Fridays Academy: Institutions and Growth

Like every Friday, from Raj Nallari and Breda Griffith's teaching notes.

At their most fundamental, institutions are the informal rules and norms that govern personal and social behavior, and the formal rules and norms that govern economic, social, and political life. Institutions emerge as rules and norms developed to provide the predictability needed for societies to function. Put another way, society is an organization in which exchange and production are mediated by formal and informal institutions, themselves the underpinnings for markets. Institutions can be more or less effective in facilitating exchange, production, and market operations. Studies have shown that institutions matter greatly for growth but, given their deep-rooted nature, are very difficult to change.

Institutions perform certain functions in every society, the form they take in doing so varies considerably. Unfortunately, very little of the empirical work done to date on the importance of institutions examines the link between institutional form and performance. Researchers have focused instead on the link between institutional performance (for example, perceptions of the rule of law or of protection of property rights) and economic performance. This is important, but it does not teach us how to improve institutional performance and, in turn, foster economic growth. We do know, however, that adopting other countries’ laws and formal regulations will not necessarily produce the same institutional performance or indeed economic performance.  The Washington Consensus that held sway in the 1980s suggested that developing countries would improve their fiscal position by liberalizing the banking system, reforming and privatizing state enterprises and reforming tax structures. The success of these policy prescriptions depended on properly functioning instutitions; developing countries that did not have the necessary regulatory and legal frameworks in place, endorsed by government policies and committiment – in effect good governance -  ended up in far worse macroeconomic positions. 

The importance of good governance for economic growth and development has long been understood. A sub-discipline of the literature on New Institutional Economics (NIE) is the link between governance and growth.  NIE builds on neoclassical economic theory that examines the relationship between buyers and sellers.  Any transaction between buyers and sellers is beset by transactions costs that include uncertainites about the honesty of buyers and sellers and the administrative costs that exist to reduce this uncertainty.  “Institutions are formed to reduce uncertainty in human exchange. Together with the technology employed they determine the costs of transacting (and producing). It was  Ronald Coase (1937 and 1960) who made the crucial connection between institutions, transaction costs and neo-classical theory” (North, 1990).  Transactions costs are reduced when properly functioning institutions exist, i.e. rules and the enforcement of rules.  Moreover, the scope for markets – the exchange of goods and services - is increased when institutions exist.  Unwritten rules such as social customs, norms and religion that are slow to change over time are enforced by groups within society.  Unwritten rules are informal institutions and constitute social capital, they also represent the first level of Williamson’s (2000) four-level classification and hierarchy of institutions.  Formal rules are rules that are written and enforced by the state, for example, constitutions, political parties, and legal systems.  Formal institutions are also slow to change, but not as slow as social capital. (Formal institutions make up “positive political theory” in Williamson’s hierarchy). The third level is where day-to-day transactions take place to minimize uncertainity as described ibid. (North 1990).  The fourth level consists primarily of institutions for market-oriented economic activities, such as stock markets and securities regulators.

Williamson (2000) hierarchy of institutions

Source:Azfar (2002) “The NIE Approach to Economic Development: An Analytic Primer”.

 

A considerable literature has evolved in recent years on the link between economic growth, development and institutions. Driving this has been the empirical evidence suggesting that cross-country differences in income are correlated with differences in indicators of institutional quality.Institutions have been defined along a broad spectrum from the establishment of rules to “actual organizational entitites, procedural devices, and regulatory frameworks” (WEO, 2003).  In practical terms, a large proportion of the work on institutions and economic growth has focused on measuring how well public institutions function and their impact on private sector behavior.

 

Relationship between Institutions and Income

Source:  WEO, 2003.

 

Next week we will examine measures of institutional quality relating to the “perceptions and assessments of public institutions”.