Corruption, like cockroaches, has co-existed with human society for a long time. There are many definitions of corruption. This essay focuses on corrupted public practices -- illegal activities that reduce economic efficiency, such as kickbacks in government licensing and procurement. For example, in a recent bribery case in Taiwan, the government paid 3 billion U.S. dollars to buy a naval vessel from France, while Saudi Arabia only paid 1.7 billion. The reason was that the Taiwanese government officials received a larger percentage of the purchase price as a kickback.

"Corruption ... is a serious crime with devastating consequences," U.S. Vice President Al Gore said when addressing the Global Forum on Fighting Corruption last February, "a cold, vicious, often violent sacrifice of citizen security, for a narrow, greedy, private, personal profit on the part of a crooked official." Many international institutions, such as the World Bank and the International Monetary Fund, have reached the same conclusion. The World Bank believes that corruption is a major factor impeding economic development. Corruption hampers economic growth, disproportionately burdens the poor and undermines the effectiveness of investment and aid. The World Bank is helping countries develop anti-corruption strategies.

This essay has four sections. First, I will list a number of possible causes and consequences of corruption, derived from a review of the recent empirical and theoretical literature. Second, I will propose a model that can help explain the relationship between corruption and macroeconomic volatility. In the third section, I will introduce several measures of corruption, certain empirical correlations and their policy implications. I will then conclude in the last section.

I. Corruption and Economic Growth

There is an increasing volume of literature on the relationship between corruption and economic growth, and the general conclusion is that corruption slows down the long-term growth of an economy through a wide range of channels.

1. Reducing Investment and Retarding Economic Growth

Mauro (1995) presents some strong empirical evidence to help prove the negative relationship between corruption and long-term growth. Wei (1997) argues that corruption is much more costly than ordinary taxes because it generates uncertainty in addition to the tax burden.

In the presence of corruption, businessmen are often made aware that a bribe is required before an enterprise can be started and, in addition, corrupt officials may also lay claims to one part of the proceeds from the investment. Therefore, businessmen interpret corruption as a species of tax. In addition, they also face secrecy and the uncertainty that the bribe-taker may not fulfill his part of the bargain. Both the tax and the uncertainty will diminish incentives to invest.

2. Misallocating Talents

Since rent seeking is often more lucrative than productive work, talents will be misallocated. Financial incentives may lure the more talented and better educated to engage in rent seeking rather than productive work, which in turn results in adverse consequences for the country's economic growth. Ehrlich and Lui (1999) present a balance growth model to show that in some equilibria officials spend a substantial amount of time and effort in seeking and accumulating political capital, which is not socially productive.

3. Distorting Government Expenditure

Corruption may entice government officials to allocate public resources less on the basis of social welfare than according to opportunities for extorting bribes. Large projects, whose performance is difficult to monitor, may provide lucrative opportunities for rent seeking and bribes. We can expect that it is easier to collect large bribes on large infrastructure projects or high-tech defense systems than on textbooks or teachers' salaries. Mauro (1998) concludes that corruption affects the composition of government expenditure. When corruption is serious, there is much less government expenditure on education than on large infrastructure and defense projects. In addition, Mauro finds that corruption also lowers the quality of infrastructure projects and pubic services.

4. Reducing the Efficacy of Aid

In developing countries that receive foreign aid, corruption may reduce the effectiveness of the aid through diversion of funds, and foreign aid may end up supporting unproductive and wasteful government expenditures. As a result, more and more donor countries now focus on issues of good governance. In cases where governance is judged to be especially poor, some donors have cut their assistance. Alesina and Weder (1999), however, argue that there is no evidence that less corrupt governments receive more foreign aid.

5. Exposing the Country to Currency Crisis

The recent currency crises of East Asia, Russia and Latin America have stimulated research on their causes. Many authors have argued that the often corrupt "crony" capitalism is partly responsible for the crises. Wei (2000a) argues that corruption is likely to produce certain composition of capital flows that makes a country more vulnerable to shifts in international investors' sentiments and expectations.

Other possible consequences of corruption include loss of tax revenues because corruption may encourage people to evade taxes. In addition, by reducing tax revenues and increasing public expenditure, corruption may lead to adverse budgetary consequences. Corruption may also cause monetary problems if it takes the form of improper lending by public financial institutions at below-market interest rates.

