Institutions and Economic Development: Judicial Reform in Latin America

Hugo Eyzaguirre

Inter-American Development Bank Washington, D.C. Sustainable Development Department State Governance, and Civil Society Division February 1996

INSTITUTIONS AND ECONOMIC DEVELOPMENT: JUDICIAL REFORM IN LATIN AMERICA 1

I.

INTRODUCTION

In recent years Latin American governments have started reform programs directed to reduce state intervention, increase the role of the market in the economy, and open domestic markets to foreign competition. In most of the countries, the primary goal of the policy reforms was to achieve a macroeconomic stability after years of high inflationary processes, perennial fiscal and external balance deficits, and overwhelming debt obligations. Regarding this goal, the policies have been very successful. For example, in Argentina the annual rate of inflation fell from 609% in the 1987-1991 period (2314% in 1990) to 3.7% in 1994. In Peru, the inflation rate fell from 7482% in 1990 to around 15% in 1994. In the last two countries the fiscal balance turned positive over that period 2 . The impact of the reforms, however, went further. Latin America has obtained growth rates not seen in fifteen years, in the midst of a democratization process. While between 1980 and 1990 the GDP growth rate in the region was 1.1% per year, between 1990 and 1994 that growth reached 3.7% per year. While in the 1980s the external capital flow represented less than 1% of GDP, in the 1990s it reached 6%. Direct foreign investment increased by 68% to $1.4 billions in 1992, and reached $2.2 billions in 1994. In spite of these positive results, there is an increasing concern for the consolidation of the reforms and the sustainability of the growth. Naim (1995) points out that "(the success in tackling inflation, the unprecedented growth in trade among neighboring countries, and the euphoria of foreign investors obscured the drag on the region's economic prospects created by high income disparities, low productivity, low international competitiveness, and --most important of all-- ineffectual public institutions" (p. 46). The adjustment policies and reforms have not reached into other fundamental aspects of development like the modernization and strengthening of the institutional framework that guarantees the stability, credibility, and transparency of the rules of the game in an economy. However, if the policies have had positive results and the economies are growing, why should there be a concern for the institutional framework? More specifically, why is the need for a reform in the judicial system emphasized by intellectuals like Douglas North? What would be the importance of a judicial reform within the new policies that Latin American countries have been adopting? This paper is set out to answer these questions. First, it discusses the importance of institutions for the possibilities of growth of an economy and the key role that the judicial system plays in the institutional framework. Then, this paper attempts to build a framework under which to analyze the performance of judicial systems.

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This study was prepared Modernization of the State Unit (DPP/MOS), and was part of the II Conference on Justice and Development in Latin America and the Caribbean. Preliminary version of this document benefited from numerous conversations with Francisco Mejia and from a seminar organized by MOS Data taken from Inter-American Development Bank (1994), Krugman (1995) and Naim (1995).

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II. THE INSTITUTIONAL FRAMEWORK AND THE ECONOMY In recent decades, the economic science has become increasingly convinced of the need to incorporate institutional factors in the economic analysis. In particular, the New Institutional Economics (NIE) postulates the important role institutions play in the functioning of an economy and its possibilities of growth. Institutions are the rules of the game in an economy and the way in and the extent to which they are enforced. These rules determine in turn the incentives to which the economic agents react. Institutions can be formal (constitution, laws) or informal (social norms, codes of conduct). New Institutional economists, like North (1990, 1981), argue that the neoclassical model of the market has a central deficiency. For the markets to allow the best use of resources in an economy, and to generate the incentives for competition and innovation (the engine forces of economic growth), they need a set of rules (institutions) under which to operate. When it ignores the need for these rules, the conventional economic theory assumes implicit and erroneously that they always exist. 3 The NIE argues instead the need to include institutions in the economic analysis. Any economic activity can be reduced to a series of exchanges or transactions. Each exchange involves a number of costs: obtaining information about what is to be exchanged, about the other parties to the exchange, negotiating and establishing exchange agreements or contracts, monitoring the compliance of the agreements, sanctioning in case of default. The rules of the game and their enforcement (institutions) determine how well assigned and protected are the agents' rights. The better the rights are assigned and protected, the lower the costs of transacting. Therefore, the institutions determine how costly is to exchange. In turn, the costlier is to exchange, the more limited is the extension of the market and the possibilities of growth. Perfect institutions for perfectly operating markets only exist in an abstract model, not in reality. However, we can observe economies that operate within an institutional framework that tends to favor the functioning of the markets, and economies with institutions that tend instead to restrict the functioning of the markets. The conventional economic analysis, when examines different realities, does not study the prevalent institutions in each of them, limiting significantly its explicative power. More specifically, following the NIE model, we can observe that in the Less Developed Countries (LDC) institutions can not adequately assign and protect the agents' rights, generating high transaction costs and restricting the functioning of the market economy. As a result, markets can not expand, specialization is low, monopolic or oligopolic markets are very frequent, individuals have fewer possibilities to reach more complex contractual agreements, have to resort to more costly contracting and to more costly ways of organizing their economic activities. In this context, it is remarkable how little attention the institutional reforms usually receive in the design of economic development programs. Benham et al. (1995) analyze the literature on economic reform in Central and Eastern Europe. Although probably in this case, where 3

