Institutions, Markets and Economic Performance: Implications for Cuba.

Roger R. Betancourt*

Department of Economics

University of Maryland

August 2005

*This paper was prepared for the ASCE meetings in Miami, August 2005. Earlier versions were presented at the AEA meetings in Philadelphia, and at James Madison University, ODE Spring 2005 seminar series. I thank seminar participants for thought-provoking questions and John Devereux, Nuno Limao and Rodrigo Soares for insightful comments, while staking claim to remaining errors as my own.

Introduction

An important aim of this paper is to increase the level of rigor that we use to

understand the role of the state as an institution determining the economic performance of

other institutions. More specifically, we seek to increase our understanding of the role of the state

in determining the economic performance of two distinct type of markets: 'spontaneous' markets

and 'socially contrived' ones. Thus, in the next section we identify the main characteristics of

these two types of markets. Subsequently, in Section 2, we discuss in detail the role of the state

in these two types of markets by identifying the specific services that the state provides and how

they improve the functioning of the two types of markets. Sometimes these services have been

referred to as market augmenting services in the new institutional economics literature. In

general they are considered to be public goods.

What has been missing from the literature is a systematic focus on the role of these

services not as general public goods but as specific public inputs that affect the operation and

economic performance of the two types of markets. Frequently, they do so in a differential way.

In Section 3, we characterize these public inputs in detail, identify four of them explicitly, discuss

how two of them have the nature of 'pure' public inputs and their production may be subject to

threshold effects. Furthermore, we discuss how the effects of all four on the operation of markets

may be associated with the existence of increasing returns in the production of some of them or in

their effects generating increasing returns in the markets they affect. We discuss in Section 4

some empirical evidence on the importance of these public inputs for the economic performance

of these two types of markets. Finally a subsidiary aim of this paper, which is accomplished in

Section 5, is to draw some implications of this improved characterization of the role of the state in

determining economic performance for the possible paths of evolution of the Cuban economy.

1. Two Types of Markets.

We will divide markets into two general types that will be labeled 'spontaneous'

and 'socially contrived', following Olson's (2000) terminology. Others, for example North

(1990), have used the labels 'traditional' and 'modern' to make a similar point. What is

important is not the label that one uses but the characteristics that one associates with each type

of market.

In the case of 'spontaneous' markets, one characteristic that they frequently share with

traditional ones is that transactions are self-enforcing. One can say that this characteristic is

sufficient, but not necessary, for a market to be classified as spontaneous. Transactions are self-

enforcing when both parties to an exchange have a variety of incentives to fulfill the terms of the

exchange. Three features of markets are identified (by North) as making transactions self-

enforcing: 1) The transactions are repeated; 2) the number of different persons participating in

the market is small; 3) both parties to the exchange have abundant information on each other.

A recent analysis of clusters, Thompson (2005), uses the modern IO literature on

contracting to show why relational contracting in developing countries is self-enforcing. One

can relate easily the previous three features to the ones emphasized by Thompson: 1) repeated

interactions increases the value of the relationship; 2) the small number of participants allows

trust to build in the relationship, especially if friends and relatives are involved; 3) information

on both sides allows for community enforcement of contracts as an informal mechanism.

Our first point is that self-enforcing transactions are a characteristic of many

'spontaneous' markets and in these markets we will find the three features that lead these

transactions to be self-enforcing. Whether these features are expressed in terms of the new

institutional economics or modern IO contracting theory is to a large extent a question of

semantics.

In earlier work Clague, Keefer, Knack and Olson(1999) characterize 'spontaneous

markets as "...self-enforcing. These markets are common, either because many exchanges simply

meet the conditions for self-enforcement or because they are so lucrative that the absence of self-

enforcement makes even risky exchanges worthwhile." Some of these markets exist even when

the state tries to suppress them. Thus, there is a second defining characteristic of 'spontaneous'

markets that is implied in the quote: lucrative, which is a somewhat narrow term. A more

appropriate general term would be the size of the gains from exchange for both parties. If

sufficiently large in terms of the preferences of the participants, it can lead to the existence of

'spontaneous' markets even when transactions are not self-enforcing. Often illegal markets have

this feature. Olson (2000) sometimes refers to 'spontaneous' markets as irrepressible.

