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Have Institutions Failed Us?

Raj Nallari's picture

Institutions matter was the oft chanted mantra for the past fifteen years. We were told that in the presence of social conflict between various groups, between haves and have-nots, political power precedes political institutions, economic institutions and economic policies. But, political power could be de jure (due to constitution, fair elections and smooth transition to political power) or de facto such as dictatorships and authoritarian leaders usurping power by coups and violence. Sixteenth century colonialism established ‘settler’ and ‘exploitative’ institutions depending on the then existing ‘climate’ in the colonized countries. For example, if the climate was unbearable and malaria-stricken, the colonial masters established an exploitative relationship of shipping out natural resources. If the climate was hospitable, they settled in with family in these countries and started administration and other institutions.

More recently good institutions were supposed to emerge when only de jure political power is in place. Also, a political and legal system that places constraints on elites is often conducive for better institutions. Following this logic, institutional economists have reasoned that advanced economies with de jure democratic political institutions have smooth transition, predictability and place constraints on elites and abuse of political power, and have strong institutions that ensure a system of checks on the executive, law and order, property rights, etc. The theory of institutions is that bad policy outcomes are the result of bad institutions and these are common in developing countries, where the distribution of political power needs to be reformed and deeper causes need to be strengthened. Others have argued that market-oriented institutions are important for economic policy management. By this categorization, advanced economies had better institutions that led to sound economic performance and consistently higher economic outcomes.

How can we now explain the ‘mass delusion’ that occurred in the Wall Street during 2007-08 aided and abetted by government political and economic institutions (Congress) and economic institutions (Central Bank, major financial institutions, regulatory agencies, credit rating agencies, and so on)? How is it possible that the better institutions in advanced countries had mismanaged risk so badly? How could ‘relatively bad institutions’ of BRICs manage to stave off a global crisis and better managed their own ‘financial rogues?’

Olson (1965) argues that interests of the elites are narrowly defined as they prefer local and regional public goods rather than national public goods that are beneficial to all segments of population. They prefer government spending on social sectors for their benefit, bailouts and subsidies and transfers that are supposed to benefit the poor and vulnerable groups, but which they can capture while at the same time wanting to pay lower taxes. Crises in corporate governance in the form of excessive-risk taking by the CEOs of financial firms –and they are not held accountable or checked in time by stakeholders and boards– are symptoms of this broader societal problem of ‘privatizing gains and socializing losses.’

More recently, there is a growing body of work on the influence of politics on economic inputs (e.g. government policies and programs) and economic outcomes. Douglass North’s insight is that politically determined structures (of property rights, government spending allocations, etc.) do not necessarily maximize the efficiency or growth potential of the economy. Rather the politically-determined structures try to maximize the returns to the political leaders/rulers/strong groups (“elites”). If we follow this logic, then both developed and developing countries distort allocation of resources and retard growth and development. Others have argued that patron-client relationship is rampant in policy making in both developing and developed countries. Bates (1981) argues that collusion between urban-based interest groups and political elites resulted in punitive taxation of agriculture. Adam and Connell (1999) note that in countries where restraining-institutions are absent, the government is likely to be captured by a small group and trade-off growth for redistribution that is beneficial to the favored group. More recent work by Acemoglu (2005), Easterly and Levine (1997 and 2003), and Alesina and Ferrara (2005) is along similar lines of state-capture by elites, whether it is along urban-rural divide, economic sector interests (agriculture versus manufacturing) or ethnic diversity or due to ethno-linguistic fractionalization.

However, we now know from 60 years of development experience that South East Asian countries (authoritarian regimes with few constraints on executive) have generated successful economic outcomes, while African countries (mostly with strong rulers) have had relatively less success. To explain this contrast, political scientists and economists use the concept of “weak and strong economic states.” Weak economic states lack/have limited capacity to tax, regulate and play a developmental role (e.g. African states which cannot extract revenues from the rest of the society and fail to invest in public goods). In addition to weak capacity, we also know that self-interested elites will only invest if future private rewards are attractive. When the state is weak, the elites are uncertain about the future and are likely to appropriate fewer rewards, if any, in the future (Acemoglu, 2005).

