Why institutions matter for economic growth and development of a country

The fence that divides the city of Nogales between two different countries, is a case study in understanding how organising human societies lead to varying outcomes. North of the fence lies the American city of Nogales, in the state of Arizona; South of it lies the Mexican city of Nogales, in the state of Sonora. On the American side, average income and life expectancy are higher, crime and corruption are lower, health and roads are better, and elections are more democratic. Yet the geographic environment is identical on both sides of the fence, and the ethnic makeup of the human population is similar. The reasons for such differences between the two Nogales are the differences between the current political and economic institutions of the US and Mexico. Besides Nogales, examples include the contrasts between North and South Korea and between the former East and West Germany.

People everywhere try to make themselves as well off as possible, but the “rules of the game” differ across countries. The rules in some countries encourage productive economic activity, while the rules in other countries obstruct it. If two countries have the same resources but different rules, the citizens of the country with supportive rules will fare better than the citizens of the country with obstructive rules.

The rules of the game include both public policies and institutions. Policies are continually being enacted by governments, and while many are long lasting, others are short-term responses to short-term problems. The country’s institutions, on the other hand, determine its fundamental properties, such as whether the rule of law holds, property rights are enforced, and taxes are imposed in a consistent and equitable manner. A strong economy can survive the occasional bad policy, but an economy cannot be strong if it has bad institutions.

Different economists have different views about the relative importance of the conditions and factors that make countries richer or poorer. The factors they most discuss are so-called “good institutions,” which may be defined as laws and practices that motivate people to work hard, become economically productive, and thereby enrich both themselves and their countries.

Among the good economic institutions that motivate people to become productive are the protection of their private property rights, predictable enforcement of their contracts, opportunities to invest and retain control of their money, control of inflation, and open exchange of currency.

Daron Acemoglu and James Robinson, authors of the bestseller "Why Nations Fail" focus on institutional factors: initially on economic institutions, and then on the political institutions that create them. In their words, “while economic institutions are critical for determining whether a country is poor or prosperous, it is politics and political institutions that determine what economic institutions a country has.”

Inclusive economic and political institutions provide individuals with incentives to increase their economic productivity as they think best. Such inclusive economic institutions in turn arise from “political institutions that distribute power broadly in society and subject it to constraints…. Instead of being vested in a single individual or a narrow group, [inclusive] political power rests with a broad coalition or a plurality of groups.”

South Korea, Japan, Britain and US do have broad participation of citizens in political decisions; North Korea does not. From this striking dichotomy, the authors draw thought-provoking conclusions. While absolutist regimes with extractive economic institutions can sometimes achieve economic growth, that growth is based on existing technology, and is non-sustainable and prone to collapse; whereas inclusive institutions are required for sustained growth based on technological change.

Why Nations Fail offers case studies to illustrate these points: the economic rise and subsequent decline of the Soviet Union is a case in point. Regarding the likely future trajectory of Communist China, whose growth prospects appear unlimited to many Western observers - but not to Acemoglu and Robinson, who write that China’s growth “is likely to run out of steam.” The Soviet Union retained its extractive institutions to the calamitous end, but in the early 1980s, China began to replace extractive economic institutions with inclusive ones. It was rewarded with a sharp increase in its rate of economic growth. Between 1980 and 2004, China attained a growth rate of 8.2% per year, which is the highest sustained rate of growth ever observed. However, the Chinese government is attempting to couple inclusive economic institutions with extractive political institutions, which has historically been an unstable combination. The Chinese have managed to grow under extractive political institutions for about forty years. This growth is a magnificent achievement, but forty years isn’t a long time in the history of the world. The only system of growth that has been sustainable for centuries is the Western model that combines inclusive political institutions with inclusive economic institutions.

Of course, in addition to inclusive institutions, other factors like natural resources, tropical diseases and tropical agricultural productivity etc also play a role in the economic prosperity of a country. Countries differ both in their potentials, and in the degree to which they realize their potentials.

Mançur Lloyd Olson Jr. was an American economist and political scientist who taught at the University of Maryland. His most influential contributions were in institutional economics. Olson concluded that much of the variation in per capita incomes is explained by the second possibility, that is the degree to which a country realizes its potential.

If you want to predict the prosperity of a country, just look at its institutions. Together, the legal and administrative organizations that underpin every society form what the economists call an “enabling environment” for the creation of wealth. When they fail, trust is eroded and economies can become damaged. The key to a nation’s prosperity or failure is institutions, which play a key role in creating the enabling environment for realizing a country's potential. There is a broad consensus – supported by substantial evidence – that inclusive institutions are important for growth, poverty reduction, development and peaceful societies.

Acemoglu and Robinson find it useful to divide economic institutions into two kinds, inclusive and extractive, and to do the same with political institutions. Inclusive economic institutions support the material aspirations of most of the population. Extractive economic institutions are the opposite of inclusive ones: their purpose is to steer the economic rewards toward a relatively small elite. Political institutions are inclusive if they are both pluralistic and sufficiently centralized. The combination of inclusive economic and political institutions is the norm throughout the developed West.

If India has to become an economic powerhouse, it is essential to safeguard and strengthen the inclusive economic and regulatory institutions that promote prosperity of all, instead of promoting monopolies. Pluralistic and inclusive political institutions are also equally important to ensure the well-being of all citizens.

(V Venkateswara Rao is an alumnus of IIM, Ahmedabad and a retired corporate professional)