the value of the peso by holding dollar reserves against its
domestic liabilities. For more details see Mussa (2002). For the evolution of the Convertibility
and its difficulties see Galiani et al (2003).
2
Menem won the presidential elections of 1989 with 45% of the vote. Since that moment
the Peronist party won all the national legislative elections (1991, 1993 and 1995) until the
Alianza was formed. In 1994 President Menem and former President and leader of the UCR,
Alfonsín, signed the Pacto de Olivos (Olivos Agreement) in order to reform the National
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FREPASO’s leader, was elected as vice-president3. Because of the ideological
differences between both parties and as a consequence of their de-facto
alliance for several years in the House of Representatives, the Alianza was
always seen as an electoral coalition incapable of being a governmental
coalition4.
In fact, deep differences between De la Rúa and Álvarez concerning
corruption in the Senate House provoked Álvarez’s resignation in October
20005; after which the stability of Alianza became even more fragile6. Within
weeks, De la Rúa lost political capital as a consequence of several changes in
his cabinet and the loss of important support in the House from legislators
loyal to Álvarez7. Moreover, doubts about De la Rúa’s government without
Álvarez’s support dramatically increased the already high price of access to the
international financial markets (Figure 1).
From the beginning of the Alianza administration, the coalition had to
deal with the same problems that Menem had suffered from during his second
presidency (1995-99) both in the economic and political spheres. On the
political front, there were two main constraints: the struggle to hold stable
majorities in the NC that became even more intense after Alvarez’s
resignation; and the structural tension between the NEP and the PEPs due to
the absence of a definitive agreement governing the relationship among the
different levels of government8, a situation that was exacerbated because the
Constitution allowing Menem to run for re-election. In the presidential election of 1995,
Menem obtained 47.7% of the votes, the newly formed FREPASO obtained 28.2% and the UCR
16.4%. For a detailed description of the tendencies of Argentinean national elections since 1983
see Torre (2003), for the main data concerning the elections since 1983 see Ministerio del
Interior de la República Argentina, Presidencia de la Nación Argentina at
http://www.mininterior.gov.ar/elecciones/estadistica/estadistica.asp, for a general description
of the party system of Argentina between 1983 and 2003 see Malamud and De Luca (2005).
3
The Alianza was mainly formed by the leaders from UCR and FREPASO: from UCR
former President Raúl Alfonsín, Major of Buenos Aires, Fernando De la Rúa and legislator
Rodolfo Terragno were the main figures; main figures from FREPASO were legislators Carlos
Álvarez and Graciela Fernández Meijide. This group was known in Argentina as Grupo de los
Cinco (Group of Five). For an account of the formation, evolution and inherent problems of the
Alianza coalition see Novaro (2001).
4
Novaro (2001), p. 85
5
The New York Times (2000)
6
The Economist (2000b) and (2001)
7
After the elections of October 1999, the Alianza was the largest minority in the House of
257 seats with 124 legislators, the PJ had 99, provincial parties 22 and Acción por la República
had 12; After the resignation of Álvarez in October 2000 the UCR legislators numbered just 81.
At that moment FREPASO’s legislators explicitly conditioned their support for the De la Rúa
government. See La Nación (1999e) and La Nación (2000d).
8
Between 1984 and 1987, the financial relationship between the NEP and the PEPs was in
a legal void and it was characterized by continuous bargaining between the counterparts leading
to a high discretionary scheme for the distribution of national resources. In 1988 the Alfonsín
Administration designed a transitory FTSM. Despite the many changes introduced since 1988 in
the tax structure, the essence of FTSM remained the same throughout the 1990s. During the
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Figure 1. (Source: Elaboration by the author)
Alianza only won governor elections in a few provinces9. In the economic
realm, during 2000 the De la Rúa Administration faced the consequences of a
two year long recession10. Moreover, his electoral commitment to the CP and
the weak fiscal situation of the NEP reduced the new government’s
manoeuvres.
Menem Administration two main changes were introduced which remained in essence until the
CF2000: a) “pre-coparticipation” – the redirection of parts of the taxes originally destined to the
coparticipation scheme towards other purposes – was introduced and b) a fixed-sum transfer
and a minimum transfer to the PEPs were guaranteed by the NEP. The need for coordinating
the efforts at the federal and the provincial levels in order achieve the fiscal and macroeconomic
stability desired by the Menem Administration lead the NEP to design the FPI and FPII in the
early 1990s. The Tax reform of 1998 introduced a new deduction of the coparticipated
revenues. In 1999 the De la Rúa Administration signed the first Compromiso Federal freezing the
transfers from the NEP to the PEPs for one year. For more details see Cetrángolo and Jiménez
(1998) and Scwartz and Liuskila (1997).
9
During the presidency of De la Rúa, the Alianza or the UCR controlled 8 out of 24
electoral districts: Ciudad de Buenos Aires, Catamarca, Chaco, Chubut, Entre Rios, Mendoza,
Rio Negro and San Juan. The province of Corrientes had a federal intervention and thus was
under the control of the NEP – under certain circumstances in Argentina the NEP can remove
the provincial authorities and appoint a federal authority. In 2000 the provinces controlled by
the NEP represented only 30 % of the total transfers from the NEP to the PEPs and
accumulated 35% of the total PEP’s debt.
10
Among the main problems faced by the De la Rúa Administration were: high volatility
of international investment, weak performance of exports, deep economic recession, high
unemployment, deficit management and an impressive governmental debt. For a description of
the Argentinean economy at the end of the 1990’s see Ministerio de Economía de la República
Argentina, MECON (several numbers)
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The PEPs’ fiscal performance showed different phases during the 1990s
as result of both the changes associated with the relationship between the
NEP and the PEP and national macroeconomic performance (Figure 2). Due to
the launch of the stabilisation programme of 1991 and the fast economic
recovery, the PEPs showed a significant growth in tax revenues leading to a
recovery in provincial finances until the financial crisis of 1995. The PEPs
suffered acutely during the Tequila crisis: it was not only an important decline
in tax revenue but also many provinces had to rescue their own provincial
banks and legal limits to control expenditures were introduced in several
provinces. When the economy recovered momentum in 1997, the PEPs
showed the lowest deficits of the decade. However, the fiscal imbalance grew
at the end of the decade mainly due to two factors: the poor revenues of the
provinces and the expansionary expenditure policies11.