Not surprisingly, given the previous discussion, a necessary characteristic of

'socially contrived' markets is that transactions are not self-enforcing, i.e., the participants in an

exchange have strong incentives not to fulfill the terms of the exchange. Sometimes these

markets are identified as modern, North (1990), and again three features that are complements to

the ones associated with traditional markets are used to generate the incentives for non-

enforcement of the terms of the exchange: 1) transactions are unique or not repeated often; 2) the

number of different persons participating in the exchange is large; 3) the participants have little

or no information on the persons participating on either side of the exchange.

In Clague, Keefer, Knack and Olson's (1999) view these markets are not self-enforcing

because the benefits to one party to the exchange are separated temporally or spatially and/or by a

state of nature from the benefits to the other party and this, by itself, creates an incentive for non-

fulfillment of the terms of the exchange by one of the parties. These markets are characterized by

non-simultaneous transactions. In these markets third party enforcement of contracts becomes

critical for their existence or operation at a high level. Incidentally, one can credibly argue that

Hernando de Soto's (2000) book, "The Mystery of Capital", is an argument or a plea to convert

the informal assets of the poor in developing countries into formal assets through the

development of these 'socially contrived' markets for property held by the poor.

What is the relative importance of these two types of markets in an economy? One pass at

the answer comes from Clague, Keefer, Knack and Olson (1999, p.397) who state "To obtain

the broadest reasonable measure of the industries that are especially dependent on contract

enforcement, we took the aggregate of the finance, insurance, real estate, and business services

sectors as a percentage of GDP from the United Nations Accounts data." From the US Statistical

Abstract these figures in recent years would be : 1990, 21%;1995, 22%; 2000, 25%.1 An

alternative pass comes from Wallis and North (1986) who identify transaction sectors and non-

transaction sectors. The former includes finance real estate and insurance as well as retail and

wholesale trade. The share of GDP of their ' transactions sector' for the US yields: 1990, 33%;

1995, 34%; 2000, 35%. In sum, conservative estimates suggest that sectors of the economy were

third party enforcement is important take up between a fifth and a third of GDP in 1990 and that

this proportion grew to between a quarter and 35% during the last decade of the twentieth

century.

Wallis and North (1986) also argue that many transactions in the other sectors

fall into this category but can not be directly identified as transaction activities that are

separate from the transformation ones. Thus, these numbers are an underestimate of the

resources devoted to this type of market because there are activities in other sectors of the private

economy where the same considerations with respect to third party enforcement would apply, but

it is not easy to separate by sector if the activities are taking place in 'spontaneous' markets or in

'socially contrived' markets. For instance, most modern labor markets are 'socially contrived',

regardless of the sector in which the firm operates.

In addition, the government sector uses up resources to create the possibilities for markets

of both types to exist, but especially so for the 'socially contrived' ones. The ratio of US

government's contribution to GDP during this period is:1990, 14%;1995, 13%; 2000, 12%.2 Of

course, not all these government expenditures are incurred to provide contract enforcement

services but 'socially contrived' markets also need other public inputs frequently provided by

governments. We now turn to consider what these inputs may be.

2. The Role of the State in the Two Types of Markets.

Both types of markets require the state or an alternative institution to provide several

services to exist or operate at a high level. For instance, in evaluating Cuba's reforms Betancourt

(1998) follows an early version(1994) of Clague, Keefer, Knack and Olson by stressing two

services that apply to both types of markets and one that applies to 'socially contrived' markets.

The two that apply to both types of markets are: 'law and order', in the sense of absence of a state

of anarchy where people are dispossessed of the gains from exchange arbitrarily on a frequent

basis3; and a reliable medium of exchange, in the sense of a currency that allows transactions to

take place without the need for barter exchange4. The one that applies only or mainly to 'socially

contrived' markets is the existence of third party enforcement of contracts as normally provided

by an impartial judiciary.

One of the arguments made by Betancourt (1998) is that alternative institutional

mechanisms, for example corruption, arise to fill the void created by the absence of the

government providing impartial third party enforcement. This factor and the predominance of

'spontaneous' markets in agricultural societies may be one basis for the explanation of short-run

economic success in Vietnam and China despite the absence of impartial third party enforcement

by the judiciary. This alternative may not be as effective in promoting growth over the long-term

as an impartial judiciary. Because it generates more uncertainty, especially when there is

competition among the suppliers of corruption services.

