The November issue of the Economic Journal, the journal of the Royal Economic Society and a leading publication for new economic research, has just been published.

In the latest issue:

Combating Corruption: The Value of Economic Analysis

UK Courts Fail to Compensate People Adequately for Loss of Earnings Following Personal Injury

Emerging Markets: The Significance of Competition and Corporate Governance for Future Economic Growth

Competition is More Intense in Emerging Markets than in Developed Countries

Firms’ Investment Performance: The Impact of Corporate Governance

Contrasting Asian Success Stories: ‘Creative Destruction’ in Taiwan and Korea

The November issue also includes an appreciation of 1981 Nobel Laureate Professor James Tobin – ‘the greatest macroeconomist of his generation’ – by Willem Buiter, Chief Economist at the European Bank for Reconstruction and Development.

Combating corruption - the value of economic analysis

Recent advances in economic analysis have helped to clarify why corruption is so detrimental to economic development and to the efficient functioning of mature economies. More significantly, this research has produced some general guidelines for how to combat corruption. Writing in the latest issue of the Economic Journal, Dr Toke Aidt of the University of Cambridge emphasises the importance of getting incentive structures right and avoiding inefficient policy measures.

Corruption – understood as an act in which the power of public office is used for personal gain in a manner that contravenes the rules – is a persistent feature of societies around the world and throughout history. The sale of parliamentary seats in ‘rotten boroughs’ in England before the Reform Act of 1832 is just one historical example. Contemporary examples also abound – and not just in developing countries like Nigeria, India and the Philippines and transition economies like Russia.

While sociologists and anthropologists often focus on culture as a key determinant of corruption, economists emphasis incentives and view corruption as the outcome of a rational calculation. Corruption, then, arises if a combination of circumstances is present:

First, the relevant public official (a bureaucrat, politician or judge) must possess the authority to design regulations or to administer them in a discretionary manner.

Second, the discretionary power must allow extraction of ‘rents’ or creations of rents that can be extracted.

Third, the incentive system embodied in political, administrative and legal procedures and institutions must be such that officials are left with an incentive to exploit their discretionary power to extract or create rents.

Thus, incentives are crucial both for understanding why corruption arises in the first place and for what can be done to reduce it. Proper incentives can be created by effective monitoring, by rewarding public officials with salaries above market alternatives and by penalising corruption when it is discovered.

Importantly, however, all these measures are costly to introduce: there is no free lunch. As a consequence, it can be optimal to allow corruption up to a point.

This does not, however, imply that corruption levels as observed in, for example, Russia or India are anywhere near to being optimal: there is no presumption that incentive structures have been adjusted appropriately. In an environment with ill-designed incentives, corruption carries large social costs. This is because corruption and inefficient policy measures are two sides of the same coin.

Take the example of industrial licenses, a policy measure used in many countries to regulate entry into certain economic activities. To allow public officials to collect bribes, license holders must earn a ‘super-normal’ profit. Such scarcity rents, in turn, require that the number of licenses issued is inefficiently low.

In short, corruption feeds on super-normal profits that are created by the introduction of inefficient policy measures. It is the latter – the inefficient policy – that is the real cost of corruption and which is so detrimental to economic development.

This line of reasoning also demonstrates why the proposition that corruption can enhance efficiency by ‘greasing the wheels’ and allowing firms to circumvent cumbersome rules and regulations is misguided if not outright wrong. It simply overlooks the reason why these cumbersome rules exist in the first place.

Once it takes root, corruption can be very persistent. This is because incentives to accept bribes are very different in societies with high and low levels of corruption. One reason is that reporting of corruption is less likely to happen in an environment in which almost all individuals take bribes and so, it pays for each individual to accept bribes because the risk is smaller.

This makes it extremely difficult to combat corruption in societies with high levels of corruption, and sustained, large-scale reforms of the incentive structures are the only way to move a society away from a high corruption ‘equilibrium’ to one with low corruption. The example of the Hong Kong police force, however, demonstrates that it can be done.

UK courts fail to compensate adequately for earnings' losses

The damages that UK courts award to people involved in accidents fail to compensate them fully for the loss of future earnings. That is the conclusion of new research by Professor Bob McNabb and colleagues at Cardiff University, published in the latest issue of the Economic Journal.

The researchers argue that UK courts should move to a US-style system for setting damages, taking more explicit account of labour market information, such as the way people’s earnings change over their lifetime and the likelihood that an individual will be in employment in the future.

They researchers find that:

Adopting a US-style approach would produce higher levels of compensation. Damages could increase by around 25% on average, although compensation would actually fall in about one quarter of cases.

There would be an important gender effect of employing the new approach. Current court awards for men are consistently lower than those based on the US approach. The differences for women are considerably smaller with actual awards often larger than the predicted ones.

UK courts currently under-estimate the impact of disability on post-injury earnings potential. As a result, they make inadequate adjustment for lower post-injury earnings potential and award damages that are lower than they should be.

The current approach to setting damages may under-compensate people from ethnic minorities for future loss of earnings.

Although judges apply the current approach consistently, they do not always determine the ‘multiplier’ (which estimates the likely number of years of loss) accurately. But there is no evidence that judges are influenced by gender or ethnic background, nor by region or the attributes of the case.

The research team notes that each year, thousands of people make claims for damages to compensate them for the earnings loss they suffer following an accident. Although most of these claims are settled, those that do go to court establish precedents that are used as guidelines for other awards. Under the current system, to determine the appropriate amount of compensation, UK courts rely on two factors:

- the annual loss of earnings the person will face as a result of the accident;

- and the number of years over which this loss will be sustained.

The annual loss of earnings is based on the person's earnings at the time of the injury less any earnings potential the person may have post-injury. The annual figure is multiplied by a figure that represents the number of years of loss, but this ‘multiplier’ has to be reduced to allow for early receipt (the person receives the payment now rather than as separate payments over their working life) and the risk of early death. The multiplier thus helps convert the loss of a future stream of income into a lump sum.

Within the legal profession, there has been concern that there is too much uncertainty involved in calculating the multiplier. It has been described as ‘an arbitrary process, in which the multiplier is not calculated in a precise or logical manner’. In particular, the multiplier takes virtually no account of the factors that influence the way an individual's earnings change over time. The approach is in marked contrast to the way courts in the United States and Canada assess damages for loss of earnings, which explicitly incorporates labour market analysis and predictions.

The research examines how the levels of compensation would differ if the courts in England and Wales adopted North American practices. A subsidiary analysis considers whether the subjectivity involved in assessing the amount of damages introduces systematic bias in the amounts awarded. In particular, do gender and ethnic background of the injured person affect the amount of damages judges award? Are damages higher in some types of cases, such as medical negligence, than they are in other? And is there a regional bias in the amount of damages awarded?

The research focuses on over 100 personal injury cases that went to court. Detailed information relating to these cases was collected from solicitors' files from across the country, providing a new and unique database on how damages are calculated.