Doc. 8458

8 July 1999

Democracy and economic development

Report

Committee on Economic Affairs and Development

Rapporteur: Mr Mikko Elo, Finland, Socialist Group

Summary

The report sees democracy as fundamental for lasting economic development, just as economic development can lead a country to a stage where more democracy will not only be possible but even necessary for economic development to go further. In an integrated world economy, where a financial crisis in one country or region increasingly risks involving all the others, democracy in its deepest and widest meaning provides the best guarantee against domestic and international economic instability.

Noting that international financial institutions largely failed to alert the world in advance to the recent financial crisis, the report recommends the establishment of an “early attention” mechanism within the IMF or the World Bank, with other organisations such as the OECD playing a supporting role. The mission of an “early attention” mechanism would be to highlight any departure from democratic standards in individual countries, especially as it may affect the soundness of an economy and its financial system. The report welcomes the IMF's recent proposals for country ratings on variables relevant to financial stability and for a code for governmental relations with the banking sector and investors.

The report recognises the contribution by the IMF and the World Bank to overcoming financial crises so far and welcomes the increase in IMF funds to counter any future recurrence. Finally, it highlights the importance that equitable wealth distribution and rising labour and environmental standards has for democracy and development within countries and for international economic stability.

I.        Draft resolution

1. The recent financial crises in various countries around the world - Mexico, South-East Asia, Japan, Russia and Brazil - have not only caused major suffering for the populations affected, but they have also added to the instability of an increasingly integrated and volatile world economy driven by rapid technological development especially in computers and telecommunications, vast amounts of instantly mobile capital and ever more liberalised trade and investment. In order that this development may benefit the largest number of countries and ordinary citizens rather than jeopardise the world economic fabric, the international community must jointly search for common principles and new solutions.

2. The Assembly notes that the crises in question have hit countries where democracy is weak, incomplete or even absent, while the more fully developed democracies have on the whole withstood their international impact. This points to the importance of democracy for lasting economic development, including respect for human rights, the rule of law, social justice and solidarity, transparency and accountability in public affairs, an independent judiciary, a free press and a firm stance against “cronyism”, corruption and economic crime. Similarly, economic development can lead a country to a stage where more democracy will not only be possible but even necessary for economic development to go further.

3. Member states of the Council of Europe - an organisation founded on these very values - must work actively with other like-minded countries and international institutions to draw attention to the importance of democracy for economic and social development and the stability of the international economic system. They must also do their utmost, individually and jointly, to improve further the functioning of their own democracies in all the above respects.

4. The Assembly notes that international financial institutions gave insufficient advance warning to the world before the recent financial crises, and that even private credit rating and country risk agencies largely failed to do so - either because of faulty analysis or out of concern not to provoke the crises they feared. It is clear, however, that the damage to the countries concerned and the world would have been much less pronounced had early warnings been sounded.

5. The Assembly, with this in view, calls on the international financial institutions, in particular the IMF and the World Bank, to reinforce their “early attention” role as regards any departure from democratic standards in individual countries, especially as it may affect the soundness of an economy and its financial system, or those of neighbouring countries or the world economy. In this context, it welcomes the Declaration at the June 1999 G-7 Summit in Cologne on strengthening the international financial architecture, as well as the IMF's recent proposals for country ratings on variables relevant to financial stability and for a code for governmental relations with the banking sector and investors. The Assembly also recognises the contribution made by the IMF and the World Bank to overcoming past financial crises and welcomes the recent increase in IMF funds so as to be in a better position to face any future emergencies.

6. Finally, the Assembly welcomes the new emphasis placed by Council of Europe member states and others on the need for adequate world-wide social, labour and environmental standards to be established through forums such as the WTO, the World Bank, the IMF, the ILO and the EBRD. It sees progress in these areas as essential for the strengthening of democracy, development and hence, world economic stability.

II.        Explanatory memorandum by Mr Elo

Contents

I. INTRODUCTION

II. DEMOCRACY AND DEVELOPMENT IN A GLOBAL ECONOMY

III. THE IMPORTANCE OF DEMOCRACY AND TRANSPARENCY

iii.       Good governance and financial crises

IV.       CONCLUSIONS

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I.        INTRODUCTION

1. Over the last twenty years the world economy has changed considerably, bearing witness to the profound transformation from relatively closed national economies to much more open ones operating in one increasingly integrated world economy. This is what we normally refer to when we talk about “globalisation”. Distinguishing features of the changes that have taken and continue to take place – at the same time causing and being caused by the transformation under way - include technological progress, trade liberalisation and regional economic integration, international economic co-operation and the rising tide of increasingly mobile international capital. These sea-changes imply, among other things, that lasting economic development can no longer take place in the absence of certain internationally shared values and principles.

2. The globalisation process has softened, in theory as well as policies, the orthodox approach to economic development issues that was in vogue until the early 1990s. Today, many of us tend to accept that the participation of the state in the economy should not be overwhelming, and that it should if possible be more limited – especially if we come from pronounced welfare state countries. (The strength of our conviction will of course depend on our political orientation.) But most of us at the same time strongly believe that the state should act as a reliable partner in establishing a good regulatory framework – governance –seen as necessary to render optimal the private sector activities that are the life-blood of any healthy economy. The compromise consensus therefore seems to be that while the state should be less involved as a direct economic actor, it should enhance its capacity to act as a facilitator between different economic interests in society, and maintain acceptable standards of social justice, labour conditions and environment protection.

3. Globalisation has thus contributed to making the notion of “good governance” central to economic development. Governance, be it at the national or international level, can be defined as the interplay of institutions, legislation and social behaviour that facilitates the efficiency of society as an economic organisation aiming to achieve maximum prosperity for the largest number of its citizens. It follows that democracy is the sine qua non for long-term economic development; for democracy ideally permits all parts of society to dialogue with each other and to reach compromises that reflect different opinions. Democracy maximises commitment to the compromises reached, and therefore renders governance at once more just, precise, transparent and legitimate. Conversely, phenomena such as corruption, economic crime, bureaucratic inefficiency, weak regulatory environments, disrespect for human rights, economic mismanagement and distorted information take root where democracy, the rule of law and human rights are weak or absent. Often such societies are also less able to compete economically on the global level.