In a book published posthumously Olson( 2000) argues that the above services capture the

active role of the state, but that in addition for 'socially contrived' markets to thrive there is a

passive role that involves a commitment not to predate or to have the power of the state used for

predation by small groups and that this is demonstrated through the protection of individual

rights, of persons and firms, that are broad and secure. Betancourt (2004) picks up on this theme

and characterizes this passive role of the state as a commitment to abide by the rule of law.5

More generally, the existence of this commitment also facilitates the operation of

'spontaneous' markets at a higher level, but its absence has a much smaller effect on

'spontaneous' markets than on 'socially contrived' ones.

Services provided by governments in support of markets have been recently referred to as

market augmenting government at a conference in honor of Mancur Olson, Azfar and Cadwell

(2003). Clearly the three identified above as well as the rule of law would qualify as deserving of

the name. This name, however, should not obscure the reality that these services can and should

be thought of as public goods. Furthermore, Betancourt (2003) points out that these services are

public goods that increase market output indirectly by increasing the gains from exchange through

a reduction of transaction costs and are likely subject to threshold effects and increasing returns.

3. Public Goods, Public Inputs, Threshold Effects and Increasing Returns.

There is a vast and substantial literature on public goods, but most of the literature

approaches the subject by viewing public goods from the consumption side, e.g., Drazen (2000).

The two defining characteristics of a public good in this setting are non-rivalry, or the extent to

which consumption by one agent does not affect consumption by another agent, and non-

excludability, or the extent to which barriers to entry into consumption are feasible in the

provision of the good. The former determines whether the public good is a pure public good (no

effect on other consumers) or an impure one. The latter determines whether or not it is feasible to

provide the public good as a club good (if barriers to entry into consumption are possible).

At least two of the four public goods identified previously qualify as pure public goods or

as close to pure public goods as one can come.6 For, it is difficult if not impossible to conceive

of some core elements of the rule of law or of a medium of exchange where congestion effects are

relevant, at least with homogeneous consumers. On the other hand, it is easy to think

of situations where basic aspects of law and order available to some maybe less than what is

available to others. For example when crime is at a high level in a given area, law enforcement

services are likely to vary across even homogeneous consumers. Because location itself will be a

source of heterogeneity, even if everything else were indeed equal.

Similarly, it is easy to conceive of situations where contract enforcement services available

to some differ from what is made available to others. Indeed, recently Chemin (2004) uses

differences in the pendency rate across Indian state courts to measure the impact of contract

enforcement on breaches of contract and relationship specific investments for a sample of Indian

non-agricultural informal firms. Similarly, Visaria (2004) uses the differential introduction of debt

recovery tribunals across states in India to evaluate the impact of differential contract enforcement

due to judicial quality on loan repayments.

From the exclusion perspective it is difficult to exclude individuals from access to a

medium of exchange or to the rule of law while these two public goods continue to perform their

role as market augmenting services. For instance, even as oppressive a regime as the Castro

government did not try to exclude some of its citizens from the use of the dollar as a

medium of exchange when it made the dollar legal tender in 1993. Similarly, it is incongruent

with the rule of law to have it apply to some individuals and not to others as the historical

disappearance of slavery as a recognized legal institution makes evident.

It is much easier to conceive of mechanisms where law and order and contract

enforcement services can be made available to some and not to other members of society by

introducing barriers to their consumption. For instance, one can observe communities that

provide their own security services within their gates in cities of both developed and developing

countries. Similarly, the need to pay for lawyers to access some contract enforcement services

suggests that exclusion is possible in the provision of this service. In all four cases, however, one

of the most relevant features of these public goods or services is that they are inputs into the

operations of markets. They are inputs in the sense that higher levels of these services allow

markets to operate at a higher level of transactions. It is this role of public inputs that has been

neglected in the literature on institutions.

While the public finance literature has extended the analysis of public goods to public

inputs, it has done so primarily under the assumption of economy wide diminishing returns,

referred to as firm augmenting public inputs, or economy wide increasing returns consistent with

perfect competition, referred to as factor augmenting public inputs. This terminology is developed

by Feehan and Matsumoto (2000). Furthermore, the standard assumption in this literature is that

the production function for the public input itself is a neoclassical one subject to constant returns

to scale, for example Feehan (1998).