Figure 2. PEP’s global and primary result as percentage of the GDP
(Source: Author’s own elaboration on MECON)
The fiscal deficit of the provinces was financed in different ways
throughout the decade. The CP and the reform of the BCRA Charter of
1992 imposed important constraints on the fiscal deficit financing
limiting the capacity to borrow from official banks, a tendency that was
exacerbated with the privatisation of many provincial banks after the
Tequila crisis. These restrictions were counterbalanced by the
favourable financial context of the early 1990s and the provinces had
good access to the private markets until the 1995 crisis. After the
Tequila crisis the borrowing conditions for the provinces changed,
11
The data concerning the results for each province for the period 1991-2000 can be found
in Annex 2
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requiring a more active participation of the NEP. Stock of provincial
debt accelerated at the end of the 1990s, the ratio debt stock/GDP
growing from 4.6% in 1997 to 6.7% in 1999.
There are two main characteristics of the relationship between the NEP
and the PEPS that are useful to introduce the framework upon which the
bargaining of the CF2000 was based. Firstly, general and intra-party electoral
rules in Argentina12 transfer power away from the NC and the national parties
in favour of provincial leaders or governors. The provincial leaders are key
players in the nomination process of the legislative candidates, with the
national party leadership and rank-and-file members playing a secondary role.
Therefore, national legislators owe allegiance to the provincial party leader.
Politics are done at the level of provincial party leaders; during informal
assemblies of governors, with each of them controlling a substantial number of
legislators, each governor may actually act as a veto player and increase their
power vis-à-vis the executive13.
Secondly, PEPs undertake a large portion of total spending and a small
fraction of taxation in the Argentinean federal fiscal game. So the provincial
leaders get a large share of the political benefit from spending and a small
fraction of the political cost from taxation. Moreover, the central government
usually bails out provinces with fiscal problems in a context of FTSM rigidities
and loopholes that provide poor incentives for fiscal responsibility. The
provinces’ dependency creates incentives for opportunistic manipulation from
the NEP; to avoid discretionary allocation of resources, political actors have
attempted to increase the rigidity of the FTSM14,15.
3. CASE STUDY: NEGOTIATIONS BETWEEN THE NEP AND PEPS FOR
PROVINCIAL DEFICIT REDUCTION IN NOVEMBER 2000
3.1. The initial movements
12
Argentina is a federal republic with a presidential form of government and a bicameral
legislature. Argentina has 24 electoral districts (23 provinces and a federal capital) which have
their own elected head of government, the governor. According to the National Constitution,
the PEPs hold all the powers that they have not delegated to the NEP.
13
Spiller and Tommasi (2003), p. 292.
14
Ibid, p. 296.
15
According to the National Constitution reformed in 1994, a new “definitive” FTSM
should have been approved before the end of 1996. Nevertheless, there was no revision of the
FTSM made at all during the 1990s and consequently all the arrangements established to rule
the FTSM since 1997 had a “transitory” character. Between the reform of the ANC and the end
of 1999, several proposals to reform the FTSM were made by Remes Lenicov in 1997, López
Murphy in 1998, the Menem Administration itself and Ortega, both during 1999. For more
details of these proposals and the difficulties of reaching a “definitive” agreement on the FTSM
see Cuevas (2003),
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The De la Rúa Administration had among its main objectives the
reduction of the budget deficit. From the first moment he was elected
president16, De la Rúa showed a clear interest in the reduction of both the
national deficit and the provincial budgets17. This signal was internationally
welcomed, generating the public support of top bureaucrats in international
organisations as well18.
In November 2000, once the government disclosed that negotiations with
the IMF for an extraordinary assistance package were on the table, De la Rúa
personally started negotiations with the PJ. Before important details of the
NEP plan associated with the FS conditionality were known, PJ’s legislators
and governors informally expressed their support to the NEP in order to
strengthen the government’s position vis-à-vis the IMF19. In the first round of
negotiations, the NEP announced its position to the PEPs: a freezing of both
the transferences from the NEP to the PEPs and of PEPs spending for 5 years
until 2005.
The PEPs rejected the NEP’s offer. Showing that both the acceptable
spending and transfer minimums were much higher than those offered by the
NEP’s, the PEPs made a new proposal: control of employment and food
assistance programmes managed by the NEP, the creation of an
unemployment insurance, a new educational programme, a new infrastructure
investment plan, an agreement for provincial debt repayment, and a new
national budget law. When the heads of the PEPs, such as Ruckauf, De la Sota
and Kirchner20, made their suggestions, trying to raise the sovereignty cost of
the NEP, they pointed out that the NEP needed to undertake measures in
response to the social problems of their provinces21.
According to the model developed in the annex, the NEP’s ideal point was
in segment [A]. In such a situation the best outcome the NEP could obtain
The formula De la Rúa-Álvarez won the presidencial election on 26, November, 1999.
La Nación (1999a), La Nación (1999b) and La Nación (1999c). Moreover, the
appointment of several economists in his first cabinet was seen as a clear signal of the
commitment of the government to fiscal discipline. See The Economist (1999a)
18
See La Nación (1999d) and The Economist (2000a). After his trip to Argentina in May
2000, IMF Managing Director Mr. Köhler was asked in a press conference about the
Argentinean need to reduce the deficit. He answered that he was “quite impressed that the
President of Argentina strongly told me that it is his government’s program and not an
imposition of the IMF. So I took note of that and of course I was pleased with that because it is
my own understanding. And I will look how it is implemented, that whatever we do, from here,
from the IMF, the ownership of programs and reforms is very, very important. That there is
ownership is more important than a short-term effect of maybe a number, a specific number, in
a program of the IMF”. See IMF (2000)
19
Clarin (2000)
20
Ruckauf was the governor of Buenos Aires, De la Sota of Córdoba and Kirchenr of Santa
Cruz.
21
For the declarations of Kirchner see La Nación (2000a), for declarations of De la Sota see
La Nación (2000b) and for Ruckauf’s see La Nación (2000c)
16
17
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was the minimum value of deficit accepted by the PEPs. The ideal deficit of
the NEP was much lower than the minimum value of deficit tolerable by the
PEPs. At the same time, in such a situation, the deficit demanded by the IMF
was higher than the one demanded by the NEP. Moreover, in the particular
situation of the bargaining for the CF2000 the NEP knew that a higher
reduction in the deficit would be achievable if some patterns of the bargaining
were changed. In order to do that, the NEP needed to change some of the
most relevant sets of information available for the PEPs.