The argument could be made inversely: since the neoclassical theory assumes that the appropriate institutional framework always exist, ignores it in the analysis 2

there has been a drastic change in the economic system, the need for institutional reforms is more obvious, the authors find that "little attention has been given to many core elements of institutions: path dependence, transaction costs, information flows, incentives, measuring and monitoring, credible commitments, and corruption." (p.46) "The word 'monetary' was used over 50 times. as often as 'monitoring', 'corruption', 'governance structure', or 'transaction costs'." (p.32) The Latin American governments have also made an important switch in their policies, perhaps not as dramatic as in Eastern Europe, but also adopting a change in favor of a market economy. The market plays now a more important role determining the possibilities of growth, replacing the tight control the State had in the past over the economy. Since markets need an adequate institutional framework to perform well, a program of institutional reforms should be an important element in the new development strategy that is being shaped in Latin America. For long time, governments attempted to solve the so-called market failures with an aggressive State intervention in the economy. Basically, in numerous instances, the market mechanism was replaced by the public decision. However, we must now understand that what usually fails is not the market mechanism and, thus, it need not be replaced. The failure is instead on the lack of the necessary conditions for the markets to work. It is there where the role of the State must be important, generating such conditions. Finally, a development strategy that favors the strengthening of institutions and the functioning of the markets has important implications to confront the problem of income inequality. This problem is one of today's concerns regarding the recent policies adopted, and was also one of the arguments used in favor of the past statistic policies. As we will see below, the problem of income inequality in Latin America has been getting worse in the last decades. Under a deficient institutional framework, only few are able to actively participate in the markets because they can obtain (based on personal relations or economic resources) the protection of their rights. Most people, however, without this protection, have limited possibilities to improve their economic situation. In this context, an enhancement of the institutional framework would allow a greater participation of the people in the markets and on the benefits that such participation generates. III. THE JUDICIAL SYSTEM AND THE INSTITUTIONAL FRAMEWORK What is the role of the judicial system within the institutional framework? As said, for the markets to operate adequately, they need a set of rules under which to operate. That is, a set of rules that is enforced. The function of enforcement, in a modem society, is primarily the responsibility of the judicial system. In this way, the judicial system has the role of last resort in assigning and protecting the agents' rights. Given its critical role, a judicial system that is deficient can generate important costs for an economy. On one hand, the decisions of a deficient judicial system can lead to an inefficient assignment of rights (ultimately resources), and generate a too frequent transgression of others' rights (theft, contract default) with the resulting social cost. On the other hand, decisions of a deficient judicial system may generate an environment of uncertainty that would repress significantly the development of economic activities, and restrict the extension 3

of the markets, competition, and innovation. The reform of a judicial system can have, consequently, an important impact in the possibilities of growth for an economy. In this context, in a program of institutional reforms, the judicial reform should clearly have priority. Given its role of last resort in the definition of agent's rights, if the judicial system does not work adequately, the whole institutional framework would be weak. Similarly, reforms that attempt to improve other aspects of the institutional framework would have a limited impact if the judicial system performs poorly. For example, regulations can be improved to eliminate some restrictions to contracting. However, if any conflict that emerges could end up being solved by a deficient judicial system, the improvement in the regulatory system would have only limited benefits. IV.

THE PERFORMANCE OF THE LATIN AMERICAN JUDICIAL SYSTEMS

When we observe the Latin American judicial systems, three are probably the most salient characteristics of these systems and illustrative of their poor performance. The judicial processes are inefficient. The judicial decisions are uncertain. The access to the judicial service is unequal. 4.1

Inefficient processes

There is a clear perception in Latin America that judicial systems perform poorly, even in comparison with other State bodies. For example, in surveys both to the public opinion and to "victims" that are participating or have participated in a judicial procedure in Peru, the Judiciary is viewed among the least efficient public bodies. It ranks behind the tax collecting agency, the Presidency, the Armed Forces, the Cabinet, the Central Bank, Congress and the Office of the Attorney General (Fiscalía) . (Instituto Apoyo, IA, 1993) This inefficiency is observed in the following aspects: the judicial procedures are slow, require excessive expenditures, given the service offered, from the State and the users. The most important expression of this inefficiency is the slowness of the judicial processes. These are in general in Latin America extremely lengthy, especially in comparison with the own rules of the Latin American countries. For example, in Bolivia (World Bank, WB, 1994) an ordinary procedure that goes through the three instances takes 2,616 days (more than six times what is prescribed in the Code of Civil Procedure). An executive procedure in first instance takes 519 days (more than 10 times what is prescribed in the Code). In Venezuela (WB, 1992), the investigation phase of criminal cases takes on average 286 days (more than 8 times what is prescribed by law). To reach the sentencing phase the courts require on average 754 days (more than 11 times what is prescribed by law). It was also found that 75% of the cases in which the investigation phase had been completed were still waiting for a decision. In civil cases, it takes on average 190 days to complete the investigation phase (almost 3 times what is prescribed by law) and 302 days to reach judgment (more than 5 times what is prescribed by law). In Ecuador (WB, 1994), in 1993 there were 12,000 pending cases in the Supreme Court, 7,000 of them in the Civil Chamber alone. There is an estimate of 500,022 total pending cases in the Ecuadorian judicial system. 4

The time it takes is not only too long, but also continues to increase. In Costa Rica (InterAmerican Development Bank, IDB, l994), the duration of procedures in Criminal Superior Courts increased in 12% between 1990 and 1993. In the same period, the average time of cases resolved by sentence in criminal courts increased in 19% and in the labor courts in 88%. In Venezuela (WB, 1992), according to data for 1990 a criminal court on average receives 675 new cases each year, has between three and seven thousand pending cases, and reaches decisions on 120 cases. A civil court receives on average 3,100 new cases each year, has between six and nine thousand pending cases, and reaches decisions on 1,650 cases. Estimates indicate that between 1992 and 1997 the number of cases entering the trial courts would increase from 270,000 to 450,000. As a result, the pending cases would rise in 36%, to almost 150,000 cases. To give a better idea of the magnitude of the problem, given the current processing times and procedures, 800 additional judges would be needed just to prevent any further increase in backlogs. This additional hiring would imply a 75% increase in the budget. Table 1. Costs of some judicial procedures in Peru Procedure Ordinary Executive Summary Summary Executive Setting and collecting alimony