While these assumptions may be eminently sensible when applied to public inputs such as

infrastructure, it is not clear that they are equally sensible when applied to two of the market

augmenting services we have identified here. Both the production of the rule of law and of a

reliable medium of exchange seem subject to thresholds in that either you have them or you don't

have them at a certain level. Changes in the levels of these two market augmenting services seem

to be quite discrete. It also seems easier for the state to 'produce' a reliable medium of exchange

through the introduction of fiat money, for example, than to 'create' a rule of law through

credible commitments not to engage in predatory behavior. In the former case declaring a

medium of exchange legal tender seems usually sufficient to generate a minimum level of this

service. By contrast, declaring respect for the rule of law by itself is unlikely to be a credible

commitment in many if not most cases.

With respect to the rule of law it is less clear how one accomplishes the task of creating or

increasing the service than with respect to a reliable medium of exchange. Furthermore,

increasing returns seem to be potentially important in the following sense. Suppose one were to

double the resources devoted to the creation of the rule of law. This could be done, for example,

in the form of protecting human rights such as freedom of assembly and speech by devoting

resources to encourage citizen participation in these activities. This doubling may take us from a

very low or minimal level of the rule of law to a very high one (more than double so to speak) if

successful or to not much change if unsuccessful.

The other two market augmenting services, law and order and impartial third party

enforcement through an independent judiciary, seem more suitably described as produced on a

continuous basis according to a neoclassical production function. Nevertheless, in both cases one

can argue reasonably that increasing returns may play some role in their production over some

range of values. For instance, doubling the amount of resources devoted to law enforcement or to

the judiciary may more than double the level of law and order or of impartiality in third party

enforcement at some points and increase them by far less than twice their levels at other

points.7

To my knowledge, no one has tried to model explicitly the production of these four public

inputs and/or their effects on the two types of markets that we have been discussing. Attempts to

do so would need to pay attention to some of the distinctions emphasized here. Taking into

account thresholds and increasing returns in the production of the rule of law as well as the

potential for increasing returns on its impact on the operation of 'socially contrived' markets

would seem to be the highest priority, at least judging by some of the results available in the

empirical literature discussed below.

4. Effects on GDP/POP, Growth and the Variance of Growth

Do we know anything about the impact of these public inputs or market augmenting

services on economic outcomes? There have been some attempts at measurement and at

exploring their impacts on per capita income and its growth, which we now review. There are a

number of conceptual and/or measurement issues that arise in connection with these market

augmenting services or public inputs. For instance, we just argued (note 7) that the rule of law is

a multidimensional concept and that one of its elements is produced by the same mechanism as

impartial third party contract enforcement. When we come to measurement, these subtle

distinctions can be difficult to capture.

Clague, Keefer, Knack and Olson (1999) introduce contract intensive money (CIM) as an

"… objective measure of the enforceability of contracts and the security of property rights." This

measure is simply the ratio of demand deposits (DD) plus time deposits (TD) to M2 = DD + TD +

C, where C is currency. The fundamental idea is that CIM is a reflection of the type of

governance that improves economic performance. The rule of law (as the main determinant of

the security of property rights) and impartial third party enforcement by governments (as the main

determinants of the enforceability of contracts) are the more fundamental causes of economic

performance that this variable is capturing.

In a more recent paper Acemoglu and Johnson (2003) try to unbundled institutions by

separating property rights institutions and contracting institutions. By property rights institutions

they mean "…institutions constraining government and elite expropriation …"; by contracting

institutions they mean "… institutions supporting private contracts …". In principle these two

correspond, respectively, to what we have called the rule of law and third party enforcement.

They use two measures to proxy for the rule of law: Political Risk Services assessment of

protection against government expropriation in a country and Polity IV's constraint on the

executive measure. The extent of third party enforcement is measured by the number of formal

legal procedures necessary to resolve a simple case, for example collecting on a bounced check or

evicting a non-paying tenant. This is derived from the legal formalism data base compiled by

Djankov, La Porta, Lopez de Silanes and Shleifer. Presumably the higher the costs of enforcing

private contracts by government the lower the effective level of third party enforcement.