3.2. The final agreement
After each of the proposals was rejected by the other party, the situation
arrived at a deadlock. How could the NEP rapidly overcome the impasse in
order to obtain the financial support of the IMF and achieve a higher
provincial deficit reduction than the one demanded by the IMF? To achieve
an agreement that fulfilled its expectations, the NEP had few alternatives: to
increase the value of the general rejection cost, to increase the value of the
particular rejection cost of the PEPs, or to change its ideal point. The adoption
of the last option meant that the NEP would not use the IMF as leverage for
bargaining. Since the negotiations with the IMF were already public, the
strategy of increasing both costs was adopted by the NEP.
In order to be able to blame the PEP leaders for rejecting IMF
conditionality, the NEP started to stress the high cost that a non-agreement
would have for both the national economy and the provincial economies22.
When the De la Rúa Administration made its first move, the economic
situation of Argentina was dramatically worse than the year before he took
office. The combination of internal and external shocks produced an increase
to the interest rate that the government had to pay in order to access the
international financial markets. This consequently started to generate doubts
about Argentina’s capability to service the debt23. The high level of the PEP
debts and the need to get financial resources forced the PEPs to attempt to
avoid the closures of any international financial source, and this was used by
After one of the bargaining rounds concerning the viability of the PEPs’ plan, Colombo,
the Cabinet Chief, said that “the (PEPs’) proposal is inadmissible economically and politically.
We are responsible enough to not accept a proposal that would increase the expenditure up to
the point that the economic plan and the Argentinean economy will explode”. Concerning the
eventual cost for the provinces, Colombo stated that “if an agreement is not reached, it is going
to be very harmful, even for some Peronist provinces with high debt burden”. See La Nación
(2000a)
23
The Economist (2000c). According to Vreeland (2003) the cost of rejecting the IMF, (r
in the model in annex 1), is that it sends negative signals to creditors and investors. A country
particularly sensitive to the decisions of creditors and investors has a high r. Therefore,
Argentina during the negotiation had a very high rejection cost.
22
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the NEP as another tool in the negotiations24. When signing the CF2000 with
their allied governors, the PEPs also pressed the PJ heads of provinces.
Moreover, with the next election close, the PJ governors did not want to bear
the burden of the domestic political costs of rejection25.
During the negotiations, the links between international and domestic
actors played a very important role. The American, Spanish and Italian
governments publicly stated that their countries would support the
international assistance package. The IMF announced in several instances that
its bargaining groups were ready to go to Buenos Aires and it was just waiting
for an agreement between the PEPs and the NEP26. Both strategies could be
read as attempts to show that the PEPs were to blame for any failure in
negotiations. Moreover, according to some versions, the bureaucrats of
international organisations participating in the bargaining emphasised the high
risk that their provinces would bear if the agreement was not achieved to
influential governors such as De la Sota and Ruckauf27.
Finally, after nine days of bargaining, the CF2000 was signed by the NEP
and the PJ governors. The final document stated that the NEP’s and PEP’s
budget was frozen until 2005 and spending increases could only be made in an
emergency context in the education, health and security realms. Essentially,
the new CF2000, replacing the one signed in December 1999, froze monthly
NEP transferences to the PEPs at $ 1,364 million for 2001 and 2002 (the same
level as 2000) and forced the NEP to transfer entirely the amount for Social
Programmes in 2001 ($225 million) and only 30% of that total between 2002
and 200528.
4. CONCLUSIONS
In this essay I have described the negotiations between the NEP and the
PEPs in the context of bargaining between the Argentinean NEP and the IMF.
We have tried to demonstrate how the presence of the IMF gave the NEP
important leverage in bargaining. At the end of the negotiations, the agreement
was celebrated by the NEP while the PEPs pointed to the great effort made to
sign it. Nevertheless it is very hard to know whether the level of provincial
spending finally agreed was consistent with the NEP’s ideal point.
24
Colombo again said that “ the majority of the provinces, and the nation, need to roll-over
because they have a stock debt and need international financial assistance”, La Nación (2000e)
25
The electoral horizon was not restricted to the legislative elections of 2001 but also to
the presidential one of 2003. The governors of the three more important provinces controlled
by the PJ (Buenos Aires, Córdoba and Santa Fé) were participating in competition within the PJ
to become the Peronist candidate. In that context, these governors tried to avoid blame for any
political costs that the country might bear.
26
La Nación (2000f)
27
La Nación (2000g) and La Nación (2000h)
28
A detailed explanation of the CF2000 can be found in World Bank (2001)
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To know if the first proposal of the NEP was the product of its ideal point
or was just a bargaining strategy is a topic that requires more research. At the
same time it is very important to decipher whether the provincial deficit
objective of the NEP was more rigorous than the IMF’s objective. Moreover,
the role that the IMF played in the negotiation also requires further analysis
since at the end of the day, the success or failure of Argentinean politics are
inextricably linked to these kinds of external negotiations.
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APPENDIX 1
The model: the logic of using IMF conditionality as leverage in bargaining
Any international negotiation can be conceived as a two-level game as in
Putnam’s seminal essay Diplomacy and domestic politics: the logic of two-level
games29. An important literature containing both theoretical and case study
analyses has appeared supporting or challenging Putnam findings30. Among the
most recent and interesting works on this topic, Vreeland’s (2003) approach
on negotiations between IMF and developing countries for financial assistance
is useful for understanding my case study. Vreeland states that a pro-reform
executive of a developing country may introduce the IMF into the national
bargaining in order to achieve reforms that are seen as otherwise politically
impossible. By entering into an IMF agreement, an executive ties its preferred
policies of economic reform to the conditions of the IMF. For opponents of
economic reform, this move raises the rejection cost of the executive’s
proposal because a refusal is no longer the mere rejection of the executive’s
proposal but also of the IMF’s. A total rejection of the IMF not only limits the
credit that the IMF will extend to the country but it also sends out costly
negative signals to creditors and investors.