Cause Contract default Collection of debt in US$ Indemnification Indemnification Collection of debt in Soles

Amount (US$) 200,000 60,000 20,000 4,000 1,500 250

Length 4 years 1 year, 9 mos 3 years 3 years 1 year, 9 mos 2 years

Cost (US$) 27, 111.61 12,196.58 7,134.11 1,110.50 549.06 321.07

Another important aspect is the excessively high amounts that the users spend, considering the quality of the service, and in particular for cases that involve relatively small amounts of money. Based on interviews to specialist lawyers and given certain assumptions, costs of some judicial procedures in Peru have been estimated. These costs include direct cost of the process, payment of lawyer fees, and financial costs. Indirect costs like transport, room and board, paper, photocopies, etc. are not included (they vary substantially from case to case). The following table presents such estimates. (IA, 1993a) It is not surprising that in surveys to victims that participate or have participated in judicial procedures in Peru, 85% respond that the procedures are long or very long (62% that they are very long). (IA, 1993) A survey of businessperson was conducted in Peru on issues related to the judicial performance. The survey shows that businessperson are willing to discount the value of bad debts by a high percentage. Although the cost of using the judicial system is important, certainly other factors affect this decision. In any case, the results are shown in the following table. (IA, 1993b)

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Table 2. Survey to business persons in Peru Percentage willing to discount the value of bad debts in 20% or more 53% 25% 20% 17%

Magnitude of the bad debts less than $ 5,000 between $5,000 and $10,000 between $10,000 and $50,000 more than $50 000

There is no good available information on the effectiveness of the use of resources in the judicial system, but this is a problem mentioned in most of the studies cited before for different countries. The judicial systems in Latin America usually receive a very small fraction of the public budget (below 1% in many cases). The expenditures are fundamentally used to cover the payment of salaries, benefits, and pensions. This expenditure distribution does not necessarily reflect a problem in the efficiency of expenditures. However, it is important to remark the little attention paid to infrastructure and maintenance, when the lack of adequate infrastructure characterizes the judicial systems of the region. In the case of Peru, the Judiciary absorbed 0.8% of the General Fiscal Budget in 1993. Only 8% of the Judiciary's budget was devoted to infrastructure and institutional improvements. The salaries were equivalent to 18% and the payment of pensions to almost 25%. It must be stressed that pensioners were just a little more than a third of the active employees. The total personnel in 1993 was 6,893 people, which included 1,153 judges. The number of pensioners was then 2,493 people. The current transfers, which include social security payments and other benefits, were 31 % of the Judiciary's budget. A1l these expenses add up to 74% of the budget (IA, 1993b). In the case of Ecuador (WB, 1994) the situation was very similar. Less than 1% of the budget was assigned to the Judiciary and most of this amount was devoted to personnel expenditures (74% in 1992 and 89.9% in 1993). 4.2

Uncertainty about the decisions

The problem of uncertainty about the judicial decisions has not received enough attention in the past (for example, in the studies mentioned before), at least according to the importance assigned by the postulates of the NIE. It is much harder to adapt one's decisions when facing uncertainty on the service being bought than when that service is simply very expensive. There are no statistics at the moment that describe this situation. However, that the judicial decisions in Latin America have serious inconsistency problems, both with legal merits and among similar cases, is certainly a generalized opinion. Given the importance of this problem, the construction of indicators that measure judicial uncertainty is necessary for the design and evaluation of judicial reforms.

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Table 3. Survey on judicial performance in Peru Not very trustworthy

Public Opinion "Victims" who have participated in a judicial procedure

Judges 49% 44%

Judiciary 40% 32%

Not trustworthy at all Judges Judiciary 24% 32% 26% 44%

Total Judges 73% 70%

Judiciary 72% 75%

The already mentioned surveys in Peru show how little trust people have on the system, especially those that have participated in a judicial procedure. Some salient results are presented in the following table. (IA, 1993) 4.3

Unequal access

If the costs of using the judicial service are high, an important fraction of the population would be de facto excluded from the service. This situation is particularly serious because of the usual ban on self-representation and the lack of legal aid systems (WB, 1994). 4 Additionally, even though there is no available information, one would expect that the judicial infrastructure is very centralized and that the quality of the judicial service varies accordingly from place to place. In this manner, some segments of the population would be discriminated in the provision of the service. In the surveys in Peru, the problem of access is noted as one of the most important that affect the Judiciary .In the surveys to public opinion, the lack of access of the people to justice is the second problem according to the total number of mentions (excluding corruption) and represents 45% of the total. In surveys to victims the lack of access, after corruption, is the problem that receives more "first" mentions. Also, it received 45% of the total mentions. (IA, 1993) V.

IMPACT ON THE ECONOMY

As seen in the previous section, the performance of the Latin American judicial systems is rather poor. All the problems already described must have an important impact on these economies. According to what was discussed in section III, this impact can be desegregated in three fundamental aspects. 5.1

Direct impact

This is the most immediate impact and basically consists of the costs of providing and using the system. A judicial service excessively slow and costly generates waste of resources that could have been used more productively by the users as well as by the Judiciary. 5.2

Inhibition of economic activity

To have an ineffective Judiciary as the entity that guarantees the compliance of contracts is particularly important in the impersonal and intertemporal transactions, typical of a modem economy. A costly and uncertain judicial system limits the variety of contractual relations 4

See, for example, WB (1994) for the case of Ecuador, pp. 24-27. 10 See, for example, WB (1994) for the case of Ecuador, pp. 24-27.