4. Where national governance is weak, international agreements such as trade accords or adjustment programmes agreed with multilateral financial organisations, often serve as “fig leaves” to force through unpopular policies. What little “international governance” there is may, under special circumstances, therefore contribute to democratisation at the national level – such as the world has seen in, say, Indonesia, over the last year. However, the world would of course be much better off economically and politically if “good governance” came from within countries, rather than being imposed from still weak international “policemen” such as the International Monetary Fund, the World Bank, the UN, the WTO and the ILO.

5.       This report describes the situation in various regions and countries of the world in an effort to show, that where democracy is weak, so very often is economic development. The origin of the report is to be found in a motion for a resolution on the implications for Europe and the world of the financial crisis in south-east Asia presented by the Rapporteur and several of his colleagues (Doc. 8014). The motion contended that the south-east Asia crisis had "at its roots not only imprudent lending and investment but, even more fundamentally, the lack of democracy in the countries concerned – with a resulting absence of transparency in public affairs, of free and open debate, and of an appropriate legal and institutional framework”. Democracy, human rights and the rule of law, the motion went on, have “a meaning going beyond the dignity of man to include also the prospects for lasting economic and social development, adding urgency to the need to defend these values in Europe and beyond”.

6.       There are numerous examples of unsuccessful economic development that can be at least partly attributable to weak democracy and lack of government accountability. One is in many countries in eastern and sub-Saharan Africa, where development policies have largely failed. This includes the continent’s most populous country and the one richest in natural resources, Nigeria, which has not seen democracy for some twenty years. Another is the financial crisis in Mexico that began with the December 1994 devaluation and a large, US-sponsored IMF rescue package. This event for the first time shook the world's confidence in the fire-brigade capabilities of multilateral financial institutions.

7.       There is also the economic harm caused by corruption, economic crime and money laundering in many countries around the world, or the relatively slow economic development in some of the more autocratic states in Northern Africa and the Middle East. In countries where the absence of democracy and democratic tradition has been a factor behind civil war the situation is both tragic and economically disastrous; parts of the former Yugoslavia, Albania, Sierra Leone and Angola spring to mind. No-one can be in any doubt that the people of Iraq would fare better under a democratic regime. We have already referred to the south-east Asian financial crisis. And as these lines are being written, the economic problems besetting an otherwise richly endowed country, Brazil, are to a large extent caused by a lack of accountability, transparency and legislation.

8. A few words need to be said about the reasons behind the collapse of various economies around the world as from the middle of 1997. There is the growing tendency of financial markets to overreact, upwards or downwards, in response to the first signs of trouble. A "herd instinct" dominates international financial and investment markets. During much of 1998 it caused them, for instance, more or less to boycott most developing countries.

9. Certain Asian economies were sicker than anyone understood at the time, with some still in a precarious condition. Complacent global investors and poor data from the countries themselves enabled them to appear in much better health than was actually the case. It soon became clear that much of the recent growth in countries such as Thailand, Indonesia, South Korea and Malaysia had been artificial. “Cronyism” and political considerations had caused their governments to encourage local banks to shovel loans into unproductive enterprises. Meanwhile, foreign lenders eagerly provided new financing. The result was overcapacity, unprofitability, bad loans and a dependence on foreign capital, usually denominated in dollars.

10. As the true condition of numerous industries and banks became clear, investors ran away. They sold local assets in such a panic that currencies fell dramatically. In order to defend them, the countries under attack emptied their treasuries and soon found themselves on the brink of national insolvency. This prompted a series of vast, IMF-led bailouts. Through these, defaults were prevented, but serious declines in financial markets and national economies could not be avoided, with untold misery for ordinary people in their wake.

11. Indonesia under its now departed President Suharto was an extreme case. The taxi company that would bring you from the airport into Jakarta would be owned by one of Mr Suharto's children, as would be the toll roads you would have to pass through to reach the city. The major hotel where you might have stayed would also be owned by one of his relatives. This was basically how the whole country functioned – and some say, still functions. It was clear that there could be no political, social and economic stability in Indonesia without fundamental political change in the direction of democracy. Characteristically enough, Indonesia has not managed the same turnaround as, say, Thailand and Korea, precisely because it has not managed the transition to democracy. The latter countries, by contrast, have been able to begin adjusting by voting in new laws of transparency and accountability.

12. Asia's financial turmoil stemmed less from the operation of free markets than from a special kind of capitalism tainted by personal and governmental excesses. In many of the countries concerned there were excessive amounts of short-term lending and borrowing. Over-valued exchange rates were supported for too long, since the assumption was that governments or multilateral agencies would prop up the currencies if they came under attack.

13. There are signs of a turnaround for a country like the Republic of Korea. The financial system is being overhauled. The problems caused by the dominance of the chaebols (closely intertwined industrial groupings) and their lack of transparency are being addressed, and the financial system is beginning to be overhauled.

14. In Russia, legal and other institutional restraints required for the smooth operation of markets were missing. There was widespread fraud in the privatisation of state-owned assets, much lent money disappeared and statistics were scant. This eventually led to international distrust of the whole economy. (For a fuller account, see Assembly Resolution 1180 (1999) on the Economic Situation in the Russian Federation and in Ukraine; Doc. 8294; Rapporteurs: Mr Telgmaa and Mr Wielowieyski.)

15. These are just a few examples that can help us understand the key importance of democracy for economic development. Just as there is a direct relationship between the two, there is also one between such things as corruption, economic crime, insufficient, inadequate or excessive regulation, incapable government, inefficient or bloated bureaucracies, dishonesty, lack of societal values on the one hand, and slow, absent or negative economic development on the other.

16. For markets to operate effectively, there have to be clear and explicit rules of the game. These include the protection of property rights, established and reliable ways of settling disputes, legally binding and enforced contracts, and free and open competition among producers, consumers, lenders, borrowers and investors. There also has to be open and frank political debate and an independent, inquisitive press. Without such principles, markets will malfunction.

17. It would be an over-simplification to say that open markets, the free flow of capital and globalisation as such have caused the recent financial crises. They were not at the root of, say, Russia's inability to collect taxes, or of Korea's sudden industrial overcapacity and unprofitability. It is rather that the nations mentioned did not meet the basic test of a market economy. When capital is able to circulate freely it favours good performance and punishes failure, like any competitive system. When markets discover - which they will sooner or later - that a group of nations have been economically mismanaged and have resisted truly open markets, then punishment is often swift and excessive.

