Government Reforms to Reduce Transaction Costs and Promote Private Sector Development

Government Reforms to Reduce Transaction Costs

and Promote Private Sector Development

Paul Holden, Ph.D.


Enterprise Research Institute


Over the past few years, opposition to reform has been growing in many developing countries. In particular, in Latin America, a series of crises has led to disillusionment regarding the ability of reform programs to bring prosperity. Argentina crisis is only the most recent example of an early reformer experiencing severe crisis and halting or reversing earlier efforts. The policies associated with the “Washington Consensus,” which involved privatization, trade reform, and macroeconomic stability, is now viewed in many developing countries, as well as, among many “activists” as having added to poverty in the countries where it was implemented. In some quarters, globalization is considered to be anathema – promoting the worst evils of capitalism. The proponents of such views claim that it has destroyed jobs in the industrial countries. and has led to the exploitation of low paid workers in developing countries.

These views, however, are misguided and ignore the facts. Countries where there has been genuine reform have, in general, performed well. For example, per capita income growth in Chile, one of the deepest reformers among developing countries, was among the top four worldwide in the 1985–2000 period. In many cases, the countries that have experienced the greatest problems, and that are held up as examples of the failure of market oriented economic systems are those where reform was incomplete there was a failure to follow through on initial reform efforts involving privatization and trade liberalization to ensure that markets worked effectively to allocate resources efficiently. Governance in the vital realm of economic activity failed to support market oriented reform, thus diminishing the impact of reform efforts and, in several cases, dooming them to failure.

It is only recently, however, that much attention has been paid among those concerned with economic development to analyzing the impact of governance on the efficient operation of markets. In particular, governance has a central impact on the way that markets are organized. In all developing economies, large informal sectors that operate primarily on a cash basis are the norm – this is one form of market organization. However, in most developing countries there is a marked absence of long term contracting. In most of these countries, business communities deal with people that they know and are reluctant to engage in arms length contracts that are the norm in countries like the United States.

Why is it that types of transactions that are taken for granted in modern economies are so conspicuous by their absence in so many developing countries? In most cases it is because the costs and risks of entering into long term contracts are much higher in developing countries than they are in the industrial world. And these costs are largely a function of governance – the way in which governments supply and administer public goods and the way in which they regulate economic activity. When governance is weak, the costs of transacting (in other words, the costs of doing business) rise. Without governance reform to promote private sector development, growth and prosperity will continue to elude most developing countries.

This paper commences with a discussion of transactions costs and the impact they have on the private sector. It outlines ways in which weak governance contributes to high transactions costs. It then discusses in some detail issues related to the reform of governance as it pertains to promoting private sector development. It gives two examples of successful governance reform that have had a strong impact on promoting growth and alleviating poverty in the countries where they occurred. It concludes that similar reform is the only option available for governments intent on promoting growth and development.

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