How efficient is capital allocation in rural developing economies?

Brad DeLong's blog referenced an MIT working paper entitled "The (mis)allocation of capital". Two standard properties of the neoclassical economic model are questioned:

1. Is capital allocated so that the Marginal Product of Capital (MPK) is equated to the market interest rate?
2. Is the marginal product of capital equalized across its alternative uses?

The conclusion, capital markets in India are very far from the neoclassical ideal evidenced by large gaps between the MPK (marginal product of capital) and

1. The market interest rate.
2. The rate paid to savers

The legal system may be to blame:

"Investors who on average are less productive may invest as much as three times more than their more productive counterparts. All this is not necessarily surprising given that the legal system is slow, inefficient and sometimes corrupt, and defaulters usually get off lightly."

This seems to imply that there is a moral hazard problem. An inefficient legal and bankruptcy system making default easier during business cycle downturns, creating a contagion effect or "culture of default". It shouldn't be so surprising that traditional agricultural economies closer to the Polyani reciprocity end of the spectrum than the market-based economy end, should exhibit deviations from neoclassical theory. Neoclassical ideals seem more like an ideal to be achieved only with a perfectly frictionless legal system.

How to alleviate rural indebtedness without inadvertently creating incentives for default on that debt in the future? Rural life needs to be sustained for sure, it is the lifeblood of most cultures. Economists who have neoclassical daydreams of frictionless transitions to perfect neoclassical economic realitiees, should live in one of these communities for a while. Sustain the agricultural lifeblood to be sure, but through cancelling outstanding debts? Or through subsidies? Protecting land and sheltering traditional agriculture a bit locally might help. That a rural family, even teachers and civil sservants, produce their own food supply is axiomatic. They can play with the surplus beyond that commercially.

The rural agricultural economy is thoroughly saturated with politics that effects the legal system and moral hazard incentives. Take the transition from the colonial era in Burma. It was too easy for, for instance, for ethnic Burmese to blame the chettiar money lenders who fueled the expanding rice frontier of Lower Burma during the colonial era with credit, documented by Michael Adas, with culpability. From my residences in Yangon, I still have images of those Indian families who had all their wealth, such as rice mills nationalised after World War II. One old guy, living down the street from the secretariat building, still remembered the day Aung San was shot in front of the secretariat building. Another was slowly drinking himself to death, supported by his grandson in Bangkok. Guaranteed this nationalised Indian capital equipment did not go to more efficient uses after it was nationalised and given that there were not even banks as we know them and various degrees of coercion probably existed in the price set for buying farmers' rice. There's probably a whole oral hsitory of market distortions waiting to be written.

How does one reify the moral hazard that the legal system creates for lenders? There are always informal credit networks that avoid taxes and the legal system entirely, perhaps using violence, and certainly summary repossession of motorcycles bought at usurious interest rates, effortless repossession with the help of the local mafia, followed by resale on a very robust second-hand motorcycle market, actually moped by American definitions.

I love economic models with their simple assumptions and clear modelling of effects, but human institutions create mismatches between reality and model that quickly cascade into the necessity of analyzing this reality of "political economy" with words and language, looking to history for similar examples in the past while trying to construct some historical cover law (See Wikipedia and a paper that discusses Hempel's notion of historical covering laws, not much online about this topic).

There are many dimensions to the moral hazard effect on a firm's incentives. Besides legal delays, that can be used strategically by one partner to stonewall the other, there is also the uncertainty of laws. For instance, in foreign holding rules that require 51% local ownership, for instance, local nominee shareholders are used to hole the remainder of the corporation. Larger companies, like Hutch in Thailand, get away with this, until it becomes a political issue, then there is a significant risk that some local shareholder will end up with the foreigner's investment. I would even characterise this as a strategic way of doing business employed in the past. The business people willing to play the legal system like this verge on being legal themselves. The use of gunmen to shoot business rivals being another case of extra-legality.

What about loan guarantees for foreign multi-nationals doing projects in developing countries. MIGA provided Thailand's Siam Cement and Japanese companies with political risk insurance for participating in a polyurethane plant. Wikipedia's Moral hazard page provides an example of a Westinghouse built nuclear reactor in the Phillipines during the Marcos era.

I guess my conclusion is merely that, yes, there are a lot of political-social-legal factors that might lead to interest rates being out of sync with Marginal Products of Capital. There might be small well-defined localities with their own justice system and well-functioning social norms, for intance, for which the neoclassical ideal holds though.

Whew! That was a little bit too long-winded, but by gabbing with myself, I've better defined some of the issues and started to read further....and learn.