Institutions, growth and prosperity


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.

The same conclusion was reached by Thorvaldur Gylfason, who hypothesized that countries with higher natural resources tend to have less trade, more corruption, less education and less domestic investment consequently leading to lower rates of growth as compared to countries with scarcer natural resources.

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.

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