To explain how the NEP used the IMF conditionality during the
negotiations for the assistance package that attempted to reduce PEPs’
spending in November 2000, I will adapt Vreeland’s model. Consider a game
involving three actors: the NEP, and the veto players consisting of the PEPs
and the IMF. The agreement between the NEP and the IMF is negotiated over
one dimension: the provincial budget deficit, d, that can be expressed by the
interval [0; 1]. At the beginning of the game, the status quo (SQ) implies that
d=1. Each of the actors has an ideal deficit point di, the ideal deficit of PEPs31 is
1, the IMF’s ideal is 0 and the ideal point of NEP is somewhere in the interval
[0; 1]. The ideal point of IMF and PEPs are publicly known; however, NEP’s
Putnam’s main idea is that during international negotiations each national leader sits
simultaneously in two boards that interact: at the international board, the national
representative sits amongst his foreign counterparts while at the domestic board he shares the
table with his constituency, such as party and parliamentary figures, spokespeople from
domestic agencies, or key interests groups. The main goal of the international negotiator is to
make moves that are rational simultaneously on both boards, despite the fact that some moves
that are rational for the national leader on one of the boards are impolitic for him in the other
one.
30
See Milner, H. and Rosendorff, P. (1997), Mo (1994), Mo (1995) and Mayer (1992).
31
During the essay I consider the PEPs as a unitary actor, which requires additional
qualifications. First, it is logical to exclude from the PEPs the provincial leaders that are of the
same party as the NEP. Second, among the PEPs governed by opposition parties, several
differences exist on the ideal point. We can suppose that the veto player with the most distant
ideal deficit reduction from the NEP ‘absorbs’ the other veto players. See Tsebelis (2002),
especially Chapter 1.
29
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ideal point is private information. In short, PEPs want to keep the provincial
deficit at the SQ level, the IMF wants to eliminate it, and the NEP wants a
new level between the two.
Figure A1 – The structure of the game
Situation 1
Accept
PEP
Reject
Proceed
NEP
Approach
Situation 2
Stop
NEP
Situation 3
Not Approach
Situation 4
Source: Author’s own elaboration on Vreeland (2003)
What are the dynamics of this game? The NEP makes the first move: it
chooses to approach or not approach the IMF for the negotiation of an
agreement. If the NEP chooses not to approach, it accepts the SQ (Situation 4
in Figure A1). If the NEP approaches the IMF, it must pay the sovereignty
cost, s, and the IMF reveals its position of the maximum acceptable level of
deficit, n. After observing n, the NEP can ‘proceed’ with the negotiations or
‘stop’. If the NEP stops, the deficit remains at SQ and the game ends (Situation
3). If the NEP ‘proceeds’, it must, with the IMF, stipulate a level of provincial
deficit, a. The IMF only agrees the values of a lower than or equal to n. The
higher the value of n, the wider the range of acceptable a values becomes. The
NEP announces publicly the value of a, that was agreed with the IMF. The
PEP may ‘accept’ or ‘reject’ the agreement. If the PEP ‘accepts’ the agreement,
the new deficit is a (Situation 1). If the PEP rejects the agreement (Situation
2), both the PEP and NEP will send a strong negative signal to the markets: the
country has not the political will to undergo economic reforms. Thus, by
choosing to reject, the deficit remains at SQ and both PEP and NEP bear the
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general cost of rejection r plus the particular rejection cost for each of the
national actors, rp (for the PEPs) and re (for the NEP)32.
Table A1- Payoff of the game
Players Payoffs
Situation
Outcome
PEP
NEP
IMF
1
s, d = a
- │1 – a │
- │ a -dG │-s
-a- (1-n)
s, r, rp, re, d =1
- r-rp
- │ 1 -dG │-s -r-re
-1
0
- │ 1 -dG │-s
-1
0
- │ 1 -dG │-s
-1
2
s, d = 1
3
4
d=1
Source: Author’s elaboration on Vreeland (2003)
The utility of each agent can be expressed as the negative distance from
the actor’s ideal point. Each situation produces a particular outcome and has a
different payoff for each player (Table A1). Given the different payoffs, it is
possible to find equilibrium. Using backward induction, I can see that the PEP
will accept the agreement in the last node of the decision tree if the cost of
rejection is higher than the acceptance cost. We can see that the PEP has a
minimum acceptable deficit (1-r-rp), m. For any agreement value of deficit less
than m, the PEPs would be better off rejecting the agreement and paying r
rather than accepting. The PEPs will accept an agreement if a  1 – (r+rp). If
the cost of rejecting is 0, the PEP will only accept an agreement that maintains
the deficit of SQ; at the highest possible cost of rejection, the PEP will accept
any agreement. Concerning the second node, since the NEP faces r + re if the
PEP rejects the agreement, the NEP prefers outcome 2 rather than outcome 3.
Even though in Vreeland’s model the only rejection cost is r, I consider that in this kind
of situation, one of the most relevant elements is the different political costs that each actor has
to bear.
32
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Because the NEP knows the values of m and n, it will only proceed if n ≥ a ≥
m.
The conditions for an agreement can be explained as a function of the
interrelated preferences of the three actors (Figure A2). First, I must specify
the “acceptable set” for both the PEPs and the IMF. Since n is the maximum
deficit that IMF will accept and m is the minimum deficit that PEP will
tolerate, the agreement only can be reached if m < n. If the NEP observes that
m > n, the NEP will stop negotiations; as a result the deficit will be equal to
the SQ and the NEP will pay the cost s (Situation 3). Second, I have to
consider the different outcomes in function of the ideal point of the NEP. The
NEP’s ideal deficit, dNEP, can be located in any of the four segments of the
interval [0; 1]. If dNEP is located in segment A, then the best value of deficit in
the “acceptable set” for the NEP is m. In this situation the NEP is austere and
will negotiate for the minimum possible deficit, even beyond the IMF’s
demands. If the dNEP is located in the segment B, the NEP can negotiate for a =
dNEP that sets the agreement deficit in its ideal point. In this situation, the NEP
goes beyond what the IMF demands but stops before m. If dNEP is in the
segment C, the NEP cannot do better than propose an agreement with a = n.
If dNEP is in the segment D, IMF’s demands are too hard and an agreement can
not be achieved, since the NEP prefers the SQ rather than an agreement with
a = n. In brief, an agreement will only be made if m ≥ a and dNEP ≤ (n+1)/2.
Fulfilling these conditions, the value of a in the agreement will be between
the maximum value of m and the minimum between dNEP and n.
Governments often claim that the IMF austerity goes beyond their
preferences, that is, n < dNEP. Nevertheless, since the PEPs are only able to
observe a, they do not know if a reflects the maximum deficit acceptable to
the IMF, n, or the NEP’s ideal point, dNEP.
