- Understanding institutions is a prerequisite of institution-building
The Prime Minister is usually heard talking– and rightly so, including during his recent visit to USA– about improving the quality of institutions in Pakistan. It is therefore important to understand what exactly institutions are.
A lot of research work has been produced during the last three decades or so in this regard, mainly by heterodox economics through specialised fields such as institutional, new institutional, organisational and behavioural economics, bringing forth the importance of institutions as an endogenous determinant of economic growth, macroeconomic stabilisation and in addressing equity concerns.
Traditionally, mainstream or orthodox economic thinking did not give much importance to the role of transaction costs– where ‘transaction costs included costs related with gathering and inspecting information, along with pertaining to enforcement, among others’– in an economy, and hence thought of institutions- which help reduce transaction costs among economic exchanges, as an exogenous determinant in national output; or more technically, production function.
Hence, International Monetary Fund (IMF) programmes, which are primarily based on this economic orthodoxy, have not placed much emphasis, therefore, on institutional reform in their programmes. Moreover, the very concept of institutions is very limited to start with, in the IMF thought process.
Yet, the ever increasing role of IMF programmes since the last three decades or so, mainly due to the adoption of flexible exchange rate regimes in the post-Bretton Woods era by countries in general, meant greater number of countries– especially developing countries with large external debt portfolios– faced numerous balance of payments crises; initiating in turn approaching the IMF. This phenomenon of countries falling into such crises frequently, attracted the attention of research to understand the issues in IMF programmes, which did not allow countries to sustainably come out of these crises; where, in some countries, every next crisis was more severe than the previous one.
For the benefit of both policy under IMF programmes and otherwise independently being evolved by government, it makes sense for both to look at the framework, and approach the reform process in this holistic sense
Research resultantly pointed out the limited focus of IMF programmes, and overall of policy prescription imparted by orthodox economic policy, in addressing institutional quality determinants, particularly on the supply side of the economy. This brought into limelight heterodox economic research on institutions and their importance in lowering both transaction costs, and also overall in positively impacting macroeconomic stabilisation and economic growth.
For example, it was realised that for making more effective the impact of policy instruments like policy rate to squeeze aggregate demand in the economy, required better monetary transmission mechanism and that, in turn, depended on sound economic institutions. Overall, even better policy formulation and implementation required improved economic institutions. Yet this message of research on the side of heterodox economics has not been able to penetrate the thinking of IMF programmes. The same is the main issue of the current IMF programme negotiated in Pakistan, where once again there is not much focus on institutional reform in programme conditionalities.
For the benefit of policy and IMF programmes, it makes sense therefore to highlight below some of the conceptual details in this regard.
Upfront, institutional reform is positive change in institutional framework, which is composed of institutions and the underlying organisations they formulate; and such framework evolves over time through the interaction of institutions and organisations.
The organisations in turn interact with economic agents both within the domains of the organisational hierarchy or organisation, and in markets. Markets therefore are also a part of this framework, and therefore institutional reforms include reform of markets.
That being said, transaction costs in all these realms of institutions, organisations and markets are reduced so that economic interactions are more efficient, with positive consequences for investment and economic growth.
To understand institutional reform, therefore, requires elaborating its components. Institutions are the laws, rules, and procedures which define the environment, or more formally the rules of the game. They are both formal and informal, where the former are defined by parliament and other legislative bodies, while the latter are a result of norms, conventions, and culture of a society. Informal institutions feed into formal institutions over time. The role of education and its quality is exceedingly important for the formulation of both formal and informal institutions, since they are affected by the belief systems of a society, which in turn are affected by the quality and depth of education in the society.
Organisations on the other hand are the players of the game. They are hierarchical structures and their particular structures and goals are determined by the environment provided by the institutional incentive and governance structures. Here, incentive structures are both positive– for example subsidies/rewards– and negative– taxes/penalties.
In the practical sense, the ministries-for federal subjects, and provincial departments for exclusively provincial subjects, are institutions, while organisations are departments/public sector enterprises/other public entities in the public sector, and firms/enterprises/other private entities in the private sector; with underlying markets working under their respective domains.
Moreover, there are primarily two branches of institutions, and these are economic and political institutions. While the political institutions evolve on the basis of the prevalent or desired political philosophy of a society, economic institutions belong to four sub-domains: real sector, fiscal sector, monetary/financial sector, and external sector.
Also, political institutions likewise have underlying organisations like election commission, political parties, among others, along with markets, for example the market for elections; where the supply of votes is provided by the electorate, while the demand for votes is by the candidates.
In the case of Pakistan, apart from overall need for institutional reform, public sector enterprises or organisations, for example steel mill, railways, national airlines, and in the energy sector, among others, are also in dire need of institutional reform. After the initial euphoria of the current government to prioritise such reform, not much in terms of policy tangibles has surfaced. Therefore, for the benefit of both policy under IMF programmes and otherwise independently being evolved by government, it makes sense for both to look at the framework explained above, and approach the reform process in this holistic sense.