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(especially the more complex ones), limits the extension of the markets and, consequently, their positive effects through competition and specialization. At the same time, the slowness of the system provides incentives to greater number of contract defaults and criminal acts, with the consequent cost for the victims. This situation can also lead to an inefficient organization of economic activities. For example, an excessive vertical integration can take place to avoid depending on an extensive contractual network, or activities potentially profitable that requires an extensive contractual network can simply not be undertaken. A number of factors can explain contract default. This fact complicates the use of statistics that show the impact that a deficient judicial system has on this aspect. In any case, in the survey to Peruvian businessperson in 1993, 60% indicated that they had bad debts (delays in payments of 60 or more days) and 24% indicated that bad debts were over 10% of the total. In the case of other contracts, 42% of the interviewed indicated that they were facing defaults in 10% or more of the contracts. (IA, 1993b) On the other hand, in the same survey in Peru, 32% said that would not accept an offer from a new supplier, regardless of how much cheaper the offer was. Forty-seven percent indicated that would not accept the offer if it represented savings lower than 30%, and 65% would not accept it if it were equivalent to savings lower than 20%. (IA, 1993b) A study on Bolivia (WB, 1994) concludes that the slowness of the judgment in the judicial processes causes that giving credit using collateral of short economic life is not profitable. This situation practically limits credit transactions to those that could use real state as guarantees. Finally, there are studies that show that variables associated to the stability and credibility of the government (as a "proxy" for institutional deficiencies) can affect investment and growth rates. 5 Other studies analyze the impact on the economy of the degree of contractual complexity that different economic activities require. This line of research is useful because we can expect that, in an economy that has an inefficient judicial system, contracting would be more expensive and the development of more complex contractual relations would be more limited. In this situation, we should observe a concentration (beyond comparative advantages) in those activities that do not depend on an extensive or complex contractual network (Like primary activities, for example). Although not directly shown, this situation is consistent with the results obtained by those studies. 6 5.3

Income inequality

The inequality in the access to the judicial service certainly does not contribute to overcome the severe problems of economic inequality that the Latin American countries confront today. The following table shows the great economic disparity existent in some countries of the region (circa 1987) (Hausmann & Rjgobon, 1992). Additionally, data for the first years of this decade show that in Latin America the wealthiest 10% of the households receive more than 40% of the total income, while the 20% with the lowest income receive less than 4%. In this context, it is important to stress that the deficiencies of the judicial system generate an inequality in the possibilities to improve the economic situation, affecting negatively the 5 6

See, for example, Alesina (1992, 1993), and Barro (1991). See Clague (1991) and Clague et. al. (1995).

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poorest segments of the population. As said before, with a deficient institutional framework, only few can actively participate in the markets. Those who enjoy connections with members of the government and greater resources can obtain the needed guarantees for the protection of their rights, guarantees that should be provided by the judicial system. Most of the population does not enjoy these guarantees. Their possibilities of undertaking economic activities are reduced and, consequently, they do not receive the benefits derived from a market economy, particularly in the context of a modern economy, dominated by intertemporal and impersonal transactions . Table 4. Income Distribution (circa 1987) Country Brazil Colombia Costa Rica Jamaica Peru Venezuela

I 2.4 4.0 3.3 5.4 4.4 4.9

II 5.7 8.7 8.3 9.9 8.5 9.7

III 10.7 13.5 13.2 14.4 13.7 14.3

IV 18.6 20.8 20.7 21.2 21.5 21.9

V 62.6 53.0 54.5 49.2 51.9 49.3

IV/I 7.8 5.2 6.3 3.9 4.9 4.5

V/I 26.1 13.3 16.5 9.1 11.8 10.1

For example, the cited study on Bolivia (WB, 1994) indicates that those who do not have the possibility of using real state as a collateral would have little chances to have access to credit. VI.

THE NEED FOR A JUDICIAL REFORM

We have seen that the Latin American judicial systems show important deficiencies. We have also discussed the important impact that the performance of the Judiciary can have on the economy. These facts point directly to the need of implementing judicial reforms in the region. But, what kind of judicial reforms? There are two issues that make this question very important. First, we have only seen the symptoms exhibited by the judicial systems. We should not make the common mistake of trying to correct the symptoms without understanding where the source of the problem lies. Second, to provide the best solution we need to apply the appropriate instruments for diagnosis and prescription. Regarding the second point, because judicial matters are naturally the concern of the legal profession, there has not been an important effort of applying economic analysis to deal with these matters, in particular in developing countries. I am not going to discuss this issue here, but for some time now, different schools of thought in economics --i.e. Law and Economic, Public Choice, NIE-- have been stressing that what takes place in other fields, like legal and political, has important implications on the economy and that it is necessary to include economic criteria in decision making processes in those other fields. 7 The legal profession has always been involved in matters like judicial reform. It is necessary to consider now the contributions that an economic analysis can provide. This work attempts

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See, for example, the works of Posner (1983,1986,1995) and Brennan & Buchanan (1985). An initial effort of this type can be found in Sherwood, et al (1994).

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to develop a general framework of the economic analysis of judicial reform programs. 8 In the economic literature, models and theories have been developed (usually based in the context of development economies), whose application to the analysis of problems in legal systems in LDC would be very useful. However, little has been done in this regard. Certainly, a framework of analysis of judicial issues in Latin America does not exist. Returning to the first point, as can be seen from the cited works, there is a significant emphasis on the slowness of the judicial procedures. There is the risk of stopping there and not studying in more depth what are the sources of the different problems the judicial systems exhibit. More specifically, one could be tempted to conclude that the slowness is simply a problem of a low capacity to supply the service. In consequence, an increase in resources to the system would solve the problem. Certainly, the processes are slow because the demand is greater than the limited supply. However, we should analyze the whole market, both demand and supply. We should consider what factors explain the limited supply. Is it just a matter of resources? What about the incentives of the players involved? Increasing budgets, building more infrastructures can be part of the solution, but if done alone may result in a waste of resources. Finally, even if we consider factors affecting the demand, since the judicial system is the supplier of a service, judicial reforms are designed from the point of view of the supply (basically concerned with how to improve or increase the service offered). The final objective of the State is to provide adequate guarantees to protect the agents' rights. The judicial system is the key entity in charge of this function, but there are others that play complementary roles (e.g., registries). Judicial reforms need to be compatible with the final objective. For example, should the focus of the reforms be exclusively on how to accelerate judicial procedures, or on how to provide overall better guarantees against contract default? VII.

