3.2.2  Economic institutions

The role of political institutions in the creation of economic institutions means that economic institutions will not always be designed in ways that aim to maximise economic growth. However, the distribution of political power can change over time as the political and economic environment change and create an appetite for efficiency-enhancing change in economic institutions.

The feasibility of introducing and sustaining good institutions is determined in large by the country’s existing institutional framework and the way in which it distributes political power within the country. As a consequence, institutional reform can be difficult to spur. It may take a domestic crisis or external pressure to drive institutional change or it may be a slow evolution as gradual change in underlying social institutions drives change in political and economic institutions. Profound institutional change and development may need to be made slowly to ensure that the system created is compatible with social institutions and to ensure that it can be effectively enforced (Aron 2000). In more developed countries, change is likely to be less fundamental as many of the necessary institutional settings will already be in place.

For change in economic institutions to be successful it is important to consider the feasibility of introducing and sustaining good institutions, to understand what successful market based institutions deliver, to recognise the appropriate form institutions should take, and to understand what can be done to spur institutional reform (New Zealand Treasury 2004).

The development of economic institutions can be fostered by three broad types of policy mechanisms identified by the IMF (2003). Competition and trade openness may help to weaken vested interests and lead to demands for institutions that are suitable for a wide variety of transactions. Greater transparency and better information can help reduce corruption, increase government effectiveness and improve policy development. Conditionality for international economic agreements and associations can help to break through domestic impediments to reform.

There are a number of ways of characterising efficient economic institutions. Good economic institutions can be defined as those that provide security of property rights and relatively equal access to economic resources to a broad cross-section of society. Such economic institutions would reduce pressures to seek change to political institutions and thereby future economic institutions. The quality of both formal and informal institutions can also be assessed in terms of their respect for contracts, property rights, trust, and civil freedom (Aron 2000). Successful market based institutions should also improve certainty about the outcomes of economic activity.

Property rights and contract enforcement improve the environment for economic activity by reducing the transactions costs faced by firms. As Coase (1960) suggests, institutions matter when there are transaction costs. Since transaction costs, that include all the costs of doing business, are ubiquitous, institutions always matter. North (1994) notes “When it is costly to transact, then institutions matter. And it is costly to transact.”

Uncertainty about whether a firm will receive its expected return from an exchange with another party gives rise to transaction costs. It is not possible to anticipate in advance all the circumstances that may affect an agreement. It is not always possible to determine whether the parties to an agreement are acting honestly or opportunistically. Risks also arise from outside the agreement where parties that are not involved in an exchange (such as the government) can take some or all of the profits or assets involved in the exchange.

Firms encounter transaction costs when they attempt to reduce their uncertainty about the outcomes of an exchange. Uncertainty is reduced by rules around property rights and contract enforcement that increase the likelihood of expected outcomes. These institutions provide assurance for firms that they will maintain ownership of assets they have invested in and will receive their due from an exchange with another party.

All countries have economic institutions and their quality determines the level of transaction costs facing firms. Institutions can reduce the level of transaction costs if they improve the information available to firms and make bargaining, monitoring and enforcement easier. As North (1991) notes, effective institutional arrangements provide comfort that the gains of trade are realisable. Institutional arrangements that lead to a greater shared understanding of the grounds for trading and to greater confidence that those grounds would be enforced reduce the efforts that firms need to make to manage risks, allowing them to focus more on production and exchange.

Property rights provide protection of assets held by an individual or firm against expropriation by others. They ensure the firm maintains control over the returns to the assets it has invested in. Economic institutions that allow property rights to be secured enable people to keep the returns on their investment, make contracts, and resolve disputes (Djankov et al 2002). Such security encourages people to invest in themselves and in physical capital, and therefore fosters economic growth. This security will also provide firms with the confidence to invest in human capital to improve the productivity of labour and as a complementary investment to physical capital.

In modern societies property rights are defined and enforced by the state. However, the greatest risk of expropriation comes from the state, often through uncompensated regulation (Epstein 1985, 1999). Countries with greater constraints on politicians and elites, and more protection against appropriation by these powerful groups, have substantially higher income per capita. When there are no checks on the state, on politicians or on elites, private citizens do not have the security of property rights necessary for investment (Acemoglu and Johnson 2003). Nevertheless, governments do face pressure not to violate the rules set for their own purposes (Rodrik 2003).

Without reliable property rights enforcement, firms will tend to be small scale, to use low-capital technology, and to have short-term horizons (Aron 2000). Investment in human and physical capital is especially sensitive to the security of property rights, because of the long time period involved (Borner et al 2004). If property rights are improperly defined or left ambiguous and unenforced, resources will be wasted as people try to capture or defend their claims to resources (Saleh 2004).

