What makes nations grow and how
The study of prosperity has been one of the central questions in the field of
economics. Why do some countries prosper and why are others stuck in a vicious
cycle of low growth and poverty? Surely, countries which prosper must have
something going for them, there must be some factor that accounts for the
difference between low and high prosperity countries. Could it be that the
geographical setting of some nations favours their flight towards prosperity?
What about natural resources, do nations with more abundant natural resources
outgrow those that do not? And institutions, do institutions play any role in
the development of a country?
Being the ‘dismal science’ there has been no final, causative verdict on the
issue. However, research can point us towards the right direction and
investigations on the causes of prosperity seem to point towards one underlying
factor beneath this disparity. Surprisingly, it is not natural resources, with
resource rich countries having a harder time sustaining periods of high growth
as compared to countries with scarcer natural resources. In his highly cited
paper ‘Natural Resource Abundance and Economic Growth’ Jeffrey Sachs states that
countries with a higher ratio of natural resource exports to GDP have lower
rates of growth compared to countries with a lower ratio of the same.
If anyone ever thought the economy works in intuitive ways, be warned and be
prepared to have your confidence in yourself shattered.
So really, what then determines which countries will prosper and which will not?
Extensive research on the subject has unearthed one oft-overlooked aspect of
economic growth: institutions. Defining what institutions are has been a matter
of much academic nit-picking. Broadly though, institutions are said to be the
constraints that dictate or guide human interaction in society or as Douglas
North put it institutions are ‘the rules of the game in society’. The ‘rules of
the game’ or institutions can either be formal or informal. Property rights,
laws and statutes, police, army all would be of the former kind whereas customs,
social norms, the importance of social capital are of the latter kind.
As a subset of guiding human interaction, it is institutions that provide the
incentives and payoffs in a society and therein lays the great importance of
institutions. By being the ‘rules of the game’ or constraints if you will,
institutions also decide the payoffs for actions taken by individuals. To
illustrate, think of your local police station. The police, as an institution,
have created a clearly positive payoff for bribery. Social norms coupled with
negligible penalties and a positive outcome for both the individuals involved in
the transaction create an environment which makes bribery part of the game’s
rules.
As stated above, institutions dictate the payoffs for individuals’ actions and
in the same vein economic institutions dictate the payoffs for individuals’
actions in the context of a market. It is this aspect of economic institutions
that make them so important for a country’s economic well-being. When a country
has a set of enforceable, nonpartisan property rights, an individual’s incentive
for trying to swindle people is low and the resulting penalties are high, hence
lowering the payoff to operate outside the ambit of the established legal
framework. Consequently, investors are more confident of earning a return on
their investments and hence more willing to invest in that country, fuelling the
engine of growth.
Again, to illustrate, there is a reason why property in Defence, Lahore is the
most liquid and considered a real estate investment safe haven. There is a trust
and confidence amongst investors that there is very little likelihood of a
property in DHA being disputed or having any sort of legal baggage with it,
because the DHA ensures that that never be the case, that the properties it
sells to investors should be free of any legal disputes. This example should not
be taken as an endorsement but is only to showcase how properly enforced
property rights can create an environment conducive to investment.
Economic activity and transactions thrive in environments where individuals can
rely on a fair, enforceable framework to back them up in case of any dispute. A
lack of such a framework creates a perennial trust deficit amongst transacting
parties, especially ones that do not have some sort of personal connection. This
trust deficit increases the volatility and risk inherent in that environment,
thereby shutting out from the market investors with a lower risk tolerance than
that required for the market. Functional economic institutions lower the
market’s risk enough for more investors to be willing to commit their capital to
it. Furthermore, a higher number of individuals in a market will also make that
market more efficient, competitive and innovative.
Without going into too much detail, embarrassingly clear is the fact that
Pakistani institutions are dysfunctional, rotten and incentivizing actions
society could do without, for example corruption and a blinding desire to hoard
as much power as possible; though one feels the latter is also a symptom of our
society’s dysfunction. Informal institutions have a much greater importance in
our lives than formal ones, which will kowtow to anyone having enough social
capital and wealth.
At best, institutions are woefully slow to change. Unjust and dysfunctional are
bad enough but not being able to change the same is where the real horror lies.
Bad institutions will get stuck in a self-perpetuating cycle where the people in
power and those who derive benefit from such institutions will use their
political and economic power to keep this self-serving status quo in place and
not allow the development of any such organizations and institutions that might
hurt their interests. An acronym comes to mind, SROs.
Suffering most from this lack of formal institutions is rural Pakistan, where
power is structured in such a fashion that the local elected representative is a
focal point in the distribution of service delivery, encompassing anything from
justice to getting an electricity connection. Given the scope of powers that
local elected representatives wield, would it be rational to think that at some
point in the future, these representatives will voluntarily give up such
precious, discretionary powers and hand them over to a set of functional formal
institutions?
It would be unwise to presume so. However, if society exerts enough pressure on
political organizations and institutions, institutional change can be brought
about. Institutions, especially political ones, are a function of society and
when society so desires, it can force about institutional change.
Our policy makers must realize that increasing public spending will only bring
about so much prosperity. It might kick-start the economy into some sort of
gradual ascent towards prosperity but to sustain the same over a longer time
frame will require Pakistan to build up non-partisan, functional institutions,
without which it will be extremely difficult for Pakistan to drag itself out of
its poverty.
- See more at:
https://www.pakistantoday.com.pk/2013/07/02/comment/columns/institutions-growth-and-prosperity/#sthash.BsmDABC6.dpuf