This is a re-posted article.

MY FRIEND, comrade, and fellow BusinessWorld columnist Toti Chikiamco sent me the open letter of the Foundation for Economic Freedom (FEF). The open letter is written in activist style, with the title being in the form of a slogan: Advance the Fight against Corruption, and Strengthen our Institutions: Lift the Nationality Restrictions to Foreign Investment in the Constitution!

Toti is the president of FEF, and FEF and Action for Economic Reforms (which I coordinate) have been collaborating on a number of key issues like the sin tax restructuring, the competitiveness of the exchange rate, and reforms in the energy sector, including non-renewable energy.

Of course, it is unavoidable that disagreements occur in any relationship. In Toti’s email, he was appealing to AER "to change its position. After all, you are ‘institutionalists.’"

Below, I quote the key message of FEF:

"To be sure, some economists would list lack of infrastructure, poor tax revenues, galloping population growth, and others as of a higher order priority in terms of binding constraints. They will cite countries like China which has some nationality restrictions, especially in the ownership of land, as countries that developed despite nationality restrictions.

"However, these economists make a faulty assumption: that there’s a strong state and strong institutions that can act on these binding constraints.

"We argue, however, that the nationality restrictions in our Constitution have a corrosive and corruptive effect on our state and institutions, thereby making them less able to tackle these first-order problems. Therefore, the highest priority is to strengthen our institutions, rather than assume these exist, and that economic problems can willynilly be solved."

In an earlier email, Toti wrote: "Just would like you to know that AER’s stance on ChaCha is wrong. While it’s true that there are ‘binding constraints’ of greater import like low tax revenues and lack of infrastructure,this assumes that there’s a capable state able to act on these binding constraints.

"But that’s exactly the problem -- the lack of a capable state and strong institutions. And what these nationality restrictions do is to have a corruptive and corrosive effect on our state and institutions."

Our disagreement with Toti and the FEF can be found in their words. We have different views on what we mean by binding constraints and strong institutions.

The FEF recognizes "there are ‘binding constraints’ of greater import." It cites low tax effort, inadequate infrastructure and high population growth rate, as among the binding constraints. We can even add other binding constraints to the list. FEF and AER, for instance, will agree that among the other binding constraints are a) the market failure in the energy sector, b) the pressure on the currency to overvalue, and c) the slow pace in the resolution of judicial cases. And this list is already long and the necessary reforms are politically challenging. In other words, FEF acknowledges that there is greater urgency in addressing some issues than the amendment of the restrictive clauses in the Constitution.

By their very nature, binding constraints constitute a very narrow set. Through experience, we have seen that attacking too many issues at the same time is unsound and impractical. That is the problem with the Washington Consensus (too many prescriptions) and with the Radical Left (all the "basic problems" must be solved). At least in the case of the Philippine Left, whether we agree or not to their analysis and solutions, they recognize that the resolution of the basic problems is a protracted struggle.

Binding constraints are not just about a narrow set of issues that need an urgent response. (The Makati Business Club has identified at least eight issues more important than amendments to the Constitution.)

The identification of binding constraints is also based on diagnostics, not on our own opinion, not on ideology, not on the normative (or what ought to be).

The diagnostics approach identifies what the binding constraints are for a particular moment (or conjuncture). Addressing this narrow set of binding constraints will lead to a higher stage of development, in which a new cluster of binding constraints emerges.

The key question to be asked in a diagnostics approach is: What impedes investments? Some are binding and some are non-binding. Given the limited resources policy makers have, it is not practical and efficient to cover all the constraints.

We assert that based on our diagnostics, the restrictive economic clauses in the Constitution are not a binding constraint at this moment. The good investments are in fact coming in and will come in despite the constitutional constraint.

Further, the constraints in the Constitution can be addressed or are already being addressed through legislation or through executive action. Examples abound-a liberal interpretation of the 60-40% rule on foreign ownership, the open sky policy, the liberalization of telecommunications, and land ownership. The pending issues, we also argue, can be addressed through innovative legislative or executive intervention.

For lack of space, I cannot delve into the particulars of how we can address the economic restrictions without amending the Constitution. Our more detailed and nuanced analysis can be found in a paper titled "Making the Philippines Investment Friendly for Growth and Employment: Policy Reforms to Address Binding Legal Constraints to Investments (2010)."

The point is, the Constitution’s restrictions on the economy are non-binding because they can be addressed through other means. On the other hand, frontally attacking the Constitution exacts high transaction costs and can derail the passage and implementation of the urgent first-order problems.

In fact, one legal binding constraint is the unpredictable, finicky and slow response of the judiciary. In the AER study, we make the argument that "focusing solely on the protectionist clauses alone -- without restraining the aggrandized judicial powers -- will not achieve the goal of liberalizing the foreign equity regulations, and itself will face compelling odds."

One last point about the State and institutions: FEF and AER agree that institutions matter. We have to be clear though that institutions are a long-term determinant of growth. Institution building is a sequential, incremental process.

The quality of institutions is likewise relative. Surely, China and Vietnam do not have the best of institutions, if we use as benchmark the institutions of the advanced liberal democracies.

Yet the evolving institutions China and Vietnam have are so far responsive or suitable to their current conditions. The key is to have the appropriate institutional arrangements (formal or non-formal), even if they are second best, to deal with the binding constraints at a specific stage of development.

Focusing on binding constraints does help build institutions, for after all sound policies on taxation, exchange rate, or transparency, to enumerate some, shape the behavior of the citizens and the elite and thus lead to deep institutional changes.

***

Source: Filomeno S. Sta. Ana III | Yellow Pad, BusinessWorld (12 August 2012)

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