II.        DEMOCRACY AND DEVELOPMENT IN A GLOBAL ECONOMY

i. Globalisation, governance, democracy and the role of the state

18. Viewed from a historic perspective, globalisation is likely to increase the relative importance of economic actors and institutions vis-à-vis the state. The state is already less characterised by its political sovereignty than in the past and is increasingly changing into a sort of co-regulator, with other states, of the global market. Its new role is therefore going to be vital in enhancing domestic regulation as a sound basis for international order and co-operation. States with “full” political sovereignty are those which can enforce their “sovereignty” both internally and externally. After WWII only the United States and the Soviet Union could be said to belong in that category, and today the US is largely alone in remaining somehow “fully sovereign” in this sense. Many other states should also, however, have a vested interest in developing appropriate means to exercise, with others, some form of international governance.

19. Globalisation is determined by technological progress. It intensifies internationalisation by establishing relationships which go beyond the limits traditionally set by states, for instance by making it possible to develop exchanges - material or conceptual - among economic subjects other than states, such as through the Internet and electronic commerce. Globalisation implies a victory of international economic interests over the raison d’Etat. Apart from technological progress, globalisation has also been sped up by such things as the changing nature of the international division of labour (such as production going to countries with lower and lower labour costs and social protection); capital accumulation beyond the borders of any given state; the demise of communism and the opening up of China. Put somewhat simplistically, globalisation has permitted the expansion of capitalism to the far corners of the world.

20. Private economic actors acting internationally are today more capable than ever to concentrate resources in their hands while escaping democratic checks and controls. They can affect political decisions at the state level without in return providing political and social accountability. Because countries have understood this, the post-war trend of economic globalisation has witnessed a parallel political globalisation, beginning with the United Nations and the Bretton Woods institutions and continuing up until the present array of more or less powerful inter-governmental organisations, as well as “global regulatory institutions” such as the Group of Seven industrialised countries. While globalisation may necessitate freedom for companies to function and distribute their benefits, political oversight may well be needed to ensure that it does not derail either the global economy or national economies.

21. It is widely felt that global institutions are still largely ill-equipped to control as they should the activities of economic actors. But then nobody really seems to know what is needed to do what. Everybody wants less turbulence in world financial markets. Yet how can controls be shaped so as not to choke the world's growing need for mobile capital? Public global institutions seem to react much more slowly than globally operating financial centres. This poses a problem of governance. The state has the power to implement policies and laws to ensure domestic control, but it is largely unable to influence the decisions of many powerful international economic actors. Indirectly, it can be argued, the problem is one of global democracy, less in its form than in its substance. The issue of international governance has yet to be given a satisfactory solution. It probably lies in a combination of domestic and international action, and in the proper co-ordination of institutions.

22. However, international order, like charity, presumably has to start at home. The issues related to domestic governance, and their impact on economic development, are many. They include the rules that govern elections, the various forms of government of a country, the constitution and the structure and action of interest groups, including social, economic and business associations.

23. The role of the institutional structure and of market regulators is fundamental, because they have the power to influence economic growth. In this context, democratic control is essential to avoid that small minority interest groups in or close to the government tailor domestic economic re-distribution policies to the needs of their own constituents exclusively. For example, the desire of some politicians to manage the economy directly – thus going beyond their more appropriate role of economic facilitators – goes against the logic of privatisation. The idea behind privatisation is that the market is more capable than the state to satisfy the needs of citizens through production and services. The state, on the other hand, has a comparative advantage in setting up rules to make the market function more smoothly and equitably. So the state does have a role in the economy. This notwithstanding, public officials often gain vast amounts of information to which the general public is not privy, for instance as regards imminent privatisations or mergers. It is necessary, then, that their actions be monitored and that they are imbued with the necessary ethics to uphold sound governance.

24. In the field of development co-operation the role of the state has been re-thought in recent years, and the importance of governance is now at the centre of development policies. Until the early 1990s, bilateral as well as multilateral financing to developing countries was granted for various purposes (including short-term emergency aid) and was mostly based on the notion that the “free hand” of the market would suffice to spur the forces for long-term growth. The common thinking behind development policies at the time was certainly supported by the failure of communism vis-à-vis western capitalism. It was believed that the market itself would continually strengthen democracy and governance as liberalisation was pursued.

25. However, already as from the late 1980s this notion began to look debatable to many. Policy-makers and analysts started to re-think the fundamental importance of the role of the state in the management of the society and the economy. Even the changing perceptions of multilateral agencies with regard to the role of the state for economic development can be observed, for example, in policies for in the Sub-Saharan region.

26. After the debt re-scheduling negotiations of the late 1970s, the World Bank identified one factor it thought hindered development, namely the massive presence of the state in the economy. Several reports indicated that the state was inefficient as a mechanism for economic efficiency as well as wealth distribution. Thus, international conventional wisdom held that liberal policies were the recipe for success. Structural adjustment programmes were seen as the tool to diminish the presence of the state and, therefore, allow economic and political liberalisation. All in all, the formula was one of “less state and more market”.

27. The political consequence of the liberal economic policies pursued in the 1980s were, however, a strengthening of many autocratic regimes that tried to control the discontent of rural and urban populations who had to bear the brunt of sudden economic austerity. Moreover, government spending cuts on social services, accompanied by price increases in primary food commodities, exacerbated social conflicts.

28. Although some considerable macroeconomics improvements were reached as a result of adjustment policies (and things might well have gone even less well without them), the 1994 World Bank’s Report "Adjustment in Africa - An Assessment of a Decade of Experience)" acknowledged the problems, indeed the desperation, of the African continent. Already in 1989 the Bank had begun looking at the African crisis from a different perspective. The focus was now on governance, and the new pre-conditions for financing included the preparedness of beneficiaries to move toward a multi-party political system.

