3.2  Formal institutions

Formal institutions, both underlying and specific, provide the context within which firms operate. Property rights and contract enforcement can be seen as “market creating” institutions, without which exchange cannot occur (Rodrik 2003).

Underlying institutions such as the constitution and rule of law contribute to political stability, prevent corruption, enhance public sector efficiency and protect private property rights from misappropriation by private parties or government.[3] More specific institutions include legislation and regulations and organisations that create and enforce them, such as government agencies and the legal system.

Formal institutions become more important, relative to informal institutions, the more the scope for market exchange broadens and deepens, possibly because establishing formal institutions has high fixed costs but low marginal costs while informal institutions involve high marginal costs (Rodrik 2003). Increased specialisation and the division of labour may also make formalising political, judicial and economic rules worthwhile (Aron 2000).

Societies with weak institutions not only grow more slowly in the long run, but experience greater volatility (Acemoglu, Johnson, Robinson and Thaicharoen 2003). Strong institutions are associated with high levels of real per capita income since they shape overall conditions for investment and growth (IMF 2003). For example, where corruption and appropriation of private property are common, the potential returns on investments are reduced and possibly eliminated altogether. Political control of resources may also limit the extent to which firms can secure the inputs they need for production. Formal institutions also influence the balance of diversionary (rent-seeking) and productive activities in society (Hall and Jones 1999). Countries with a history of institutions that support productive activities such as capital accumulation, skill acquisition, invention and technology transfer produce much higher levels of output per worker.

Formal institutions include the political (those that determine the structure of the state and the procedures of the political decision-making process) and economic (those that determine property and contract rights and thereby reduce transaction costs) (Borner, Bodmer and Kobler 2004).

3.2.1  Political institutions

Political institutions shape the political process that produces legislation and regulation. They also determine the legal system and coordinate the processes that create and enforce the law. Political institutions therefore produce economic institutions and determine their quality. Institutions like democracy and social protection legitimise market outcomes and ensure their endurance. Political institutions can support a market economy by shaping and safeguarding property rights and making the market compatible with social stability and social cohesion (Borner et al 2004, Rodrik 2000).

Political institutions tend to reflect the interests of those in power and can therefore produce economic institutions that are redistributive or productive (Granovetter and Swedburg 1992). Where a particular group has control over political processes and/or economic resources it may ensure that institutional arrangements enable it to maintain this control rather than improve efficiency.

The IMF (2003) has found that countries where Europeans settled in large numbers have sustained greater economic development than countries where they empowered a local elite. In the latter group of countries the institutional emphasis has been on maintaining the power and wealth of the elite.

Limiting the power of different segments of society to subvert institutions to their own interests, may therefore be important for economic growth. For effective institutions, the state should be strong enough to specify good property and contract laws and must be committed to enforcing them, even when this means constraining itself from violating these laws for its own ends (Borner et al 2004). Djankov, La Porta, Lopez-de-Silanes and Shleifer (2002) consider when it is appropriate to enable government to control the activities of such groups. They suggest that for New Zealand, a country with strong law and order and no powerful elite, protection of property rights should generally be left to the courts to manage.

As fundamental institutions are longstanding, they tend to change slowly, but occasionally windows of opportunity to effect broad efficiency-enhancing reform arise (Williamson 2000). Civil wars, occupations, perceived threats, economic breakdowns, military coup and financial crises can provide such opportunities. In the absence of such events, change will be slow to achieve. The nature of the political power structure will shape a country’s institutions and thus economic growth (Acemoglu, Johnson and Robinson 2004). At the same time, existing economic institutions affect the distribution of resources (which in turn affects political power and political institutions) and the gains to be made from changing the status quo. The development of economic institutions can thus been seen as endogenous. As Rutherford (2001: 190) notes, “institutions shape economic behaviour and outcomes and are themselves shaped by economic, political and ideological factors”.

While there are links between economic growth and political institutions, it is not necessarily clear that political institutions cause economic growth (Aron 2000). Glaeser, La Porta, Lopez-de-Silanes and Shleifer (2004) suggest that investments in human and social capital lead to economic growth, which leads to better political institutions, which then have second order effects on economic growth. They suggest that higher human and social capital leads to more benign politics, less violence and more political stability. This in turn brings about greater security of property and economic growth. Secure property rights support investment in human and physical capital and these can be achieved under dictators as well as democracies. Countries that emerge from poverty can accumulate human and physical capital under dictatorships and are more likely to improve their institutions when they became richer. Neither Aron nor Glaeser et al rule out political institutions as an influence on economic growth but raise questions about the methodologies used in previous literature to measure institutions and their impacts. However, they reiterate the importance of economic institutions, ie, secure property rights, for investment and economic activity regardless of the role of political institutions.