State capture could be defined as the efforts of affluent individuals or groups, private firms, or oligarchs, to shape the laws, public policies, rules and regulations of the state to their own advantage. This ‘shaping’ may be done not only by the private firms or richer elites (top 20% on the income distribution scale) but in some countries by ethnic groups or powerful economic groups. As such, to fully understand the dynamics of state capture, the analysis must be based on winners and losers not only in terms of income groups but also in terms of powerful groups and vested interests, including bureaucracy. In other words, state capture and re-distributive conflicts are part of the same spectrum of good-to-bad governance.

Countries that are ‘highly captured’ may exhibit capture of all or most institutions by ‘big businesses’ and powerful groups. As such parliament, political parties, the executives including ministries and public enterprises, judicial courts, and bureaucrats, may all be captured. The capture may take place jointly or separately depending upon the economic interests of the powerful groups or elites. So a highly-captured country, in the absence of effective institutions, is likely to suffer from low tax revenues, lower private and public investment, higher redistribution, and therefore slower output expansion, and lower level and quality of public provision of services to the poor.

So the bottom line is that state capture (of institutions, regulations and economic policy) is happening in almost all countries and this should be avoided; otherwise economic outcomes will be bad; or would they? How does one avoid state capture

There is a need to continuously promote competition but this is not automatic just because there is freedom to compete. Powerful, vested interest groups, usually large oligopolistic firms, capture the institutions and the benefits of market-oriented reforms (e.g. in the transition countries, the oligarchs benefited from privatization and de-regulation of prices and investment). In advanced, transition and developing countries, domestic and international cartels and anti-competitive business practices have taken hold in product, trade and financial markets. In fact, the OPEC cartel in crude oil, and food additives, steel, large transformers and pharmaceutical products, and trade in a number of areas (from bananas to arms sales) is dominated by firms from the richer countries.

There is a need for breaking up the too big to fail institutions and curbing the monopolistic firms, and to encourage civil society groups to organize and advocate, for consumer protection agencies, for community-driven development, for encouraging small and medium enterprises, for fiscal and political decentralization though decentralized units that are shown to be as ‘captured’ as centralized units, for term limits on elected or nominated officials in executive, legislative and judicial bodies, curbing the revolving door of patron-clients, and above all for more punitive punishment for ‘white collar crime’ of financial fraud and pension-raiding, and of course ‘enlightened leadership.’


“How is it possible that the better institutions in advanced countries had mismanaged risk so badly?” Some of them were allowed to turn into incestuous mutual admiration clubs. Their management always preferred consensus to any debate. The networks of people became more valuable than the ideas. A misguided sense of automatic solidarity pervaded the networks. Risk adverse human resource departments mostly hired experts from “safe pools” Think tanks and universities turned from being critics into being commercial agents. Too many opinion journalists trapped in their own opinions and too few questioners. Too many dedicated silencers of the opinions that differ from the common held views.

Submitted by Anonymous on
Most Bank work is US-centric, at least in its underlying ideological assumptions. After President Carter, US elites have been infected by a culture of insatiable greed, justified/rationalised by specious free market and other right wing ideologies, generated by prestigious business schools and economics depts. No institution can stand up to this kind of overwhelming force -- not just a life force like money, but also a societal and cultural force which enshrines money and the profit motive as the only "incentives". Just to highlight the cultural shift, it was inconceivable that Presidents Truman, Eisenhower, Johnson or Carter would take large sums of money as "speaking" fees or trade on their offices in any way. Since then, no president has not traded aggressively on his office. The less said the better about self-dealing CEO and officer compensation, obliging boards, etc looting companies and shareholders under the guise of rewarding/retaining "talent" (a phrase unerringly picked up by the Bank's HR, slavish imitators...)

Submitted by Guilherme Lichand on
Better institutions will on average yield better economic outcomes, in particular higher returns to economic investments. Higher returns are usually linked to higher risk. The 2008-09 crisis was the materialization of a low-likelihood but massive-impact risk. I hence see no contradiction of such an event with the findings of the Development and Institutions literature. Moreover, developed economy's institutions are more adaptive to evolving challenges and should therefore, in principle, be able to cope with the need of strongly regulating financial sector innovations.

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