Figure A2- The conditions for an agreement
A
0
B
m
C
n
D
(n+1)/2
Source: Author’s Own elaboration on Vreeland (2003)
1
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APPENDIX 2: Argentinean Provinces: Global Result (in $ thousands)
POWER VS. PRIDE: U.S. POLICY TOWARD
IRAN’S NUCLEAR AMBITIONS
Iyanuloluwa Adewuya‡
1.
INTRODUCTION
The proliferation of nuclear weapons among states is widely recognized as
the most serious threat to the national security of the United States. Official
and public attention to nuclear proliferation issues, however, has varied over
the decades from near-hysteria to apathy. Although non-proliferation efforts
have steadily advanced over the past two decades, these advances have never
been easy and never without serious setbacks. While some nations renounced
their nuclear weapons programmes, others started new ones.
One of the most urgent issues confronting the U.S. today is Iran’s nuclear
ambitions. Iran’s recent rejection of a European demand to stop building a
heavy water nuclear reactor indicates a hardening of its position on a key part
of its nuclear facilities that observers claim is part of a weapons program.1 This
announcement comes as the clearest declaration yet of its nuclear intentions.
Furthermore, in recent weeks, Iran’s top leaders have adamantly stated that
Iran won’t entirely abandon its nuclear program.
Historically, U.S. efforts to control the spread of nuclear weapons has
focused on keeping countries from getting the technical means for building
and delivering the bomb. Robert Hunter rightly notes that “rarely have U.S.
administrations considered the incentives that countries have to build nuclear
weapons, with a view to helping provide some alternative means for satisfying
such ambitions.”2
This paper will therefore attempt to provide an in-depth view of Iran’s
current domestic configuration and international environment with the goal of
M.Sc. candidate (International Public Policy), School of Public Policy, University College
London (expected November 2005). Contact with questions/comments:
i.adewuya@gmail.com.
1
Ali Akbar Dareni, “Iran Rejects European Demand on Reactor,” Associated Press,
February 13, 2005.
2
Robert Hunter, “Engage, Don’t Isolate, Iran,” San Diego Tribune, June 27, 2004.
INTERNATIONAL PUBLIC POLICY REVIEW, vol. I, no. 1 (September 2005): 151-164. [ISSN 1748-5207]
‡
© 2005 by The School of Public Policy, University College London, London, United Kingdom. All rights reserved.
151
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threshing out its motives and incentives for embarking on a nuclear
programme in the first place. Having mapped out these elements, this paper
will then seek to examine several policy options that are currently being
debated by Washington policymakers and finally lay out an alternative
proposal of what an appropriate U.S. foreign policy would be towards Iran’s
nuclear ambitions.
2.
INSIDE IRAN
Iranian officials have admitted to the United Nations International Atomic
Energy Agency (IAEA) that they have been secretly developing a broad range
of nuclear capabilities for the past 18 years.3 Although the IAEA did not
consider Iran’s many violations of specific nonproliferation rules proof that
Iran had a nuclear weapons program, many international nuclear experts have
agreed that the types of experiments Iran was conducting—such as uranium
enrichment by laser—strongly suggest the existence of a nuclear weapons
program. This suspicion was enhanced by the discovery that Iran’s secret
nuclear program included all the steps needed to make fissile material for a
nuclear bomb. Predictably, Iranian officials insist that their program is
committed to nuclear power and other peaceful commercial uses including
the goal of becoming a major nuclear fuel supplier in 15 years.4 This argument
is swiftly rebutted by those who point out that it is highly economically
inefficient for a country with the world’s sixth largest oil reserves to spend
billions of dollars on developing nuclear power plants.
But beyond these claims and counterclaims, effective non-proliferation
policies must account for the differences in capabilities, intentions, priorities
and incentives between governments. Hence, a clearer understanding of why
the Iranian government chose its current nuclear policies is primordial in the
search for policies that contribute to efforts to halt the spread of nuclear
weapons.
2.1. Internal Elements
Takeyh rightly observes that “as a state unleashes a nuclear program, it
creates political and bureaucratic constituencies and nationalistic pressures
that generate their own momentum. As such, a state can cross the point of no
return years before it assembles a nuclear bomb…As Iran crosses successive
nuclear demarcations, its program becomes a subject of national pride and
3
Council on Foreign Relations, Iran: Nuclear Weapons,
http://www.cfr.org/background/iran_nuclear.php (February 8, 2005).
4
Ali Akbar Dareni, “Iran Rejects European Demand on Reactor,” Associated Press,
February 13, 2005.
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popular acclaim.”5 Quite noticeably, the nuclear issue has become
progressively subsumed in Iranian nationalism. Notions of sovereign rights and
national dignity are rapidly displacing calls for adherence to international treaty
commitments. As former President Hashemi Rafsanjani acknowledged in a
sermon June 11, "No official would dare allow himself to defy the people on
such an issue."6 These domestic political imperatives were most recently
reflected in President Mohammed Khatami’s recent statements asserting Iran’s
sovereign right to pursue a nuclear program. Khatami, who is widely
recognized as a leader of a moderate faction in Iran, indicated that the talk of a
possible U.S. invasion was pushing him into a united camp with Tehran's
hard-liners.7
This overall logic is supported by the striking observation that, some of
the most strident critics of Iran's accommodation to the international
community on the nuclear issues have been student organizations. Although
Iran's students have largely been associated with progressive causes since they
have been the most vocal advocates of greater democratization and reform, on
the nuclear issue, Iran's educated youths view disarmament agreements as a
weakening of their national rights and have warned their elders against
relenting to external pressures.8 The effect of these domestic pressures is
reflected in the recent statements of various Iranian officials who have
suggested that any acceptance of a permanent freeze of its nuclear activities
would collapse the government since its program is a matter of national pride
and prestige.9
Complicating matters even further is the emergence of a domestic
establishment with its own parochial considerations. With the patronage of
the Revolutionary Guards, a variety of organizations such as the Defense
Industries Organization, university laboratories and a glut of commercial firms
often owned by hard-line clerics have spearheaded Iran's expanding and
lucrative nuclear efforts.10 Furthermore, the fact that Iran’s nuclear program is
run by the hard-line Revolutionary Guards becomes even more disturbing
when considered in light of Scott Sagan’s seminal argument that “professional
military organizations—because of common biases, inflexible routines and
parochial interests—display organizational behaviors that are likely to lead to
deterrence failures and deliberate and accidental wars.”11
Ray Takeyh, “Nuclear Momentum,” Baltimore Sun, September 1, 2004.