IN SEARCH OF A SOUND REFORM

In this section, by analyzing the functioning of the judicial system, I attempt to establish what are the possible factors that cause the described symptoms. This analysis will be useful for the design of an adequate judicial reform program. 7.1

Market for judicial service

T o analyze the performance of the judicial system, it is necessary to understand first that this system is in practice a market in which a supply and a demand for a service (the judicial service) meet. Individuals demand a solution for their conflicts and the Judiciary supplies such solution. More specifically, then, to analyze the performance of the judicial system, it is necessary to understand the forces behind the supply and demand for the judicial service. In consequence, we must identify the agents who participate in this market and which factors determine the way in which they act. 7.2

The agents and their incentives

There is a diversity of agents who could participate in the market for the judicial service: the parties in a conflict, their lawyers, the district attorneys, the judges, the court clerks and the rest of the administrative staff. Literature in economics, such as the NIE and the 8

An initial effort of this type can be found in Sherwood, et al (1994.).

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Organizational Economics (OE), emphasizes the role of the incentives in the actions of the agents. 9 The agents try to maximize their wealth within the available opportunities and the existing restrictions. In an economic analysis, the actions of the agents in the market for the judicial service should be analyzed like in any other market. The restrictions the agents confront are what determine the particularities of this market. Among the restrictions, the rules that regulate the actions of the agents are important to determine the incentive structure to which they will react. These rules can be formal (laws) or informal (social norms, codes of conduct, commercial practices, bureaucratic practices, and so on). In their decision-making the agents depend also on the available information, their capacity (education), and the available resources. The so-called "principal-agent" problem is the one that has received the most attention in the OE literature and, as will be seen, is also fundamental in the analysis of the judicial market. In short, the principal is any actor who delegates functions to an agent. The incentive structure not necessarily motivates the agent to behave in the best interest of the principal. The problem of information asymmetry is the most important in this context. The principal does not have the necessary information to determine the agent's effort. 10 This type of problems will be observed in the context here studied, between society as principal and public employees as agents, the parties as principals and lawyers as agents, and so on. In general, these works are very useful for the economic analysis of the judicial reforms. First, they indicate the need to study the incentive structure as an important factor in explaining the deficiencies of the judicial system. Second, they indicate the priority that this aspect should receive in a judicial reform. If this aspect is instead ignored, the possibilities of success of any judicial reform can be compromised because of the potential interference of affected participating agents. 7.3 Incentives in the public sector The subject of public sector incentives deserves special attention because typically the economic analysis considered that a public service was supplied with the objective to maximize social wealth. However, this assumption has been seriously questioned both because it is not observed in reality and because it implies a theoretical inconsistency. "Development economists have typically treated the state as either exogenous or as a benign actor in the development process...In fact, the state can never be treated as an exogenous actor in development policy." (Capitani & North, 1994) The theory that argues that the State has the objective of maximizing social wealth presents a serious inconsistency. Why would individuals in government, the most powerful organization of society, act differently from other agents? Brennan & Buchanan (1985) argue that this theory violates a fundamental methodological principle. If a theory postulates a model of human behavior (maximization of own wealth), that model should be the same across different contexts: markets or politics. 9

For more detail on OE see, for example, Pratt & Zeckhauser (1985) and Williamson (1985). For a synthesis of this literature see, for example, Pratt & Zeckhauser (1985) and Arrow (1985).

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The actors in the public sector are many. The judges and the court's administrative staff are the agents that determine the supply of the service. 11 The district attorneys and their administrative staff are part of the agents that determine the demand for the service (besides the parties and their lawyers). 12 None of these public agents has, in principle, a direct interest in the result of the judicial procedures. This is only the case for the parties in the dispute. The public agents act representing the interest of others, in this case of the public interest. In this context, the best way to focus the analysis of the public sector incentives is with the principal-agent model. Some studies in OE apply the principal-agent model in the context of the public sector (Becker & Stigler, 1974). In this case, the public employee is the agent and society as a whole (or the public interest) is the principal. A simple way to analyze this problem is to consider that a public employee has a mission or duty defined in terms of the public interest (if police officer, to protect citizens against crime). Thus, the analysis must be centered in how the incentive structure affects how well the public employee (the police officer) performs his/her duty. The problem of corruption is the most salient in this segment of the literature (Shleifer & Vishny, 1993). However, this analysis can be generalized (Rose-Ackerman, 1986; Klitgaard, 1989, Johnson & Libecap, 1989): how to create the incentives to achieve greater efficiency in the supply of services by the public agents. What factors determine the actions of the public agents? These factors will certainly determine the quality and quantity of supplied service in the case of the Judiciary and, partially, of the service demanded in the case of the district attorneys. In what follows, I concentrate in the case of the Judiciary, although the analysis is easily applicable to the case of the district attorneys. Four basic factors are discussed: the set of formal rules that norms the actions of the public agents, the degree of discretion that in practice they enjoy, the existence or the degree of competition the public agents face in their functions, and the social context in which they operate. First, there is a set of formal rules that establish some objectives and in some detail dictate the way in which the judicial procedures should be undertaken. These rules cover aspects from judicial independence to the steps a court should follow in judging a case. Thus, first, the public agents are supposed to guide their actions according to the objectives set by the rules. Second, and more specifically, they are supposed to act as described by the rules and, in part, based on their own decisions according to the degree of discretion given by the rules. Second, the discretion that in practice enjoy the public agents plays a role at least as important as the formal rules. The principal-agent relationship becomes the key problem. The formal rules are like the contract between the principal and the agent. The problem is how to enforce them. There is another set of rules, not directly about the judicial procedures, that governs this aspect. These rules would certainly also be part of the contract between the principal and his/her agent. They refer to the monitoring of the public agents' actions, the way in which they are rewarded or penalized for their actions, and so on. These rules are, in 11 12

In a more general analysis, we should include those working in private systems of dispute resolution. Those who work in legal aid services, if they exist, would also affect the demand.