29. The emphasis on democracy and governance for economic development was therefore accepted long before the south-east Asian development model - i.e. the primacy of economic growth over democratisation - was questioned after the 1997-1998 financial crises. The World Bank's 1997 World Development Report - whilst failing to recognise the extent of the endemic problems in the region's democratisation – nevertheless identified the fundamental importance of the state for global development. Today, the establishment of good governance and government accountability is often part of the conditions required by multilateral agencies for the disbursement of loans or development aid.

ii.       Trade and Foreign Direct Investment in a global market

30. Economic growth in industrial and developing countries alike is today possible only when private sector investments are sufficient - either in the form of financial flows or as foreign direct investment (FDI). In this respect, trade and investment should be seen as increasingly important aspects in the debate about democracy and economic development – especially since international economic interdependence has grown rapidly since World War II precisely on account of these two phenomena. Indeed, both trade and foreign direct investment have grown much more rapidly throughout this period than has world economic growth.

31. The effects of international trade are relevant to the present discussion for several reasons. Firstly, world trade has long been identified as one of the most constant and positive causes behind economic growth anywhere. Secondly, in today’s global marketplace there is a close relationship between trade and foreign direct investment. FDI does not “replace” trade, but trade has been shown to increase even faster as a result of FDI. Thirdly, multilateral trade agreements increasingly comprise huge exchanges of services, that is, immaterial activities such as tourism, insurance, transportation, licensing and consulting (some of which, incidentally, are being utilised by those engaged in economic crime to launder their proceeds, as we shall see below).

32.       FDI is thus a cornerstone of economic development and is closely related to growth in trade. This is also due to the new character of the world economy, where technological change has enabled economic operators to implement almost instantly the movements of capital in particular, but also, increasingly, of goods and services.

33.       A study by UNCTAD on FDI and trade (World Development Report, 1996: Investment, Trade and International Policy Arrangements), indicates that, although FDI in the 48 least developed countries rose by 29 per cent in 1995, it only amounted to a total of US$ 1.1 billion. FDI is very much concentrated to a few countries. Thus, the 100 smallest recipient countries received only 1 per cent of all FDI, while the ten biggest accounted for 68 per cent of a total of US$ 315 billion in inflows. However, while FDI in LDC’s is still relatively negligible when compared to figures for industrial economies, the trend is for it to increase and become an ever more important factor behind development.

34.       FDI tends to flow to where a given market has gained the confidence of investors. This can be found where democracy allows for reforms that are consistent with the principles of a market economy and the establishment of a clear legal framework. Reforms must address fiscal and monetary discipline, as well as measures to regulate the financial and banking system. Especially after the Asian crises, which have shown the dangers of spill-over effects into other countries and regions, it is vital for, for example, transition countries to carry out those fundamental institutional reforms that are urgently needed to build market economies.

35       EBRD studies argue that there is a direct relationship between the amount of FDI inflows and the stage of political transition achieved. For instance, in the period from 1989 to 1997, cumulative FDI accrued mainly to central and eastern Europe and the Baltic republics (67.3% of the total), while the Commonwealth of Independent States (CIS) only received 32.7% of the total. Hungary, for example, which in 1997 had one of the highest FDI inflows rate (as a percentage of GDP) and the highest cumulative figure for the period 1989-97 (over US$ 15 billion), witnessed investors’ confidence even during the run up to its 1998 elections - displaying its enhanced international standing as a country with a maturing democracy and one which, it was widely felt, will complete its market-led reforms and join the European Union within the next few years. The European Commission sees a direct link between the economic reforms in countries aspiring to join the EU and their ability to attract foreign investment.

36.       Globalisation has caused companies to focus more on how to gain access to international markets and invest resources around the world. It is natural that firms in this situation – especially after the various financial crises recently - will not only look at markets per se, but also at the quality of governance in individual countries.

iii.       International financial markets and economic crime

37.       Trade in services includes the vast financial industry, which now account for more than 20% of global exchanges. Globalisation has increased the relative importance of world finance as an engine for economic growth. The fast pace of liberalisation and development of international capital markets has brought about a great expansion of sophisticated financial services worldwide. These have become one of the preferred vehicles for illicit money laundering. Economic crime uses them extensively to launder their proceeds around the world - in industrial countries and offshore centres, as well as in transition and developing economies.

38.       Financial operations resulting from economic crime, including money laundering, significantly affect the global economic system. For example, growth is affected when crime operators transfer large funds to countries where the recycling process is more secure rather than where rates of return are higher - regardless of the quality of economic policies, “country fundamentals” and the rule of law. The absence of democracy, or a weak democracy, in a given country tends to attract those engaged in economic crime or money laundering. Large recycling operations can have an impact on interest and exchange rates even at the global level. The IMF has estimated (precise data being difficult to obtain) that the net worldwide criminal gains from illicit activities may be as high as US$ 500 billion.

39.       Laundered money is certainly larger than the GDP of most individual transition and developing economies. The impact of economic crime and corruption on the economy therefore threatens the transparency and good functioning of financial markets, with direct consequences for the global economic system. These illicit capital investments for non-productive purposes not only draw resources away from economic development, but also place those who want to invest or produce according to sound business principles at an unfair disadvantage in the competition for financial resources.

40.       The fight against money laundering must be conducted at a global level. The recent agreement on financial services concluded through the WTO in December 1997 following signature of the General Agreement on Trade in Services (GATS) signals, inter alia, the importance attached by the international community to the threat posed by economic crime to good governance as regards trade in financial resources. Among many initiatives already undertaken internationally over the last decade to guarantee co-ordination in the fight against economic crime one notes the Council of Europe’s Convention on Laundering, Search, Seizure and Confiscation of the Proceeds from Crime, which came into force in 1993. It has played a significant role, further promoting the idea that international co-operation must form a central part in the fight against economic crime and money laundering.

41.       Other important international treaties and measures include the UN Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances, the European Union Council Directive on Prevention of Use of the Financial System for the Purpose of Money Laundering, the Organisation of American States Model Regulations concerning Laundering Offences connected to Illicit Drug Trafficking and Related Offences.

42.       In addition to such conventions, a number of international agencies have been established in recent years to deal specifically with the problem of economic crime and money laundering. The Financial Action Task Force (FATF), established at the July 1989 Group of Seven Economic Summit in Paris by the Heads of State or government of the seven major industrialised nations is perhaps the most important, both in terms of the strictness of its anti-money laundering policy and in the mobilisation of global awareness.