Ibid.
7
Ali Akbar Dareni, “Khatami: Iran Would Be Hell for Attackers,” Associated Press,
February 10, 2005.
8
Ray Takeyh, “Nuclear Momentum,” Baltimore Sun, September 1, 2004.
9
Dareni, “Iran Rejects European Demand on Reactor”
10
Ibid.
11
Scott Sagan & Kenneth Waltz, The Spread of Nuclear Weapons: A Debate Renewed (New
York: W.W. Norton, 2003), p. 47.
5
6
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A vital, yet underanalyzed, factor is the fact that the domestic political
security benefits of a nuclear program can be quite substantial. “On a
commercial scale, nuclear power can centralize government authority, and
extend it throughout the economy, in so far as it is imposed upon businesses
which had relied on their own electric generators. It can enforce popular
dependence upon the leadership, while widening the base for government
revenues to include all buyers of state-generated electricity.”12 Since, by its
own admission, the current regime’s overriding socioeconomic goal of
equitable distribution of wealth has yet to be met, a convincing argument can
be made that one of the prime motivations of the regimes nuclear energy
program is to consolidate and reinforce its domestic hold.
But do the Iranians want to get the bomb regardless of its consequences?
Despite the ominous developments discussed above, it should not be assumed
that the perennially fractious Iranian theocracy has settled on its course of
action. A subtle yet significant debate regarding the strategic utility of nuclear
weapons is going on within the government’s corridors of power. Although all
contending factions are united on the need to sustain a vibrant nuclear
research program, the prospect of actually crossing the nuclear threshold has
generated vigorous disagreement.13
A coalition of pragmatic conservatives and reformers that questions the
strategic value of nuclear weapons has gradually emerged. This coalition has
challenged the hard-liners' reasoning by counter-arguing that the possession of
such arms would actually increase Iran's vulnerabilities. Their logic holds that
“Should Iran cross the nuclear threshold, the Persian Gulf states and the newly
independent Iraq would probably gravitate further toward the American
security umbrella. Moreover, such a brazen act of defiance would probably
trigger debilitating economic sanctions and estrange Iran from its valuable
European and Japanese commercial partners.”14
Although the discussion above is unable fully explore the full scope of all
the vital domestic factors and internal dynamics that are directly affecting the
Iranian government’s calculations, it has adequately demonstrated that the
interplay between public sentiment, parochial politics and domestic political
security presents a far more complex but accurate picture of its motives and
intentions. Furthermore, it hints at the possibility of a peaceful solution
through of a carefully calibrated strategy which wisely harnesses various
competing aspects of Iran’s domestic environment.
12
Daniel Poneman, “Nuclear Policies in Developing Countries”, International Affairs 57,
(Autumn 1981): p. 574.
13
Ray Takeyh, “Wrong Strategy on Iran,” The Washington Post, September 10, 2004.
14
Ibid.
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2.2. External Factors
A strong argument can be made that Iran’s nuclear calculations are not the
products of irrational plans but are rather the result of a purposeful attempt to
create a viable deterrent capability against a range of regional threats. Takeyh
itemizes the primary sources of these calculations:
For the past two decades, Saddam Hussein's Iraq determined Iran's
defense priorities, propelling Tehran toward a nuclear option as a
means of deterring a dictator who had already proved willing to
unleash weapons of mass destruction against Iranian cities.
Given Hussein's demise, America has emerged as Iran's
foremost strategic quandary. The Bush Doctrine, which pledges the
preemptive use of force as a tool of counter-proliferation, along
with the substantial growth in American power along Iran's
periphery, has intensified Tehran's fears that the Islamic Republic
will be the next U.S. target. Borrowing a page from the North
Korean playbook, Iran is now brandishing its nuclear program to
strengthen its leverage vis--vis the American colossus.
Iranian policymakers across the political spectrum agree on the
necessity of maintaining a nuclear program with advocates
propounding the existential threats surrounding Iran.15
It must be pointed out that in the mid-1970s Iran was often referred to as
an example of a state that might be motivated to acquire nuclear weapons by
the desire for national prestige. “This was implied by the Shah’s ambitious
programs of modernization, economic development, and investment in
sophisticated conventional military forces, and the increased acceptance in the
West of Iran as the dominant power in the Persian Gulf area.”16 Although the
Shah’s works are despised by the revolutionaries who overthrew him, it is not
clear that their foreign policies have been far different. What appealed to the
Shah as a means to grandeur appears to now appeal to his successors as a
means toward independence from both Eastern and Western powers.17
Old-fashioned strategic analysis quickly reveals that Iran genuinely feels
insecure in its neighborhood. This is not just because of historic tensions with
neighbors like Iraq but also because it is surrounded by U.S. military power
(present in Afghanistan and Iraq) and a declared U.S. intent on bringing about
regime change. “For years, America supported Iranian exile groups in military
operations within Iran, including the Mujahedin-e-Khalq, which was harbored
by Iraq's Saddam Hussein and has only recently been put on the U.S. list of
Ray Takeyh, “Iran’s Nuclear Skeptics,” The Washington Post, April 25, 2003.
Richard K. Betts, “Incentives for Nuclear Weapons: India, Pakistan, Iran,” Asian Survey
19, (November 1979): p. 1063.
17
Ibid.
15
16
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terrorist groups.”18 Having been branded as a member of the infamous "axis of
evil", Iran could reasonably assume it was on the U.S. hit list. It is hard
therefore to be surprised that U.S. statements and actions may actually
reinforce Iranian ambitions to acquire a nuclear capability. Furthermore,
“international sensitivity to the abuse of nuclear technology gives its users
considerable bargaining leverage, which increases the closer a country comes to
nuclear weapons-building capability.”19
The above discussion on Iran’s external environment reveals that the
Iranian government may have legitimate fears that are brought about by the
nature of ‘self-help’ international system and is simply resorting to nuclear
capabilities as a means of satisfying its current security imperative. Whether
these fears are legitimate and whether there may be effective policies to help
alleviate them is a subject will be explored further.
3. THE POLICY OPTIONS
On both sides of the political spectrum, it already seems to be a settled
political question in Washington that Iran cannot be permitted to acquire a
nuclear weapon. Analysts assert that even if Tehran did not threaten to use
them against its neighbors or give aide to terrorists, Iran’s becoming a “nuclear
power,” however fledgling, would radically alter regional politics and
relationships in the Middle East and significantly complicate the problems
facing the U.S. and others.20
Although a full investigation of the pros and cons of all the policy options
available to the current U.S. administration is beyond the scope of this paper,
this section will analyze the most vital elements which will play a significant
role in the analysis of the both the efficacy and feasibility of several policy
options which are currently being debated. Finally, an alternative policy
proposal will be laid out.