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essence, mechanisms that attempt to solve the problem of asymmetric information. The principal can not observe the actions of the agent without incurring costs and, probably, the costs of obtaining perfect information about those actions are prohibitively high. If there is not an adequate monitoring system that makes the public agents' actions transparent, the influence they would have over the supply of the service would be decisive. In this case, in practice the public employees would enjoy a high degree of discretion, even if the laws do not allow it. Similarly, even if the legislation allows some degree of discretion, if there is an effective monitoring system in place, problems like discrimination or inconsistencies in the supply of the service could be controlled. On the other hand, if aspects like job security, promotions, and level of income do not depend substantially on the performance of the public agent, s/he will have no incentive to perform to the best of her/his capacity. Without monitoring and reward/penalty systems, without an adequate incentive structure, the provision of the judicial service (in terms of quality and quantity) would be deficient. Two additional aspects are linked to the problem of incentives: the degree of competition and the social context. On one hand, there is the problem of the existence (or not) of competition in the functions of the agents. Some studies consider that the problems of the public sector, and in particular of corruption, comes from the so- called problem of "the tragedy of the commons" (Benson, 1988). 13 A service like the one supplied by the police is considered a public good (police is supposed to protect society in general and not only specific individuals). In this context, the service is provided by the State and it is not directly charged according to its use. This situation translates into the lack of property rights over the use of the service, and the lack of a price that would ration that use. In consequence, the resource (police protection, for example) is inefficiently used (there is an excess demand). Due to the congestion problem, in practice the public agent is given the discretion to assign property rights over the service (whom to serve) .In other words, the property rights are being implicitly assigned to the public agents, who then can exchange them. It is important to remark that these rights are a monopoly or quasi-monopoly (Dey, 1989, Jagannathan, 1986). A possible solution, in consequence, is to promote competition in these functions. Shleifer & Vishny (1993) discuss, for example, the important role that the introduction of competition in the functions of the public agents can have in the reduction of corruption. Competition can also be useful in other aspects. It can help evaluating the performance of the agents because a comparison is possible, or it can help design schemes by which market-like mechanisms reward or penalize public agents. Competition can take place within the judicial system, with other government offices, or with private suppliers of the service. The social context (informal rules) plays also an important role in the incentives of the agents. Aspects like the social value of effort and honesty affect the actions of the agents. The social prestige of the positions is important to determine who would be attracted to them. Bureaucratic practices are also important. For example, the belief by bureaucracies that promotions depend more on seniority than on merits would have an important impact on the performance of the public agents. These informal rules are very resistant to change. Only education and a consistent application of formal rules can modify them gradually.

13

This problem refers to the inefficient use of public goods.

13

Another important aspect regarding the social context is the independence of the Judiciary from other powers of the State. Often this independence is sanctioned by laws that in practice are not well enforced. Executive branches in Latin America tend to consider that they should have an absolute control of the State apparatus. If, for example, people in the Judiciary see themselves as subordinates to the Executive branch, the independence of the Judiciary would not be obtained simply by the adoption of new rules. In sum, the incentive structure in the public sector is an important factor in explaining the problems of the judicial system. Furthermore, as said, this issue should receive special attention in a judicial reform. If not, any reform runs the risk of remaining just on paper. For example, a judicial system can be slow because of lack of resources, but also because the public agents have incentives to keep the system slow. If too quickly we decide to give more resources to the system, these resources can be wasted if the incentives are not modified first. A similar conclusion can be obtained from the following quote regarding the supposed benefits of corruption. "With [a] dynamic perspective on corruption, several of the advantages that are claimed to follow from corruption, e.g., the speeding of bureaucracy by bribes, will be seen to be illusory because the problems they overcome exist so that they may induce corruption. " (Alam, 1989, p. 448) 14 Figure 1. Determinants of judicial supply and demand

SOCIAL CONTEXT*

COMPETITION*

PUBLIC EXPENDITURES

PARTIES INCENTIVES

LEGISLATION*

SUPPLY

EQUILIBRIUM

DEMAND

LAWYERS’INCENTIVES

EDUCATION

*Through incentives to public actors.

7.4

Demand of the parties for judicial service

The demand for judicial service has two special characteristics that distinguish it from other demands. Commonly, a demand consists of one decision, to buy or not a good or service. In the case studied here, as will be seen, decisions in three stages determine the level of the demand for judicial service. In addition, the users decide their demand according to the perception they have over the costs and benefits expected from the judicial process. However, 14

Even if the incentive structure is adequate, the performance of the agents always will be limited by their capacity (basically determined by their education) and the available material resources to them. These two aspects, not discussed here, should be considered in a judicial reform. See Figure 1.