43.       The FATF’s mission is to prevent banking systems and financial institutions from laundering the proceeds of criminal activities and to examine measures that could be adopted by individual countries to combat money laundering. In April 1990 the FATF issued the Forty Recommendations, largely based on the philosophy of prevention. They address the need to improve national legal systems and to strengthen international co-operation. (For a more complete report on the subject of economic crime, the reader is referred to the Parliamentary Assembly's Resolution 1147 (1998) on the Threat to Europe from Economic Crime (Doc.7971; Rapporteur: Mrs Degn)).

44.       Financial sector regulation is also important with regard to money laundering, as controls are a key instrument for operations against economic crime. Internationally co-ordinated measures to prevent the use of the financial system by criminals, such as the Statement on Prevention of Criminal Use of the Banking System for the Purpose of Money Laundering, issued by Basle Committee on Banking Regulations and Supervisory Practice, are now emerging. The Basle statement foresees the need to focus on the principles of customer identification, compliance with law, co-operation with law enforcement agencies, and the introduction of internal compliance and training programmes for financial intermediaries. Effective implementation of such principles will necessitate the establishment of appropriate legislative and investigative rules, which can be attained only in a democracy.

45.       "Offshore havens" can also add to the instability of the world financial system. Bank deposits in the Cayman Islands now total 500 billion dollars, twice the amount of five years ago. That makes about 40 million dollars for every man, woman and child in the Caymans. 575 banks and trust companies call the islands their home, as do more than 20,000 corporations. The islands have no income tax, capital gains tax, value-added tax, sales tax, inheritance tax or tax treaties with other countries.

46.       The ill-fated Long-Term Capital Management - which in 1998 might have caused a world financial collapse had it not been bailed out through the intervention of the US federal reserve - is chartered in the Cayman Islands. The LTCM kept the details of its borrowings and investments secret. Many wealthy depositors lost millions and world financial stability was at risk. This could not have happened if the Cayman Islands had been in line with the standards of much of the rest of the world. Similarly, the Caymans were home to the Bank of Credit and Commerce International, whose collapse in 1991 was the up to then biggest banking scandal in history. Until action is taken at least to reduce the unfair advantages that "tax havens" supply, taxpayers and honest players in financial market will be at an unfair disadvantage. And world economic stability will be at risk.

III.       THE IMPORTANCE OF DEMOCRACY AND TRANSPARENCY

i.       Corruption

47. Corruption denotes dishonesty and illegal behaviour by people in position of authority or power, normally for monetary gain. Because corruption has historically developed in the absence of strict monitoring rules, a state should introduce checks and balances into its structure of government in order to promote accountability and credibility. However, corruption must be fought not only through formal rules but also by attacking the root causes of the phenomenon. Therefore, an effort should be made to tackle other aspects of the problem, such as trying to reduce the payoffs resulting from corruption and increasing the likelihood that those guilty of it are caught and punished.

48. There is presumably no country in the world that is absolutely free of corruption. There are, nevertheless, countries where the governments go after economic crime and corruption most determinedly. The importance of curtailing arbitrary state action and corruption is well described in the World Bank's 1997 World Development Report: “…Restraining the potential use and abuse of state power is a challenge for any country…The misuse of state power creates serious problems of credibility, whose effects linger long after the event…But arbitrary and capricious state action undermines more than credibility. It undermines the rule of law itself, by weakening the force of whatever rules the state has set in place. And it fosters conditions that encourage state officials to place themselves above the law and tempt the rest of society to do the same. Development, in these circumstances, hits a brick wall.” The Rapporteur strongly agrees with this statement, which is in perfect agreement with the principles of the Council of Europe.

49. A strong democracy thus becomes a prerequisite for avoiding large-scale corruption. The credibility of restraint mechanisms that hold public officials accountable for their actions must be anchored in effective state institutions to be lasting and credible. Where popular participation and institutions are weak, corruption is favoured as often by excessive government regulations and inefficient public administrations, as by the absence of rules. The more corrupt a country is, the more slowly it is likely to grow and develop.

50. Finally, countries which do not do much about lawlessness pay a price. Kidnappings of business executives and members of their families are now so common in a country like Colombia that companies are pulling out or stop investing.

ii.       Regional and country examples

51. The direct relationship between democracy and economic development can be illustrated by looking at the reality of many countries around the world. More often than not, countries in the same region, sharing common traditions and political evolutions, display similar economic achievements. Nevertheless, differences in economic development status can still be remarkable among countries within the same region and with a comparable political past, due to differences in the degree to which democratisation has taken hold. The countries in transition provide good examples.

52. After the fall of the Berlin Wall, the countries of central and eastern Europe and of the former Soviet Union (FSU) embarked on a costly transition process meant to lead them from communism to a market-oriented economy. This transition process could not take place effectively without the establishment of proper mechanisms for democratic governance. The magnitude of change in these countries has varied significantly, with relatively high economic growth for those that pursued democratisation most vigorously.

53. The EBRD’s 1997 Transition Report, for example, maintains that countries which have reformed their political systems more consistently recovered from recessions more readily than those which failed in this respect, and that they attracted greater inward FDI. Following an initial period which saw the establishment of only the basic elements of market capitalism, many of them now face a new – in many ways more difficult - stage of transition, in which the emphasis will have to be on good governance.

54. These economies must now further strengthen democracy and fight corruption, in order to become even more competitive and continue to be able to attract investment. In future, wealth will result not only from economic policies per se, but will have to build on factors such as political freedom and the success in keeping corruption and economic crime at bay. To illustrate this point, Denmark came out on top among European countries in a "European Future Readiness Index" prepared for the 1998 Davos World Economic Forum, based on such criteria as economic performance, reined-in health care costs, low crime and corruption rates and vanquished poverty.

55. The strong economic growth of certain central and eastern European countries for example, which are now knocking on the door of the EU, was made possible by thorough political transition. The establishment of basic governance rules allowed the implementation of truly courageous economic policies – such as price, trade and exchange rate liberalisation - carried out after 1989 with the aim of ending central planning. Moves toward fuller and fuller democracy led to confidence on the part of domestic and foreign investors (who may also, however, have been attracted by factors in the real economy, such as low wages). Although the amount of FDI in the central and east European region may not yet compare with those found in the mature industrialised countries, it has meant much for economic development and, hence, for strengthened and more stable democratic systems.