Institutions that enforce contracts provide assurance to firms when they are negotiating an exchange that their interests are protected, should the agreement not be fulfilled. Contract enforcement addresses some of the uncertainty inherent in open market transactions. Sophisticated contracts can facilitate complex transactions, involving multiple parties, covering long time periods and requiring interrelated projects and deliveries (Saleh 2004). Without effective enforcement, potentially valuable exchange might be forgone.

While contract enforcement institutions can reduce uncertainty, they can increase transaction costs in other ways. Defining and enforcing contracts is not costless. Firms face costs associated with commissioning lawyers and spending time in court, where this becomes necessary to resolve a contractual dispute. Firms may choose not to pursue the completion of a contract if it would be more costly for them to do so than it would be to find another solution or to walk away. Thus, effective institutions are those that give firms confidence that contracts can be enforced in a timely and costly manner.

The origin of the law seems to matter. Djankov, La Porta, Lopez-de-Silanes and Shleifer (2002) found that common law is better able than civil law to provide protection against both the private expropriation of property (achieved through government controls that provide law and order) and public expropriation of property (achieved through controls over government).[4] The greater legal formalism of the civil law tradition has higher costs of enforcing contracts, longer delays in courts and results in lower perceived fairness and efficiency of the judiciary system (Acemoglu and Johnson 2003).[5]

3.3  New Zealand’s underlying institutions

New Zealand’s underlying institutions are seen to be broadly robust, providing a strong basis for economic activity. New Zealand is a parliamentary democracy following the Westminster model. Its legal framework is based on the common law system that originated from Britain. Petrie (2002) suggests that New Zealand’s institutional heritage gives it reason to be confident of the basic soundness of its underpinning institutions.

A distinctive New Zealand institution is the Treaty of Waitangi, which has come to be recognised as the founding document for relations between British colonisers and Maori at the time of significant colonisation in 1840.[6] The status of the Treaty and the nature of its obligations are a source of ongoing public debate. Social attitudes towards the legitimacy and ongoing relevance of the Treaty of Waitangi to such things as the governance of public organisations, and as a driver for settling historical claims have varied over time and between different groups. This is a process that will continue to generate tensions and to stretch the basis on which groups and communities interact with each other.

Ambiguity around interpretations of the Treaty has led to ambiguity about property rights in some areas, which have at times become the focus of social conflict. While difficult, such conflict is to some degree inevitable in any complex society, particularly one that is characterised by ethnic diversity. Contemporary interpretations of the Treaty have evoked public debate around its application to the question of property rights, particularly the nature and extent of any rights and interests that have not been extinguished, and the degree to which these impinge or otherwise on privately held or publicly administered property rights. The benefit of the Treaty is that it provides a framework for considering and dealing with conflict.

Petrie (2002) suggests differences of view on Treaty settlements reflect, in part, the presence of competing norms within New Zealand on appropriate governance models. Norms related to democratic accountability for resources at the national level may not sit comfortably with the desire by Maori for greater autonomy and different norms of governance of the assets that they receive by way of compensation for past grievances. The key issues for Maori and the Crown are to create structures that reflect the fluidity of the Maori social processes, enable efficient allocation decisions and fair distributional processes, reshape governance arrangements to reflect changing circumstances and further develop skills related to governance and participation (New Zealand Treasury 2001).

To some degree, concerns about the Treaty of Waitangi are conflated with concerns that are not institution in nature and relate to public expenditure on programmes to improve outcomes for Maori, who are, as a group, overrepresented in lower socio-economic groups. Concerns have arisen about the equity of focusing on ethnicity as a basis for targeting government funding as well as the probity of some government programmes administered by or on behalf of Maori.

New Zealand generally scores well in international assessments of its political institutions, legislative framework and economic institutions. IMD International ranks New Zealand 9^th out of 60 countries in terms of the transparency of government processes, 4^th in terms of the independence of the public service from political interference, 4^th on the absence of bribing and corruption and 12^th in terms of political stability. Transparency International ranked New Zealand second in its 2002 Corruption Perceptions Index and it has been ranked no lower than third since the index began in 1996 (Henderson, Cave and Petrie 2003). The World Economic Forum (2003) ranked New Zealand 4^th in terms of public institutions in the Global Competitiveness Report[7], including rankings of 4^th in terms of corruption and 5^th on contracts and laws. In the Economic Freedom of the World, Gwartney and Lawson (2004)[8] assess the legal structures and security of property rights around the world and score New Zealand’s system at 9.0, with 10.0 being the best possible score. The World Bank (2004)[9] looks at the ease or difficulty of enforcing commercial contracts and finds the complexity of contract enforcement to be low in New Zealand, involving a relatively simple process that takes a very short time to complete.

In terms of the consequences of social institutions for economic activity, the International Institute of Management Development, or IMD International (2004)[10], ranks New Zealand 24^th out of the 60 economies in its World Competition Yearbook in terms of whether the values of a society support competitiveness. This suggests that New Zealanders may not place an especially strong emphasis on economic activity and competitiveness.[11]