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Monday, March 22, 2004

India, Iraq and Federalism 

Over the past couple of weeks, columnist Thomas Friedman of the New York Times has been writing about his tour of Bangalore, India and its budding information-technology economy. It's been a great trip for Friedman. What an opportunity to hook together an exotic locale, the usual list of buzzwords ("Glocalization!" "superempowered angry men!") and one of this election season's big media tropes: offshore outsourcing of high-tech jobs.

Friedman actually uses his buzzwords to get about halfway to a pretty worthwhile point in today's column: while India has the "hardware of democracy" (i.e. voting, political parties, etc.), it's lacking some of the "software" (transparency, good governance) that's required to successfully develop its economy. Jonathan Rodden and Susan Rose-Ackerman made a similar point (less punchily but far more precisely) in a 1995 article, making the case that one of India's democratic institutions, its federal structure, was combining with a culture of government corruption to exacerbate India's economic woes. In other words, it wasn't just faulty "software" running on sound "hardware" that was causing the trouble, but a mismatch between "hardware" and "software."

This is a particularly cogent point, then and now, because federalism has a well-established reputation, particularly among skeptics of big government, for improving economic development. The argument basically works like this: if a state is strong enough to enforce contracts and protect property rights, it's also strong enough to start grabbing private resources. In this kind of environment, people will worry about government confiscation and will be unwilling to invest their capital. Obviously, if you could find some way of maintaining the good parts of having a government (enforcement of contracts) but guard against too much power being centralized in one place, you'd be in optimal shape. If you have a functioning federal system, with a national government that basically serves to adjudicate disputes and enforce a few basic laws, then local governments can't get too greedy and stifle economic development by overtaxing, since firms will just pull up stakes and head for another state or province with a more business-friendly policy. In other words, the state or provincial governments will be competing for firms to tax.

This ideal situation is known as "market-preserving federalism" theory, and scholars have used its insights to call for establishment of federal structures in developing countries. Indeed, at least one policy paper and one right-leaning columnist have hinted that a federal structure will play a key part in the economic development of a democratic Iraq in precisely the way "market-preserving federalism" theory suggests.

But it's worth remembering Rodden and Rose-Ackerman's insights: if firms can't move between jurisdictions easily (because, as in Iraq, their major assets are immobile oil refineries) or if a lot of public investment in infrastructure is needed (which takes a lot of tax revenue to finance), federal systems, even those meeting all the necessary requirements to be market-preserving, may actually be unstable and suboptimal. There's also evidence that federalism exacerbates income and wealth inequality across provinces by exactly the same policy competition mechanism described above. And competition among provinces can also backfire: Rodden and Rose-Ackerman document a kind of dysfunctional competition among local officials to see who can offer bureaucrats the most lucrative postings. Friedman insightfully worries about all of these things when looking at India's future (though he doesn't connect them to federalism). As we think about the development of a federal Iraq, we should worry about them, too.

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