56.        The Baltic republics are another example of the importance of democratic practices for economic development, especially given the fact that, as states that formed part of the Soviet Union, they have faced a particularly difficult transition journey. One must conclude that their pre-war history of democracy facilitated the attainment of democratic governance in a very short time. The same holds for the many central and east European countries that formed part of the Soviet orbit while being formally independent countries. And this is also why for instance Russia and Ukraine must meet with Europe's special understanding, as these countries were never able to build up democracy, having gone directly from czarism to communism.

57. The process of democratisation in the Baltic states has benefited from the proximity to the Nordic countries and western Europe in general, a region where democracy has been traditionally strong and economic crime and corruption kept largely at bay. Today the Baltic republics are quickly restructuring their economic systems, and the basic elements of a market economy are already in place in all the three countries.

58. Slovenia is one of the most economically successful transition countries, whose development was presumably facilitated by the fact that the former Yugoslavia operated an economic system with considerable market influences. Even when it formed part of that country, the Slovenian business community had extensive exchanges with the West, permitting the country to develop a political and economic culture particularly close to that of a market economy. By contrast, Albania will not be able to develop its economy and attract foreign investment until political peace returns and democratic institutions are strengthened and held in respect by politicians and citizens alike (with the aid of the Council of Europe and our Assembly, among others).

59. The five countries of Central Asia - Kazakhstan, Uzbekistan, Turkmenistan, the Kyrgyzstan and Tajikistan - are Soviet successor states undergoing great internal difficulties, comparable to those of the worst-off Balkan states. The turbulence they are experiencing as they try to implement the transition from a centrally planned to a market economy is certainly caused to a large extent by a lack of “good governance” and democracy. They have been guided so far by small oligarchies, which will now have to look beyond their own interests to those of their populations, and aim for greater democracy as a key to lasting economic development.

60. Sub-Saharan Africa regrettably offers many examples of countries where autocracy, corruption and a lack of transparency in economic life have negatively affected growth and development. In a telling sign, no country in the region appears in the 1998 World Bank listing of high-income countries, and only eleven in the middle-income group. The vast majority are in the low-income group, with an annual per capita income of US$ 765 or less.

iii.        Good governance and financial crises

61. The financial crises which in the recent past have hit Russia, several south-east Asian economies and, today, Brazil, would seem to vindicate the assumption argued in this report: that democracy and governance are vital to economic development.

62. The unparalleled growth of financial markets since the 1980s – immensely accelerated by technological development and the large-scale abandonment of restrictions on the international mobility of capital - has led investors to move often large sums of money to reach high rates of return over the short term. The size of speculative capital moving around in this way has been such as to weaken – some would eliminate – the ability of most countries ability to defend their currency with reserves only. Successful defence can in fact only be waged through responsible economic policies, underpinned by such things as democracy, accountability, transparency, the rule of law and respect for human rights. The 1992 monetary crisis in western Europe - which caused the devaluation/depreciation of currencies big and small, notwithstanding the heroic defence by central banks - showed beyond doubt that internationally mobile and highly liquid capital had become a new force to be reckoned with.

63. In time it has become clear that new international mechanisms, based on and supplementing those at national level, need to be set up to ensure a more stable and less potentially self-destructing global financial order. The IMF's resources are fully stretched, and the international community is nearly at the end of its patience with an unreformed IMF. Still, no-one really knows how it ought to be reformed and what might usefully come in the place of its financial support to countries in crisis. A large debate has opened up on this issue and more generally on the future functioning of the world economic system and the role, if any, of some form of international good governance.

64. Any solution will include political decisions within countries as well as international agreements. Political decisions within countries will have to strengthen democratic legitimacy through greater accountability and transparency on the part of governments and economic actors. This will increase the credibility of countries, reduce volatility caused by rumours and distrust, discourage international financial speculation, and reassure markets.

65. It would be wrong to see the majority of those who possess internationally mobile capital as somehow "lusting for" for countries where they can satisfy their desire for speculation. Rather, they would much prefer it if all countries could be as democratic and transparent as the best in the league. Much of the capital in question is managed by money managers in multinational companies or pension funds. If, say, Denmark is rarely the object of speculative financial operations, it is presumably for the reasons mentioned earlier. If the United States is able to attract foreign investment in bonds and shares through fair weather and foul, it is presumably because of what is seen by the rest of the world as a highly transparent political system and a fiercely independent judiciary branch that severely punishes any wrongdoings

66. It was possible to see even the Monica Lewinsky affair from this angle, for all the bemusement it may have caused us supposedly more world-weary Europeans. The United States somehow cannot function unless it is shown that the highest official is respecting the law. At present, this obsession with justice is seen by many as a source of weakness of the United States. In the longer term it can, however, be seen as a tremendous source of strength for the country. Once cleansed, such as after an ordeal like Watergate, it rapidly regains and even adds to its strength. The Rapporteur in no way intends to take sides on the issue which so dominated American debate in the recent past, but only wishes to point to the importance of the rule of law for the political, and ultimately economic, health of any nation. Perhaps we in Europe have some lessons to draw from the events in the US, as we tend to be much more complacent about the various corruption and other scandals we discover. We parliamentarians have a special duty to show resolve, as was demonstrated when the Committee on Economic Affairs and Development, through its Sub-Committee on International Economic Development, held a Conference in the Latvian Parliament in March 1999 on "The Role of Parliaments In the Fight Against Corruption".

67. Where democracy is weak, investors will look for safer havens at any hint of political turbulence, with potentially devastating effects for a whole region or for the world. In Brazil the turmoil caused by the government’s decision in early 1999 to widen the fluctuation range for the “real” led to a massive depreciation of the currency, reflecting a lack of confidence on the part of investors in all the aspects of government covered in this memorandum. Even an IMF support package of over US$ 40 billion could not calm the turbulence.

68. The crises in South-east Asia and Russia have brought to the surface the need to pay greater attention to the political and social aspects of economic development, on their own merit and because of their impact on international financial markets. Put simplistically, on the one side stand developed market economies with comparatively strong supervision and regulatory mechanisms, while on the other stand many emerging markets characterised by relatively weak legal and institutional structures, corruption, lack of transparency, nepotism and "crony capitalism". The inability of more or less authoritarian governments in undertaking the necessary reforms to overcome the crises testify to the importance of democratic governance and economic pluralism for financial sector regulation and, consequently, for economic development.