Acemoglu and Johnson (2003) find that both property rights measures have a strong and

statistically significant effect in explaining the log of GDP/POP in 1995PPP $. This is the case for

both OLS regressions and 2sls regressions using log of settler mortality or log of

population density around 1500 as an instrument. The measures of legal formalism have no

effects on GDP/POP when using constraints on the executive and the wrong sign when using

average protection against risk of expropriation as a measure of the rule of law. These results are

taken from Table 4 in their paper. Acemoglu and Johnson (2003) argue that this impact on per

capita income in their cross-country setting captures the impact on the long run rate of growth.

Clague, Keefer , Knack and Olson (1999) find that CIM , which captures both dimensions

of institutions (namely the rule of law and third party enforcement), is an important and robust

explanatory variable in explaining cross-country growth in GDP/POP between 1969 and 1990,

except when the investment to GDP ratio is also included. These results are from their Table 4.

In an Appendix Acemoglu and Johnson (2003) use the average rate of growth between 1970 and

1995 as a dependent variable and their results are much weaker in that rule of law has no effect at

the 1% level with one of the two measures using settler mortality as an instrument and it has no

effect with both measures using population density as an instrument and the eviction measure of

contract enforcement. The authors , however, argue that the results are similar to the ones on

GDP/POP. They also interpret these results as relevant for 'medium term growth'.

Clague, Keefer, Knack and Olson (1999) analyze the effect of CIM on the investment to

GDP ratio. They find that CIM is an important and robust explanatory variable in explaining the

investment to GDP ratio (Table 3). Hence, their overall conclusion is that the rule of law and

third party enforcement are important in explaining growth through their effect on investment, not

necessarily through their direct effect on growth. Acemoglou and Johnson (2003) also look at the

effect of rule of law and third party enforcement on the investment to GDP ratio and they find a

strong positive and robust effect for their measures of the rule of law and a statistically

insignificant effect for their measures of third party enforcement (Table 5). Given their results for

'medium term growth' reported above, the interpretation that both CIM and their measures are

capturing mainly rule of law effects and that these work through investment seems the appropriate

conjecture at this stage of our knowledge.

Given the recent paper by Mobarak (2005) about the effect of democracy on growth, it

seems reasonable to suspect that the rule of law in particular may have a similar effect. That is,

Mobarak finds that volatility reduces growth and this effect is robust. On the other hand,

democracy has no direct effect on growth. Yet, it is a very robust determinant (with a negative

sign) of the volatility of growth. Given the results on 'medium term growth' reported earlier

and that rule of law would be one of the main determinants of democracy, one may expect similar

results if the extent of the rule of law was used as a proxy for democracy.

5. Implications for the Path of the Cuban Economy.

In order to draw implications for the future, it is desirable to provide a synthesis

of where we are at present. There is a fair amount of agreement on the characterization of

Cuba's economic policies between 1989 and 2004 but less agreement on the evaluation

of the economic performance associated with these policies, especially in the most recent

period. The policies can be classified into four mainly chronological periods.

First, there was a period of belt tightening and inaction (1989-1992) in response to

the end of Soviet subsidies. Associated with this period was a substantial fall in

GDP and its rate of growth, which was negative in all four years and with rates of

decline over 10% in the last two years of the period [e.g., Ritter, 2004, Table 1.2]. This period

was followed by a short one (1993-1995) of substantial economic reforms oriented

toward the development of a market economy. These reforms included: dollarization;

allowing state farms to become cooperatives, farmer's markets to operate and certain forms of

self-employment; legalizing foreign investment in various sectors and promotion of tourism;

macroeconomic stabilization and a switch to western national income accounting

methods by the Central Bank. Growth of GDP stabilized and became positive by the end

of the period [e.g., Ritter, 2004, Table1.2].

A third period (1996-2002) can be characterized as treading water because some

of the earlier reforms were slowed down (for example, imposition of restrictions on and

excessive taxation of the self-employed ) and some 'reformers' were purged from

influential positions while new reforms (for example managerial improvements in state

enterprises) were supported with vigor at least on paper. The rate of growth of GDP

remains positive every year but fluctuates considerably and is fairly low the last two

years of the period. For instance, Ritter's Table 1.2 ends with 2.7 % for 2001 and

Perez-Lopez (2003) gives a figure of 1.1% for 2002, which is consistent with Ritter's

discussion of what he expected for 2002 due to the world economic slow down and the

effect of September 11 on tourism.