II. Corruption and Volatility

Ramey and Ramey (1995) present some empirical evidence to show that there is a negative relationship between macroeconomic volatility and long-term economic growth. They find that countries with higher volatilities have lower long-term growth rates.

I submit that corruption is one of the important reasons why there is a negative correlation between volatility and long-term growth. As can be seen from the survey above, corruption slows down long-term economic growth through many channels. On the other hand, my model below will show that corruption increases the volatility of business cycles. As such, we can observe a negative relationship between volatility and long-term growth.

Standard macroeconomic theories use various economic shocks, such as aggregate supply or demand shocks, to explain the volatility of business cycles. Some economists also use other factors, particularly the structure of a country's financial system, to explain macroeconomic volatility. Krugman (1998) uses a simple static model to show that financial intermediaries whose liabilities are guaranteed by the government pose a serious problem of moral hazard. Corsetti, Pesenti and Roubini (1999) use a dynamic model to show the same result. Easterly, Islam and Stiglitz (2000) argue that financial structure plays an important role in producing macroeconomic volatility. Denizer, Iyigun and Owen (2000) argue that besides financial structure, corruption may also play a role in creating volatility.

I now present a moral hazard model to show that corruption increases the volatility of business cycles. Assume officials in an economy have the power to decide which firms get loans and how much each firm gets. If there is corruption, officials take a fixed share of the loans as a kickback. Firms need to pay back the loans in full in a positive state, where firms make profits. In contrast, in a negative state in which firms lose money, firms only pay back the leftovers and need not pay back the loans in full.

There are two kinds of firms: "bad" firms and "good" firms. For each firm, there are two kinds of assets for investment: risky assets and safe assets. For simplicity, assume returns to safe assets for both kinds of firms are zero. The average returns to risky assets are zero for bad firms and positive for good firms. Volatility of returns is higher for bad firms than for good firms. As such, if there is no corruption, bad firms do not have any incentive to invest in risky assets, which means that bad firms do not have good investment opportunities and cannot survive in a perfectly competitive economy. When there is no corruption, only good firms can survive.

When there is corruption, however, it is possible that good firms with high average returns and low volatilities do not have any incentive to bribe because good firms have profitable investment projects. Good firms may lose more, such as losing their reputation, if they bribe officials. Only bad firms have incentives to bribe: they can play the game of "heads, I win; tails, the taxpayers lose." Therefore, bad firms tend to invest more in risky assets and increase the volatility of business cycles.

With bribes, government officials tend to allocate loans to "bad" firms with low average returns and high volatilities. Only bad firms can afford and have incentives to pay bribes to these officials. In addition, as a result of these bribes, government spends more money on loans to firms and less on other public goods. As such, corruption distorts the composition of government expenditure, which is consistent with the findings of Mauro (1998).

When there is corruption, it is possible for bad firms to survive because of corrupt officials. If both good firms and bad firms bribe officials, social returns of investments are much lower than private returns. Social returns are even lower if only bad firms are bribing government officials. As such, social returns from bad firms are lower than social returns from good firms. In fact, when bad firms survive in an economy with corruption, social returns from bad firms are negative, although their private returns are positive.

III. Empirical Results and Policy Implications

Empirical results from both cross-sectional and panel data for a sample of more than one hundred countries support my propositions.

When we turn to empirical study, one of the issues is how to measure corruption. There are four survey-based measures of corruption, which are all cross-sectional data. Correlations among these four measures are quite high (see Wei (1997)).

1) Business International Index: BI; 2) Global Competitiveness Report: GCR; 3) Transparency International Index: TI; 4) World Development Report: WDR.

Empirical evidence supports the following propositions:

1) There is a negative relationship between corruption and the average long-term rate of economic growth; 2) There is a positive relationship between corruption and the volatility of business cycles; 3) There is a positive relationship between corruption and the probability of an economic or financial crisis. The recent Asian financial crisis provides an excellent example: the more corrupt the countries were, the more serious were their crises. Indonesia and Thailand well exemplified this point.