IV. CONCLUSIONS

i. Committee reactions

69. The Committee on Economic Affairs and Development had a very interesting discussion about the first version of the present report in April 1999. The comments from colleagues led the Rapporteur to reformulate certain key points in his report. Thus, certain members pointed to the reciprocal relationship between democracy and economic development. They referred to the experiences of several countries in Latin America - as well as Spain before the advent of that country's democracy in 1975 - showing that not only is democracy needed for economic development, but economic development can also lead a country on to the path toward democracy. Another member pointed out that democracy was no guarantee against an economic crisis, as shown in Japan.

70. One committee member reminded colleagues that economic development under authoritarian regimes may be possible only up to a certain level. This could explain why a country like the Soviet Union had such economic difficulties toward the end of its existence, and why China may now face similar challenges. Beyond a certain level, colleagues asserted, democracy and all that accompanies it (such as a lively public debate, free press and independent institutions) become more and more essential.

71. Other members argued that democracy was important not only in countries, but also within institutions with great power and influence such as the World Bank and the IMF. They felt that there is room for improving the internal, organisational democracy within these organisations - efficient parliamentary monitoring being one means. They pointed to the important parliamentary monitoring role exercised by our own Committee and the Council of Europe's Parliamentary Assembly as a whole over bodies such as the OECD and the EBRD, and increasingly also over the IMF and the World Bank. This has indeed been a priority of the Committee on Economic Affairs and Development over the last decade at least. For delegations from elected parliaments of the 41 Council of Europe member states - and numerous Special Guest and Observer parliamentary delegations - it is increasingly important to have such a monitoring role. And for the institutions concerned it must be more practical to deal with one parliamentary body than with parliaments of all their numerous member States. The Rapporteur thus fully shares the Committee's conviction that its own and the Assembly's monitoring role has to be continued and strengthened.

72. Finally, when it adopted the present draft Resolution, the Committee engaged in a rewarding discussion about whether "social justice and solidarity" should indeed belong among the components of democracy necessary for lasting economic development (see paragraph 2 in the text). Especially the word "solidarity" was felt by some conservative members as being too politically laden. Would "equity" be preferable to "justice"? In the end, a majority were in favour of retaining the whole original wording, much to the pleasure of the Rapporteur, who can nevertheless understand the misgivings of some of his colleagues.

ii. The need for an “early attention” mechanism

73. The various financial crises in the recent past have exposed substantial weaknesses in the world's safety net against having such crises occur in the first place, and against permitting them to damage the world economy as a whole. The Rapporteur believes that two things are needed.

74. Firstly the IMF emergency lending facility is still too small, in spite of the recent increase accorded by the participating countries. Trillions of dollars course through world markets. Mexico required a 52 billion dollar rescue in 1994, and South Korea needed 57 billion dollars in 1997. The final bill on Brazil is not yet in. Facing such demands, the IMF buffer funds are still below 100 billion. The Rapporteur, while welcoming recent increases, therefore calls on Council of Europe member States to work in favour of even greater IMF emergency lending facilities. The modern world cannot function without mechanisms that serve as buffers and cushions against an all-Darwinian type of capitalism. The IMF and the World Bank were founded for this purpose, and they still have important roles to play. However, they can be made to function more efficiently, which is why internal reform must be pursued. For instance, as has been pointed out in this report, the IMF alarm bell did not sound in time in either the Asian or the Russian financial crisis, forcing it to undertake rescue operations which became all the more costly.

75. Secondly, a second instrument, an "early attention" system to spot country deficiencies, must be put in place. In the Asian example, several of the economies were unhealthy long before their bubbles burst. However, there were no real warnings, either to the countries concerned or to the international community. Whenever the IMF knew, it presumably dared not express it out of fear it might precipitate a crisis. The Rapporteur would therefore want to see the international financial institutions, in particular the IMF and the World Bank, reinforce their “early attention” role as regards any departure from democratic standards that could affect the stability of the countries in question and the international economic system.

76. The Rapporteur is, against this background, heartened that Mr Michel Camdessus, Managing Director of the IMF, is now suggesting, in a speech in Hong Kong in May 1999, a stepped up IMF role preventing a recurrence of crises such as the one in Asia. Mr Camdessus in his statement concedes that the recent financial crises have revealed deficiencies in the international system. He says that this calls for a profound change in the relationship between governments, banks and enterprises in promoting economic development. He goes on to suggest that the IMF should be empowered to rate countries on how well they share information relevant for the judgement by themselves, their neighbours and the world community at large on their financial soundness and economic stability. Furthermore, he wishes to see a code for governments to follow in co-operating with private banks and investors in order to make the international financial system more stable. Countries would be required to open their accounts to IMF inspectors to a degree not previously seen. The code of conduct would focus on security markets, accounting, bankruptcy law and corporate governance. The Rapporteur fully supports these proposals, which follow from the core contents of his report.

77. “Early attention”, as the term suggests, will really have to be early, so that corrections can be made before a crisis is ripe, and it will have to engage in a wider analysis than even private credit or country risk agencies have done. They did not warn of the crises either. Where were they when the Russian bubble burst in August 1998, or before the "pyramid schemes" in Albania overnight sent that country's rosy prospects into a tailspin? Who warned us against "crony capitalism" in Asia in early 1997? These lessons suggest that “early attention” will not be found only in more financial data, but in a deeper understanding of political economy. How much do investors really know about the politics of emerging markets? How transparent are decision-making processes in these countries?

78. In order to make "early attention" function, the new mechanism that the Rapporteur is suggesting must turn also to universities, foreign ministries and the intelligence community to get the wider, deeper picture. There will have to be people "on the spot" in the countries under scrutiny. Their mission would be to "listen in" on what is happening and apply their knowledge and common sense. After all, intelligence comes from the Latin "inter-legere", meaning "reading between the lines".