By the end of this third period Cuba's economy had changed dramatically from

where it was in 1989. Among the most dramatic changes is the decline of sugar in terms

of its contribution to output. In the first period (1989 to 1992) sugar output fluctuated

within 7.2 and 8.4 million tons of annual production; in the third period sugar output

fluctuates within 4.3 and 3.5 million tons of annual production. Similarly, there has

been a substantial increase in the production of oil and natural gas during this period. For

instance, from well under a million tons of oil in the first period (1989-1992) production

has risen to average over 2 million in the period 1996-2002 (Perez-Lopez, 2003, Table 2).

Yet, oil imports still account for 55-60% of Cuba's oil consumption. This makes Cuba's

merchandise imports from Venezuela, which went from 451.5 million pesos in 1999 to

951.5 pesos in 2001 and are mainly in the form of oil, all the more critical.

Among other significant changes during this period two are worth noting. First,

there is the increasing importance of tourism in Cuba. For instance, the number of tourists

has been growing at an annual rate of 15% since 1985 (Padilla, 2003). Tourism is now

more important than sugar in terms of foreign exchange earnings. Second, there is the

equally rapid growth of 'remittances'. The latter have grown from $263 million in 1993

(Locay, 2002) to $1.1 billion in 2002 (Perez-Lopez, 2003). Thus, they have become the

most significant single item in terms of net hard currency earnings. Incidentally, there is

a substantial difference of opinion on whether these numbers actually reflect remittances

in the usual sense, see Locay (2002) and the references therein for a discussion.

In evaluating economic performance during these three periods, Ritter (2004)

concludes that petroleum extraction and food production due to the establishment of

agricultural (farmer's ) markets have been most successful. He also goes on to argue that

Cuba is in a pre-transition stage, similar to Hungary and Poland in the 1980's, and that

economic policy and the institutional structure "…will likely remain paralyzed…" until

Castro dies. Hernadez-Cata (2003) in evaluating economic performance over these three

periods concludes that the reforms of the second period have exhausted their ability to

propel the economy in the third period. He forecasts little growth opportunities in the

absence of further reforms. His analysis is based on a decomposition of GDP by sectors

of the economy, which allows him to show that improvements due to total factor

productivity increases from the second period reforms rather than investment were the

basis for the growth in the third period. Indeed, Perez- Lopez (2003) figures show that

gross capital formation over GDP decreased from 16.2% in 1997 to 12 % in 2002.

This finding suggests that one of the critical economic problems facing the Cuban

economy, if not the most critical one, is raising its level of investment to GDP. The market

augmenting services that we are emphasizing are important for long-run growth precisely because

of their role in allowing the financial markets that make these investments possible operate

efficiently and at a high level. What can we say about these markets in Cuba?

Hernandez-Cata's research is useful in addressing this question. His decomposition of

GDP provides some information on two important transactions sectors: commerce and

finance. First, the real GDP contribution of commerce and finance goes down percentage

wise from 1989, when it is 25% and 8% , respectively, to 2000, when it becomes 21%

and 4%, respectively. This period includes data from two different sources and part of the

decline may be due to the change in source. On the other hand, state employment data for

these two sectors, which has the same problem, shows an increase from 11% to 12 % [1%

to 2% ] of total state employment during this period for commerce [finance]. While these figures

are poor measures of the operations of these markets, they are dramatic enough to suggest

significant declines in the efficiency of these markets (output goes down while one of the inputs is

going up) prior to the current period to which we now turn.

The most recent period (2003- ?) can be characterized in terms of economic

policies as a retreat to socialism. It is marked by attacks against independent journalists,

economists and other dissidents that resulted in the imprisonment of 75 of them early in

2003. The subsequent condemnation by the international community led to strained

commercial relations with Europe. This has been followed by proclamations in favor of

central planning, limits on state enterprises independent handling of foreign exchange and

in the Fall of 2004 to a dedollarization of the economy, making transactions in dollars

illegal. The performance of the economy during this period has become the subject of

controversy. Cuban authorities claim a rate of growth of GDP for 2004, for example, of

5% but ECLA estimates suggest 3%. The sugar harvest is lower than previous low

results. Persistent anecdotal evidence on electricity blackouts unrelated to industrial production

and similar reports on available portions of the monthly rations suggest a worsening economy.