3.1. Preemptive Strike
On June 7, 1981, the Israeli Air force used a surprise air attack to destroy
the Iraqi Osirak nuclear reactor which was located 30 kilometers South of
Baghdad. Although the Bush administration has not made any definitive
statements about the possibility of a lightning strike similar to Israel’s which
would destroy Iran’s nuclear facilities, this option has increasingly been on the
front burner of recent public discourse with Vice President Dick Cheney even
Robert Hunter, “Engage, Don’t Isolate, Iran,” San Diego Tribune, June 27, 2004.
Daniel Poneman, “Nuclear Policies in Developing Countries,” 574.
20
Robert Hunter, “Talk it Out Before It’s Too Late: Engagement Now Could Defuse a
Nuclear Crisis,” Los Angeles Times, August 27, 2004.
18
19
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hinting at the possibility of another Israeli-type operation.21 Such an option
must first be examined in light of its feasibility and policy implications.
David Sanger’s New York Times article reveals that U.S. military planners
are almost unanimous in their assessment that there are no effective military
ways to wipe out a nuclear program that has been well hidden and broadly
dispersed across the country, including in crowded cities.22 Analysts argue that
a preemptive strike against Iran's missile or nuclear assets is problematic
because the targets are too far away, too numerous and dispersed, and too well
protected with some of them in deep underground installations.
It is vital for policymakers not to draw uninformed parallels between
Israel’s relatively successful strike on Osirak and the possible outcomes of a
U.S. strike on Iran’s facilities. Producing a valid estimate on the likely extent of
damage to Iranian installations will be inherently problematic, given that the
more sensitive portions of these facilities were built underground specifically
to guard against a destructive attack. A preemptive strike is further
complicated by the fact that Iran has purchased and deployed advanced
Russian air defense systems to guard these nuclear facilities.23
American and European intelligence officials say Iran has taken the lessons
of Osirak to heart, spreading its nuclear facilities around the country, burying
some underground and putting others in the middle of crowded urban areas.
Sanger’s article reveals that the IAEA last year found centrifuges, which are
used to enrich uranium, behind a false wall at the Kalaye Electric Company in
a densely populated corner of Tehran, where there would be no way to
conduct a military strike without causing major civilian casualties. The
military options therefore “range from the bad to the unimaginable.”24
Finally, the political and diplomatic ramifications of such an endeavor
must be thoroughly scrutinized. In the absence of an Iranian nuclear weapons
program, which IAEA inspectors have yet to find, a preemptive attack by the
United States would provide Iran hardliners with the justification they sorely
need to pursue a full blown covert nuclear deterrent program, without the
inconvenience of current IAEA inspections. Such an attack would therefore be
likely to weaken any diplomatic coalition to back stringent sanctions against
Iran. Without intrusive inspections or threat of UN Security Council
sanctions, the only way to prevent Iran from obtaining nuclear weapons
capability would therefore be to occupy Iran. Given the gargantuan challenges
Stan Crock, “Why Iran Can Thumb its Nose at Washington”, BusinessWeek Online,
www.businessweek.com/magazine/content/05_09/b3922091_mz015.htm, February 24, 2005.
22
David E. Sanger, “The U.S. vs. A Nuclear Iran,” The New York Times, December 12, 2004.
23
Sammy Salama, Karen Ruster, A Preemptive Attack on Iran’s Nuclear Facilities: Possible
Consequences, Monterey Institute of International Studies,
http://cns.miis.edu/pubs/week/040812.htm, February 8, 2005.
24
David E. Sanger, “The U.S. vs. A Nuclear Iran”
21
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currently being faced by the United States in Iraq, the possibility of such an
occurrence is largely in doubt.
3.2. Economic Sanctions
Since the seizure of the U.S. hostages in Tehran in 1979, economic
sanctions have formed a major part of U.S. policy toward Iran. To date, few, if
any, other countries have followed the U.S. lead by imposing sanctions, and no
U.N. sanctions on Iran currently exist. A number of these U.S. sanctions have
been specifically tailored for Iran:
The Iran-Iraq Arms Nonproliferation Act (P.L. 102-484) requires
denial of license applications for exports to Iran of dual use items,
and imposes sanctions on foreign countries that transfer to Iran
“destabilizing numbers and types of conventional weapons,” as well
as WMD technology. The Iran Nonproliferation Act (P.L. 106-178)
authorizes sanctions on foreign entities that assist Iran’s WMD
programs. It bans U.S. extraordinary payments to the Russian
Aviation and Space Agency in connection with the international
space station unless the President can certify that the agency or
entities under the Agency’s control had not transferred any WMD
or missile-related technology to Iran within the year prior.25
While some experts believe that U.S. sanctions have hindered Iran’s
economy, forcing it to curb spending on conventional arms purchases, others
argue that sanctions have only had a marginal effect, and that foreign
investment has continued to flow in spite of U.S. sanctions. The latter view is
supported by the observation that Iran’s economic performance fluctuates
according to the price of oil, and far less so from other factors. Because oil
prices remain relatively high, Iran’s economy grew about 4% in 2003, and the
economy continued its gains in 2004 with oil prices exceeding $40 per barrel.26
What is abundantly clear is that sanctions would have had a far greater
effect on Iran if they were multilateral or international. Reflecting this line of
thinking, the Bush Administration has declared its readiness to seek major
sanctions against Iran through the U.N. if the ongoing talks with the Europeans
fall apart.
If international sanctions are considered, some options that have been used
in similar cases in the past could be “imposing an international ban or
limitations on purchases of Iranian oil or other trade, mandating reductions in
diplomatic exchanges with Iran or flight travel to and from Iran, and limiting
Kenneth Katzman, Iran: U.S. Concerns and Policy Responses, CRS Report for Congress,
http://www.fas.org/man/crs/RL32048.pdf, February 17, 2005.
26
Ibid.
25
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further lending to Iran by international financial institutions.”27 What remains
uncertain is whether the Security Council or directors of international
financial institutions would back such proposals.