79. It is important that private creditors assume a proper share of risk. At the present time this is not the case in many countries, since creditors can always count on being "bailed out" by the IMF through rescue packages to countries in need. This is known as the "moral hazard" problem. The IMF bailed out Indonesia to the tune of 40 billion dollars, lent 60 billion dollars to Korea and lesser amounts to Thailand and the Philippines. Against this background, investors and speculators were in a way entitled to believe that Russia would receive more than the meagre 17 billion dollars that the IMF first offered and which were not by far enough to calm markets.

80. The international community must tackle this issue as soon as possible. There is discussion about a so-called "Tobin Tax" on any international transfer. And Chile has with success imposed a requirement that capital deposited in the country will have to stay there for a certain length of time. Measures such as these raise the cost of carrying out short-term capital transactions and may contribute to increased financial stability and reduced currency volatility.

81. The highly destabilising financial crises over the last two years demonstrate the need for some kind of international financial surveillance. The May 1998 Birmingham G-8 Summit took the first steps in this direction. Five areas of action were identified: improved transparency and data analysis, assistance to individual countries seeking fuller integration into the global economy, the strengthening of national financial systems, a greater responsibility on the part of the private sector for credits given, and a strengthening of the role of international financial institutions such as the IMF and the World Bank. Work is in progress on a code for fiscal transparency permitting national accounts to be compared internationally. The same holds for the composition of central bank reserves.

82. Regulations must, however, be carefully though out, since they could otherwise create more problems than they solve. The best medicine for international financial stability remains healthy economic policies coupled with democracy, transparency and the rule of law. To this should be added the need for social justice. All citizens in a country should be able to partake of economic growth and prosperity. This presupposes a minimum of social protection, investment in education and public health, and measures to distribute wealth more evenly.

83. International economic stability would be greatly helped if the state of companies could be analysed according to similar accounting principles the world over. The International Accounting Standards Committee, a group of accountants and executives, is now ready to present a core set of fifteen universal accounting standards after more than two decades of work. If accepted, these would meet a need felt world-wide. The OECD is also working on company standards of accounting and the publication of operating results. Homogeneous accounting standards are necessary in a world where investors often struggle in vain to compare companies operating within vastly different cultural environments and systems of government.

84. Perhaps we should also start looking at the threat to competition arising from the growing number of so-called mega-fusions among major multinationals. So far, anti-trust legislation exists in individual countries, or regionally at EU level. However, new technologies permit more and more companies operating world-wide to merge, and sometimes this unduly restricts competition. The Rapporteur is aware that this proposal may meet with resistance not only from companies, but also from national anti-trust bodies wary of seeing their own influence reduced. However, if we are not careful, Marx's prediction of world monopolies in important sectors could yet come true.

85. The key principles of the Council of Europe – democracy, the rule of law and human rights - are essential ingredients for sustainable economic development. Although this thinking seems to be increasingly accepted by international institutions and policy-makers, continued efforts must be undertaken in order to strengthen the link between democratic practices and economic development policies. As recent financial crises have shown, the idea that the rule of law and democracy follow automatically from laissez-faire economic liberalism can no longer be taken for granted.

86. The relevant issue today, as concerns honesty and government, is how a country relates to the opportunities and challenges it will meet in the global market, and whether it is building law-based institutions that enable it to get the most out of that global market. The big split in the world today is between free market “kleptocracies” and free market democracies. The foreign policy of the developed market economies should be devoted to changing the former and promoting the latter. The world economy urgently needs a system of common values, an ethos founded on honesty in transactions and in social solidarity. Examples have to be set daily by honest men and women in government, parliaments and economic life.

87. Stronger international action against economic crime is needed. The rapid development of sophisticated financial instruments provides an opportunity both for economic crime and money laundering. Thus, domestic action must form the basis for internationally co-ordinated measures. Another threat against governance and economic development requiring our attention is corruption at all levels of government and business. Corruption must be tackled both from the side of prevention and punishment for offences, and from that of offering incentives to public officials to carry out their duties with integrity. We must also remember, that once a public official has made himself or herself guilty of wrongdoing, he or she will be under the sway of the criminals for fear of having the act revealed.

88. Multilateral agencies should adjust their structure to the requirements of rapidly changing global markets. They should continue advancing the promotion of good governance through the support of strategies that call for accountable institutions and transparent legal frameworks. They should fight corruption with due resolve in close co-operation with UN Agencies, the EU and the Council of Europe. The close co-operation already established between the Parliamentary Assembly of the Council of Europe -especially trough our own Committee on Economic Affairs and development - and the OECD, the EBRD, the World Bank and the IMF will prove of great value as we try to make this world safe not only for democracy but also, through that, for economic development and prosperity benefiting the many, not just the few.

*

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Reporting committee: Committee on Economic Affairs and Development.

Budgetary implications for the Assembly: none.

Reference to committee: Doc. 8014 and Reference No 2302 of 26 May 1998.

Draft resolution unanimously adopted by the committee on 24 June 1999.

Members of the committee: Degn (Chairperson), Valleix, Bloetzer, Elo (Vice-Chairmen), Akgonenc, Aliko, Andreoli (Alternate: Felici), Attard Montalto, Billing, Blattmann, Bojars, Bonet Casas, Brunhart, Calner, Cunliffe, Cusimano (Alternate: Turini), Durrieu, Eyskens, Frey, Freyberg, Galvao Lucas, Gonzalez Laxe, Grenfell, Gül, Gusenbauer, Gylys, Hempelmann, Hoffmann, Kacin (Alternate: Pahor), Kirilov, Kittis, Kuznetsov, Lazarenko (Alternate: Kosakivsky),  Leers, Liapis, Linzer, Lotz, Mateju, Mitterrand (Alternate: Ehrmann), Nagy, Niculescu (Alternate: Baciu), Nothomb, Obuljen, Pereira Coelho, Popescu, Popovski, Prokes,  Puche (Alternate: Ramirez Pery), Regenwetter, Rigo, Rutskoy, Sarishvili-Chanturia, Schmitz, Shuba, Sorocean, Squarcialupi, Stepova, Stoyanova, Tallo, Townend, Vasile, Verbeek, Verivakis, Wielowieyski, N… (Alternate: Connor)

N.B. The names of those members present at the meeting are printed in italics.

Secretaries of the committee: MM. Torbiörn, Mezei and Ms Ramanauskaite.