14

this perception depends largely on the information supplied by an intermediary with his/her own interests, the lawyer (again the principal-agent problem). 7.4.1

The three stages

Let's consider, as an illustration, the three stages in the case of a contract:15 • • •

Individuals decide whether they contract or not in a given case. If the contract takes place, each party decides whether or not to default. The parties decide whether to resolve their dispute by themselves or to ask the intervention of a third party judicial system). 16

From this series of decisions, we can observe the important role played both by the judicial costs and the expected outcome of the judicial process, i.e., the sum of the magnitude of each possible sentence weighted by its probability of occurrence (the uncertainty problem is important in this point). According to the perception that the parties have about the costs and the outcome of the process, they could reach (or not) a settlement by themselves. Similarly, that perception affects the characteristics of the settlement. The expectations about the judicial outcome or a possible settlement determine whether a person decides to default on a contract. Finally, all these elements determine whether individuals in a given case agree to a contract. (See Figure 2). 17 In sum, when we analyze the effects of a judicial reform on the demand, we have to consider the effect of the reform on the costs and the expected outcome of the judicial processes, on the different decisions involved, and, finally, the effect of these decisions on the demand. Figure 2. Decision tree of the demand for the judicial service RESOLUTION MECHANISM JUDICIAL DEFAULT CONTACT

VOLUNTARY NO

NO

15

This illustration certainly does not cover a1l the possible cases. For example, is rather applicable to the civil or commercial law than the penal law .The decision that a third party resolves the conflict can involve deciding among different alternatives within the judicial system, or opting for a private service. The analysis, however , is in essence the same in all the cases. 16 A situation in which an individual, who believes to be affected by the other party in a contract, , decides not to seek compensation is equivalent to a private agreement among the parties in which simply the status quo is maintained. 17 For more detail on this kind of analysis, see, for example, Landes (1971), Priest (1983), Polinsky & Rubinfield (1988), and Cooter & Rubinfield (1989).

15

7.4.2 Perception through an intermediary We have seen how important the perception of the parties about the costs and the outcome of the judicial process is to determine the demand. This element takes us to another problem. The perception under which the individuals decide is to great extent influenced by an intermediary, the lawyer. The lawyers' incentives not necessarily lead to decisions that coincide with the client's best interests (this situation could be related to payment schemes, for example). When the judicial process is not very transparent, the client is more dependent on the information supplied by his/her lawyer for his/her decisions. The asymmetry in the availability of information is particularly important in this context. Through the market the participants can attempt to resolve these problems by designing different contracts. The restrictions under which the market for legal advice operates determine to what extent the agents can on their own solve the principal-agent problem. VIII. POLITICAL ECONOMY OF JUDICIAL REFORM As has been said, it is incorrect to assume that members of government act with the sole goal of maximizing social wealth. So far, however, I have only considered how the public agents' interests can affect the implementation of the reforms. A previous point is the role played by private interests in the design of the policies to be adopted. In this context, there are two aspects that should receive special attention. First, the influence of those who benefit and those who lose with a judicial reform. Second, these pressures from the affected and the degree of general public support for the reform determine the political costs and benefits of the reform for the government. The problem of a judicial reform is that a number of organized groups (such as lawyers, public notaries, judges, public employees), with access to the government, congress, and the media can be negatively affected, at least in the short-run, by the judicial reform. They can then exert political pressure to block it. The benefits either are far down in the future for these players or correspond to the general public as users of the system with little capacity to organize and influence directly the policies. Besides, the benefits per individual are not high enough to make such effort worthwhile. Politicians, however, can respond to public opinion and not just to interest groups. Unfortunately, the most important benefits of the judicial reform would take some time to materialize and would never be as visible as say a new road built. All these factors, certainly, reduce the political benefits for the government of undertaking such reform. 18 Certainly, the dissemination of information about the benefits of a judicial reform must be part of a reform effort. Similarly, specific benefits, probably in the long run, should be identified and emphasized. These actions would give the government tools to obtain political support. Additionally, these actions can diminish opposition and even gain some important organized supporters (like business associations).

18

See Olson (1965) for a general discussion on the role of interests groups and Krueger (1994) for discussion on the political costs and benefits of adopting policy reforms in LDC.

16

On the other hand, to obtain larger and faster benefits, it is important to have a reform that looks as credible and as permanent as possible. People who have had no confidence in the judiciary are going to be very skeptical of any reform. Finally, Klitgaard (1989, 1994), based on a number of reform experiences, suggests some ideas on how to obtain political support for State reform policies. First, the public must be informed about the crisis of the sector and the need to implement reforms. Second, the affected parties should be involved in the design of the reform, but being firm in certain basic points. 19 Finally, to reduce resistance, some pilot projects or experiments should be selected. These projects should be easy to observe and evaluate in a short period by the interested parties. However, there are others that point to the risks of gradual reforms (Rose-Ackerman, 1978 and Quah, 1989). Problems so imbedded in the system can not be fixed with little changes here and there. Major surgery is needed. Furthermore, partial reforms leave opportunities open to evade them. On the other hand, to adopt an integral reform requires very strong political will and great capacity of the State to undertake it. The most adequate option is finally an empirical question that should be carefully resolved in each case. IX.

CONCLUSIONS

The judicial system plays a fundamental role in providing the necessary conditions for the market to work. A deficient judicial system generates high transaction costs, especially in the case of more complex contractual relations, limits the extension of the market and the possibilities of growth. Likewise, a deficient judicial system since it does not provide sufficient guarantees to protect the agents' rights generates an inequality in the possibilities of economic improvement. In this situation only a few, based on personal relations and greater economic resources, can obtain such guarantees. In consequence, discrimination in the access to the market and to the benefits derived from that access is generated. On the other hand, there is abundant evidence of the poor performance of the judicial systems in Latin America. A judicial reform, thus, is imperative in these countries and can help significantly to consolidate the economic progress achieved in recent years. The analysis just presented (coupled certainly with diagnostic studies of the judicial systems to be reformed) can serve as a starting point to design a far-reaching judicial reform. The two central issues discussed in this paper are the importance of studying the incentive structure of the players involved and the need to consider the view from the demand side in the definition of the objectives and in the design of judicial reforms.

