New Institutional Economics

New Institutional Economics

It has been argued so far that economic growth cannot occur unless
investment takes place to create the capital goods necessary to
produce increased future outputs. Technological progress must also
occur to ensure that productive resources are liberated from the
constraints of diminishing returns.
Market economies use price signals to decide the pattern of
resources to be invested in capital but will need the hand of government
to provide support for technology.
In addition, sound macroeconomic policies that prevent inflation
and its distorting effect on the price mechanism, and policies to
guarantee free trade that give opportunities for all to participate in
wealth creation are equally held to be necessary conditions to
secure economic growth.
All these conditions taken together are still not, however, sufficient
to explain why some countries grow rich and others do not.
There is a growing consensus, particularly from economic historians
who have taken a longer view of the process of development,
that the missing factor, the key explanatory variable that links all
these issues together is the presence or absence of stable social,
political and economic institutions.
In this argument, capital and technology are the product of
economic institutions that embody confidence in the future. Sound
government policies are similarly the product of sound, stable political
institutions. Secure property rights, legal systems, political
stability, LAND REFORMS and efficient capital markets, are amongst
those institutional features that facilitate economic growth and
development.
© 2004 Tony Cleaver
A country blessed with enormous natural resources (the Soviet
Union, Argentina) will make a mess of them if they have bad institutions.
Conversely, a nation with very few resources and/or starting
from a very disadvantageous situation (Singapore, Taiwan) can
nonetheless achieve rapid advance if it has good institutions. A
country with bad institutions will institute bad policies and be unable
to reverse them; whereas a country with good institutions may make
policy mistakes but will be able to recover and redesign them.
These are the views of an increasing number of different economists
and historians who have studied the factors affecting the
economic development of a wide range of countries, past and
present. They include the very first, famous economist as well as
some recent Nobel prize-winners.
Adam Smith, the professor of moral philosophy of Glasgow
University in 1776 was well aware of the ethical foundations of a
market society. It was he who first emphasised that economic
growth takes place with increasing specialisation consequent upon
the expansion of markets. Trade can occur all over the world –
providing one party to a contract, trusts the other to keep their end
of the bargain. This emphasis has returned to modern economics in
a concern about transactions costs.
It is fascinating to see how different societies do business. One of
the problems of western tourists visiting developing countries, for
example in the Middle East or Latin America, is that many fail to
understand the culture of trade in these countries. In an Arab Souk
or bazaar, for example, there is much haggling – face-to-face trading
on a repetitive basis – over small transactions. A lot effort is thus
devoted to CLIENTISATION.
What you are in effect doing in these circumstances is establishing
a personal relationship and reputation. In such societies,
reputation is everything. Other examples are on traditional caravan
trade in the Middle East, or in Native American culture, or in Mafia
trade – if you have the blessing of the local chief or sultan you go
with his protection and you can establish an efficient trade.
Similarly, the Latin American traditional method of doing business
is to go through the extended family – you rarely deal with
someone you do not know; you always go via family or personal
recommendation of someone whose reputation is recognised by
both parties.
© 2004 Tony Cleaver
What all these trades have in common is that they take place in an
environment where there is no over-arching rule of law – where
no dealer who is wrong has recourse to some authority that can
compensate him or her in full.Without such authority, the trader has
to bargain to establish his or her own rights. The essential economic
point to be made here is that the transaction costs involved in doing
business this way are excessive. Since trust in trade is established on
a personal basis, then market trade cannot develop very far. The cost
of doing transactions on this basis soon becomes prohibitive.
The contrast when people who are used to such personalised
dealings relocate in a wealthy market economy can be fascinating –
some are amazed at how trusting people can be in Western society.
To open a bank account, to buy a car or to make a deal and exchange
money over a telephone is so easy.
Highly specialised market societies can only operate if transactions
costs are minimised. We thus have elaborate systems of
monitoring and enforcing contracts that are embodied in law as
property rights. It is only because we possess such systems, that
transactions costs can be reduced and thus we can do business.
Property rights allow individuals in highly complex trading situations
across space and through time to have the confidence to deal
with others of whom they have no personal knowledge, and with
whom they have no reciprocal and ongoing exchange relationship.
Even if you only deal such people once, you should be able to rely
on them just as much as if you were in daily contact and whether
they need your business or not.
Such trading is only possible if:
 formal institutions exist to specify property rights and to enforce
contracts,
 and NORMS OF CONDUCT exist to maintain the same confidence
where – even where authority exists – there are deficiencies in
measuring and enforcing compliance.
The importance of formal institutions (government) and informal
institutions (norms of behaviour) tend to be ignored by academics
of neoclassical persuasion who in the words of economic historian
Douglass North ‘persist in modelling government as nothing more
than a gigantic form of theft and income redistribution’.
© 2004 Tony Cleaver
Yet the key to growth and development is the same today as in
Adam Smith’s time – the increasing specialisation and development of
markets – which is absolutely dependent on a complex web of institutions
which run from measurable property rights to well-run legal
systems to incorruptible bureaucracies. There are vast differences in
the relative certainty of contract enforcement over time (empires have
grown and fallen according to the strength of their customs and laws)
and in space – between the developed and developing world.
It is argued that, without exception, countries grow slowest where
property rights are weak or absent, the rule of law is unreliable and
where governments are corrupt. In such cases the custom of trust
and respect between citizens breaks down, the costs of transacting
business soon becomes excessive and no great growth in trade
beyond personal contact is possible. In contrast, countries grow
fastest where these institutions are all in place and it becomes the
norm to abide by them (see Box 7.4).
Land in poor, agricultural economies is the main source of
wealth. Such societies tend to be feudal in organisation: where
ownership is concentrated in the hands of a few and peasant
labour is paid a low wage to till the fields and deliver the product
to the landlord. Quite apart from any injustice in such arrangements,
so long as labourers cannot earn the full reward for their
efforts, there is no incentive for those who do most of the work
to strive to be economically efficient. Both land and labour
productivity tends to be very low.
The Chinese communist revolution in 1949 was driven by a
sense of injustice to dispossess landlords and redistribute lands
in huge communes to be owned by ‘the People’s Republic’. In
this way, previously poor peasants were to be given altogether
greater access to wealth-creating land.
Agricultural production stagnated, however, despite all sorts
of efforts to inspire revolutionary zeal such as in the inappropriately
named ‘Great Leap Forward’. It was not until well after the
death of the communist leader Mao Tse Tung that China was
able to experiment with market incentives in the communes.