The increasingly close political association with Venezuela is also consistent with an increased

need for their oil.

To conclude this discussion of where the economy is at present, it is useful to note in more

detail the role of foreign investment. It was not until 1992 that the Cuban constitution was

amended so that foreign investors could own property. Furthermore, the basic law governing

foreign investment (Law No.77) was not passed until 1995. Travieso Diaz and Musa (2004) note

that it explicitly allows for three different forms: joint ventures, cooperative production contracts

and management contracts. Only the first form leads to the creation of a new legal entity. Not

surprisingly, there was little FDI of any type prior to 1995 and all three types have grown

considerably in the 1996-2002 period. Perez-Lopez (2004) provides an excellent account of

the inventory of the three types of projects. He differentiates between total estimates derived as

stocks and those derived from flows. The former usually generate figures of between $5 and $6

billion, because they include announced intentions rather than actual investments. The latter

usually generate figures between $1.7 and $2 billion for the same period, because they are derived

from balance of payments figures that include only actual investments.

One of the reasons foreign investment attracts so much attention in the Cuban case is that

it is associated with the more economically successful sectors of the last 15 years: for example,

tourism, nickel oil, and food processing. Incidentally, Perez-Lopez (2004) notes that in oil an

important form of foreign investment is through risk contracts where the risks associated with

exploration are shared between the Cuban government and the exploring oil company. In the

most recent period (2003- ?) there has been concern that foreign investment is decelerating

because, for example, the number of joint ventures declined dramatically, Spadoni(2004). The

Cuban government argues that this was the natural end of some of these activities due to

unprofitability and that their policy is not to support or encourage unprofitable activities.

Spadoni (2004) provides some evidence that foreign investors are unhappy with various aspects of

the investment climate, especially their inability to compensate workers directly and to resolve

disputes with the local partners.

Given the current policy of retreat to socialism, the implications of our analysis of the

role of the state in the two types of markets for the evolution of the Cuban economy are relatively

clear. While the Cuban state provides the market augmenting services of a medium of exchange

and law and order necessary for both 'spontaneous' and 'socially contrived' markets to

function, it fails to provide the market augmenting services of commitment to a rule of law and

contract enforcement services necessary for 'socially contrived' markets to function at any but the

lowest possible levels of transactions. This has three major implications for the path of the Cuban

economy in the future.

First, given the empirical evidence in Section 4 that both of these public inputs affect long-

term growth through the level of investment, it is not surprising that capital formation in terms of

the ratio of GDI/GDP has been decreasing over the whole period (1989-2004). Nor is one to

expect any improvement in the future through the behavior of private domestic investors as long

as the current policies of retreat to socialism continue to be pursued. Second, it is also not

surprising that transaction sectors such as finance and commerce have declined in terms of their

contributions to GDP, despite an increase in public employment in these sectors. Furthermore,

little or no improvement in these two sectors is to be expected in the future. Because of the

importance of the rule of law for the successful development of markets in these two sectors.

Finally, the main possibility for growth in this setting comes through foreign investment

possibilities that can overcome the lack of commitment to a rule of law and contract enforcement

services. Having the Cuban government as a local partner helps joint ventures as a substitute for

contract enforcement services in dealing with other entities in output and input markets, but it

provides no protection against expropriation by the local partner in the absence of commitment to

the rule of law. Hence, the recent decline in local joint ventures is likely to be associated with the

retreat to socialism policies.

Joint ventures abroad, on the other hand, have been on the increase since 2003 as a

mechanism to promote exports, Spadoni (2004). They are more sensitive, however, to the

commitment to the rule of law by governments abroad. The other type of contracts

are not sensitive or much less sensitive to the commitment to the rule of law and depend much

more on contract enforcement services for which it is easer to find substitutes, for example in the

bilateral agreements on foreign investment signed by the Cuban government with other countries.

These are discussed by Travieso Diaz and Musa(2004).

In sum, the Cuban government seems to have staked the growth possibilities of the Cuban

economy on a risky bet that foreign investment, especially in oil exploration, will solve their

long-term growth problems and Hugo Chavez will solve the shot-run ones.

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