19

The judicial reform program in Venezuela (supported by the World Bank) will provide an interesting experience. As part of the program, a bi-monthly working-seminar for judges has been instituted. In these seminars the judges with the guidance of some advisors discuss the problems of the sector and possible ways to solve them. Instead of having a reform designed by outsiders, the judges seem to feel in this case that they are in large part responsible for the design of the reform. The judicial reform program in Venezuela (supported by the World Bank) will provide an interesting experience. As part of the program, a bi-monthly working-seminar for judges has been instituted. In these seminars the judges with the guidance of some advisors discuss the problems of the sector and possible ways to solve them. Instead of having a reform designed by outsiders, the judges seem to feel in this case that they are in large part responsible for the design of the reform.

17

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Greer, Patricia (1992a) "The Next Steps Initiative: An examination of the agency framework documents. " Public Administration, Vol. 70, pp. 89-98. Greer, Patricia (1992b) "The Next Steps Initiative: The transformation of Britain's civil service." The Political Quarterly, Vol. 63, pp. 222-227. Hausmann, Ricardo y Rigobon, R., eds. (1993) "Government Spending and Income Distribution in Latin America. " Washington: Inter- American Development Bank. Instituto APOYO (1993) "Evaluación del Sistema Judicial." Lima. . Instituto APOYO (1993a) "El Costo de los Procedimientos Civiles en el Poder Judicial. " Lima Instituto APOYO (1993b) "Actitudes Empresariales ante el Poder Judicial." Lima InterAmerican Development Bank(1994) "Situación Económica de América Latina." Washington. Inter-American Development Bank (1994a) "Informe Final de Consultoría. Mejoramiento de la Gestión de Despachos Judiciales. Poder Judicial Costa Rica. " Mimeo. Jagannathan, N. Vijay (1986) "Corruption, Delivery Systems, and Property Rights." World Development, Vol. 14, pp. 127-132. Johnson, Ronald and Libecap, Gary (1989) "Bureaucratic Rules, Supervisor Behavior and the Effect on Salaries in the Federal Government." Journal of law. Kakalik, J.S. and Ross, R.L. (1983) "Costs of the Civil Justice System. Court expenditures for various types of civil cases. " The Institute for Civil Justice, Rand Corporation. Klitgaard, Robert (1989) "Incentive Myopia." World Development, Vol. 17, pp. 447- 459. Klitgaard, Robert (1989) "Controlling Corruption." Berkeley: University of California Press. I. Klitgaard, Robert (i994) "Adjusting. to Reality. Beyond 'State versus Market' in economic development." San Francisco: ICS Press. Krueger, Anne O. (1993) "The Political Economy of Policy Reform in Developing Countries. " Cambridge: MIT Press. Leff, Nathaniel H. (1964) "Economic Development through Bureaucratic Corruption." American Behavioral Scientist, Vol. 8, pp. 8-14. North, Douglass C. (1981) "Structure and Change in Economic History." New York: W.W. Norton and Co. North, Douglass C. (1990) "Institutions, Institutional Change, and Economic Performance. " New York: Cambridge University Press. 0lson, Mancur (1965) "The Logic of Collective Action." Cambridge: Harvard university Press. Pastor, Santos (1992) "Eficiencia del Gasto Público, con aplicaciones al programa de gasto público en justicia." Instituto de Estudios Fiscales. Polinsky, A. Mitchel and Rubinfeld, Daniel L. (1988) "The Deterrent Effects of Settlements and Tria1s." Intemational Review of Law and Economics, Vol. 8, pp. 109-116. Posner, Richard A. (1973) "An Economic Approach to Legal Procedure and Judicial Administration." Journal of Legal Studies, Vol. 2, pp. 399-458. Posner, Richard (1983) "Economics of Justice." Cambridge: Harvard University Press. Posner, Richard A. (1986) "Economic Analysis of Law." Boston: Little-Brown. Posner, Richard (1995) "Overcoming Law." Cambridge: Harvard University Press. Pratt, John W. and Zeckhauser, Richard J. (1985) "Principals and Agents: An overview" in John W. Pratt and Richard J. Zeckhauser (eds.) "Principals and Agents: The structure of business." Boston: Harvard Business School Press. Priest, George L. (1983) "Regulating the Content and Volume of Litigation. An Economic Analysis. " The Institute for Civil Justice, Rand Corporation.

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Quah, Jon S.T. (1989) "Singaporels Experience in Curbing Corruption" in Arnold J. Heidenberg, Michael Johnston, and Victor T. LeVine (eds.) "Political Corruption. A handbook.1I New Brunswick: Transaction Publishers. Rose-Ackerman, Susan (1978) "Corruption: A Study in Political Economy." New York: Academic Press. Rose-Ackennan, Susan (1986) "Reforming Public Bureaucracy through Incentives?" Journal of Law, Economics, and Organization, Vol. 2, pp. 131-161. Shleifer, A. and Vishny, R. (1993) II Corruption." The Quarterly Journal of .. Economics, Vol. 108, pp. 599-617. Sherwood, Robert M.; Shepherd, Geoffrey and Marcos de Souza, Celso (1994) II Judicial Systems and Economic Performance. II The Quarterly Review of Economics and Finance, Vol. 34, pp. 101-116. Stigler, George (1970) "The Optimum Enforcement of Laws." Journal of Political Economy, Vol. 78, pp. 526-536. Williamson, Oliver (1985) "The Economic Institutions of Capitalism." New York: Free Press. World Bank (1992) "Venezuela. Judicial Infrastructure Project." Staff Appraisal Report No. 10635-VE. World Bank (1994) "Bolivia. Judicial Reform Project." Staff Appraisal Report No. 13052BO. World Bank (1994a) "Ecuador. Judicial Sector Assessment." Report No. 12777-EC. World Bank (1994b) "How Legal Restrictions on Collateral Limit Access to Credit in Bolivia." Report No. 13873.

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