All these empirical results support the proposition that corruption inhibits economic performance. There are also two major policy implications. First of all, good banking regulations are important for preventing financial crises. Secondly, a good legal system may be even more important in the long run.

1. Good Banking Regulations

Banking regulations are very important. Domestic depositors and foreign investors used to regard Asian banks as safe because they believed that Asian governments would stand behind their banks in cases of crises. However, these banks and financial institutions were not under effective government regulations over the kind of risks they were undertaking.

In several Asian countries, close relationship between business and government exacerbated the moral hazard problem in lending. The various "finance companies" in Thailand, often run by relatives of government officials, lent large sums of money to highly speculative real estate ventures. In Indonesia, lenders were far too eager to finance ventures of the President's family members. The excessive lending, driven by serious moral hazard, helped to create an unsustainable boom in a number of Asian economies, which temporarily concealed the poor quality of many of the investments.

2. Good Legal System

A good legal system may be even more important in the long run. If asked to name the single most important factor in explaining the wealth of nations, the answer many economists would give is probably "the rule of law."

Countries where there is no effective rule of law are places where strongest people simply take what they want from others. These are places where it often makes no sense to engage in productive economic activities because as soon as you succeed in making money, someone with more power will come and rob you. For developing countries without the rule of law, the precise content of the law is probably less important than having a functioning legal system to begin with.

"As I am sure you will readily agree, the international economy is far too important to be left to the economists," says Harvard economist Jeffrey Sachs (1998).

IV. Conclusion

In this essay, I have summarized some recent research that explores causes and consequences of corruption. There have not been many theories of corruption. The limited availability of data subjects empirical work to many uncertainties. Still, the surveyed studies provide tentative evidence that corruption may seriously inhibit long-term economic growth and increase the volatility of business cycles.

We know that corruption has been around for a very long time and will be around in the future unless governments figure out effective ways to combat it. Various anti-corruption strategies have been designed and implemented. For example, Wei (2000b) proposes the strategy of "special governance zones" as an anti-corruption tool. Now Wei's proposal has been adopted by the World Bank in some developing countries.

(The author is a Ph.D. candidate in economics at Johns Hopkins University. This essay is a summary of the author's on-going research on corruption, growth and volatility.)

References:

1. Alesina, Alberto and Beatrice Weder, 1999, "Do Corrupt Governments Receive Less Foreign Aid?" NBER Working Paper No. W7108.

2. Ahlin, Christian, 2000, "Corruption, Aggregate Economic Activity and Political Organization," Manuscript.

3. Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini, 1999, "Paper Tigers? A Model of the Asian Crisis'', European Economic Review (43) 7, 1211-1236.

4. Denizer, Cevdet, Murat Iyigun, and Ann Owen, 2000, "Finance and Macroeconomic Volatility, " Manuscript.

5. Easterly, William, Roumeen Islam, and Joseph Stiglitz, 2000, "Shaken and Stirred, Explain Growth Volatility," Annual World Bank Series of Development Economics.

6. Ehrilich, Isaac and Francis T. Lui, 1999, "Bureaucratic Corruption and Endogenous Economic Growth," Journal of Political Economy, 107, 270-293.

7. Krugman, 1998, "What Happened to Asia?" Manuscript, Massachusetts Institute of Technology.

8. Mauro, Paolo, 1995, "Corruption and Growth," Quarterly Journal of Economics, 110, 681-712.

9. Mauro, Paolo, 1998, "Corruption and the Composition of Government Expenditure," Journal of Public Economics, 69, 263-279.

10. Ramey and Ramey, 1995, "Cross Country Evidence on the Link Between Volatility and Growth, " American Economic Review 85, 1138-1151.

11. Sachs, Jeffrey, 1998, "Remarks to the 1998 Alumni Gathering of the Yale Law School, on Globalization and the Rule of Law," Manuscript.

12. Wei, Shangjin, 1997, "Why is Corruption So Much More Taxing Than Tax? Arbitrariness Kills," NBER Working Paper 6255, November 1997.

13. Wei, Shangjin, 2000a, "Corruption, Composition of Capital Flows, and Currency Crisis," NBER Working Paper.

14. Wei, Shangjin, 2000b, "Special Governance Zones," The World Bank Project Report.

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