3.3. Strategic Engagement
The final option presented here—termed ‘bilateral strategic
engagement’—represents this paper’s choice of the most adequate policy tool
that will achieve Washington’s goal of a nuclear-free Iran. Although hardly
original in its totality and far more complex than can be adequately defended
within this paper’s constraints, in my view this proposal provides the most
potent ‘policy mix’ which addresses Iran’s external vulnerability, unique
domestic dynamics and economic rationales, while holding the highest
possibility of a peaceful and permanent resolution to both current tensions and
long-term U.S.-Iran relations.
On a general level, the concept of ‘bilateral strategic engagement’ calls for
direct dialogue approached candidly and without restrictions on issues of
mutual concern. This is a response to the fact that the United States’ long lack
of direct contact with, and presence in, Iran has systematically impeded its
grasp of Iran’s internal and external dynamics. This, in turn, has reduced
Washington’s influence in Iran. Hence, dialogue between the United States
and Iran need not wait until total harmony between the two governments can
be established.
Security
At present, the U.S. has focused almost exclusively on finding measures to
prevent Iran from acquiring nuclear weapons capabilities while paying little
attention to why Tehran is pursuing this course in the first place. Given that it
has become abundantly clear that Iran's nuclear ambitions stem from the
perception of threat from the United States, this paper is of the view that the
most effective U.S. approach would be to try to diminish Iran's strategic
security anxieties. Iran must therefore be convinced that it has something vital
to gain by renouncing its nuclear ambitions. The major flaw in the European
diplomatic initiative to resolve this issue is its failure to account for the key
security motivations that drive Iran’s nuclear ambitions. Neither the
unilateralism of the Bush administration nor the multilateralism espoused by
the EU will provide a durable solution. Bilateralism, a deal between the
United States and Iran, is what is urgently needed.
Simply stated, Iran needs to understand that it would not be attacked if it
gave up the bomb, that regime change is not a U.S. precondition for a changed
27
Ibid.
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relationship, and that Iran's rejoining the international community is possible if
it takes a series of clear, precise and reasonable steps towards nuclear
disarmament. “From Iran's point of view, it currently has no assurance on any
of these points. Even North Korea has been given a U.S. guarantee of ‘nonattack’ — even though (or perhaps because) it has indicated it already has the
bomb…Even now, the carrot offered to Iran regarding its nuclear programs,
through European intermediation, is not a non-attack commitment or
economic reintegration in the outside world. Instead, it is limited to help with
its civilian nuclear programs and some relief from economic sanctions.”28 This
approach is clearly insufficient.
Economic Integration
The concept of ‘bilateral strategic engagement’ further calls for the U.S. to
subtly integrate Iran in the international economy and global society. The
inherent dynamics of such measures are bound to pressure Iran toward the
decentralization, accountability and transparency which have been long
resisted by the extreme right.29 The report by an Independent Task Force of
the Council on Foreign Relations provides the operational details of this
particular concept:
In engaging with Iran, the United States must be prepared to utilize
incentives as well as punitive measures. Given Iran’s pressing
economic challenges, the most powerful inducements for Tehran
would be economic measures: particularly steps that rescind the
comprehensive U.S. embargo on trade and investment in Iran. Used
judiciously, such incentives could enhance U.S. leverage vis-à-vis
Tehran…
Commercial relations represent a diplomatic tool that should
not be underestimated or cynically disregarded. Ultimately, the
return of U.S. businesses to Tehran could help undermine the
clerics’ monopoly on power by strengthening the nonstate sector,
improving the plight of Iran’s beleaguered middle class, and offering
new opportunities to transmit American values.30
Regional Stability
In the end, it can be argued that the key to a lasting solution lies in
building a new security architecture in the Persian Gulf. A policy of ‘bilateral
Hunter, “Talk it Out Before It’s Too Late”
Ray Takeyh, Iran: The New Reformists, Center for American Progress,
http://www.americanprogress.org/site/pp.asp?c=biJRJ8OVF&b=33716, February 8, 2005.
30
Report of an Independent Task Force, Iran: Time for A New Approach, Council on
Foreign Relations, http://www.cfr.org/pdf/Iran_TF.pdf, February 17, 2005.
28
29
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strategic engagement’ would therefore pursue an engagement between the
U.S., Iran and each of its neighbors in a dialogue which aims to establish an
effective organization to promote regional security and cooperation. Given the
Gulf's central role in Iran's nuclear calculations, this regional security
framework would not only alleviate Iran's anxieties but potentially usher in a
more rational relationship between Washington and Tehran.
The driving logic behind this proposal is the argument that such
interlocking security arrangements would give Iran a stake in upholding a
status quo compatible with its national interests. This network could evolve
gradually into a full-scale security system that resembles institutions such as
the Organization for Security and Co-operation in Europe.31 With favorable
ties with its neighbors, peaceful relations with its longstanding Iraqi foe and
better links with the West, the U.S. would stand a far better chance of having
a nuclear-free Iran.
4. CONCLUSIONS
Formulating U.S. policy toward Iran has never been simple or
straightforward. This paper set out to determine what would be an
appropriate U.S. policy toward Iran’s alleged development of nuclear weapons
based on the fundamental premise that such a policy must comprehensively
address the underlying motives and incentives that drive Iran’s current nuclear
policies. Although this paper cannot claim to have unmasked all of Iran’s costbenefit calculations, an examination of its domestic setting and international
environment proved fruitful in both explaining some of its rationales and
discrediting some purely ideological policy options which may appear to
provide a ‘quick fix’ to the crisis.
The fundamental premise of the alternative policy offered here is driven
home by Scott Sagan’s excellent argument: “Decision makers in potential
nuclear powers do not need to be told that proliferation is not in the United
State’s interests. They need to be convinced that it is not in their interest.”32
The proposal that has been presented clearly shifts the focus of policy towards
to the goal of substantively addressing Iran’s domestic concerns and external
strategic interests.
Clearly, Iran’s political leaders and general public will refuse to give up
their nuclear program unless they have something vital to gain from
forswearing the nuclear option. As this paper demonstrates, this “something”
goes far beyond the economics of civilian nuclear power as misconstrued by
the current European efforts. A paradigm shift is therefore needed in the way
Ray Takeyh, “America Has a Golden Chance to Tame Iran,” Financial Times, October
14, 2004.
32
Sagan & Waltz, The Spread of Nuclear Weapons (New York: W.W. Norton, 2003), p. 85.
31
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we think about managing nuclear proliferation among potential members of
the nuclear club.
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