by Polar Bear (guest-blogger)
In one of the chapters of his 2006 book, Undercover Economics, Tim Harford presented an engaging analysis that tries to explain why countries such as Cameroon and Nepal are poor.
The author asks the question: Why is it that in spite of (1) potentially higher rate of returns on investment in poorer countries (i.e., aggregate production function exhibits diminishing returns) and (2) the increasing availability and affordability of technology that will allow poorer countries to catch-up with richer ones, some countries like Cameroon fall farther behind?
“Banditry” at the top level which spills over to all aspects of governance is the root of persistent poverty in poor countries. It is in the nature of this problem to resist solution but according to the author, there are some simple reforms which could move poor countries in the right direction. These include (1) cutting red tape, (2) allowing business to be legally established, (3) enlisting the global economy’s help for access to cheaper raw materials, loans and manufacturing equipment, and (4) bringing down trade barriers.
Harford’s analysis is very much in line with theories on New Institutional Economics as popularized by eminent economists such as Ronald Coase, Kenneth Arrow, Friedrich Hayek, Gunnar Myrdal, Herbert Simon, Douglas North and John Commons. In his 1998 article “New Institutional Economics”, Ronald Coase succinctly explained the foundation of NIE as follows:
The welfare of human society depends on the flow of goods and services. The flow of goods and services depends on the productivity of economic system. The productivity of the economic system depends on specialization (or the division of labor). Specialization is only possible if there is exchange. The lower the cost of exchange, the more specialization there will be and so the greater the productivity of the system. The cost of exchange ultimately depends on the institution of a country.
Institution matters. But what does “institution” mean? Oliver Williamson in his 2000 article “The New Institutional Economics, Taking Stock, Looking Ahead” describes the four levels of institutional analysis as follows:
Level 1—the top level is often referred to as the social embeddedness level. This is where the norms, customs, traditions and religion are formed. Institutions at this level change very slowly – on the order of centuries and millennia. The concept of level 1 institutions has been advanced to answer questions such as “What is it about informal constraints that gives them such a pervasive influence upon the long-run character of economies?” Why for instance can the Filipino people ignore character flaws and lack of credential of political personalities the moment they become “anointed” candidates? Religion, no matter how irrational it sometimes is has been imbedded in the Filipino psyche by hundred of years of indoctrination just as the “kanya-kanya” mentality can be rooted to the archipelagic nature of our lands.
Second Level – going beyond informal traditions and codes formal rules such as the constitution, laws and property rights are introduced in this level. While constrained by the informal factors in level 1, the reform instruments in level 2 include the executive, legislative, judicial and bureaucratic functions as well as the distribution of powers across different levels of government. Although these are arguably important, introducing reforms at this level is very hard to orchestrate. Failed attempts to introduce charter change in the Philippines can be categorized in this level. Changing the rules of the game at such level has overwhelming impact that initiatives to institute such wide-ranging reforms are often clouded by distrusts. Nations sometimes need to be pushed on the brink of chaos to introduce change at this level. The massive discontent at the dictatorship of Ferdinand Marcos for instance paved the way for the introduction of the 1987 constitution.
Third level – this is where the institutions of governance are located. Going beyond established rules, the analysis is now centered on enforcing contractual relations. Since it is often costly to settle disputes in court, much of the contract management is dealt with directly through private ordering. For instance, one only has to follow the procedure in getting a business permit from pertinent government agencies in order to obtain one. The rules of the game need not be changed for each person who has to get a business permit. The term “weak governance” is thus explained by deviation from the rules of the game. “Oiling” the process of getting a business permit by giving “lagay” is a governance issue because parties to the transaction deviates from established procedures as defined by established rules and regulations. Similarly, application of the “rules” as defined by the whims and moods of a dictator to suit his personal interest is a categorical breakdown in governance.
Fourth Level – this is the level at which optimality apparatus works. Economic agents now take norms, traditions, rules of the game and enforcement of contracts as given, aligning their actions to the risks and incentives as set by these institutions.
NIE as an analytic tool implies that needed reforms, which will allow poor countries to get out of poverty have to be instituted on a case to case basis. There is no universal remedy.
For instance, while Harford’s article suggests that poor countries can be helped via cheap provision of raw materials such as fuel, loans from international banks and manufacturing equipment, there is no guarantee that this will work. There is one universal principle that guides people’s actions as economic agents – self-interest.
One has to look at levels of a country’s institutional set-up to determine how such actions will flow through its incentive system. It is possible for instance for cheap raw materials to land at the hands of a select and powerful few who could take advantage of the wider margin that they can squeeze out of such a transaction. Positive impact to growth of allowing the economy to benefit from such a concession could eventually cut the flow of cheap goods and can therefore be perceived as a threat by those benefiting from it. Hence, the response would be to ignore the growth objective and pocket as much in order to keep the money flowing in.
Without the right incentive system, economic agents’ response to aid or concessions can be pretty perverse. An example is the outreach program to AIDS infected people in Africa – because families of AIDS infected household heads were given donations, getting well was not perceived as the appropriate response (i.e., without AIDS, there is no aid). According to reports, some even intentionally acquire the disease in order to get donations that will tie their families over at least in the short-run.
There are various reforms that strike at a country’s institutional set-up giving economic agents the right incentives to adopt the appropriate actions. We agree with examples of reforms cited in the case. Among which are:
1. Trade liberalization—In the Philippines, this successfully chipped away at cronyism which was pervasive in the determination of industry winners prior to the liberalized set-up.
2. Free Market—Encouragement of market competition under a transparent environment where the rules are explicit and easy to follow would attract investors, generate jobs, promote growth and alleviate poverty
3. Promotion of Good Governance and Accountabilities—this could include pending reforms such as the botched computerization of the Philippine election system
4. Improvement of the Nation’s soft and hard infrastructure – this should include priority spending on infrastructure projects and education backed up by transparent budgeting and disbursements
Indeed institutions, be it at the first or the fourth level is susceptible to reform. It sometimes takes visionary and reform-oriented leaders to get a country’s institutions right but absent such persons, citizens of a country in their own way can help in the process.
I believe that as ordinary citizens, while it is almost beyond our sphere of influence to reform the government and steer it to adopt and implement the needed reforms as suggested above, there are ways to help facilitate the process.
For instance, as aspiring leaders in our field, we can help advocate and steer our business organizations into practicing good corporate social responsibility which will help our own organizations, and eventually organizations we deal with, to benchmark transaction processes not in the norms and standards set-up by the domestic environment (which we know needs fixing) but by the global community. This in the context of new institutional economics can help countries get out of poverty by:
1. Helping define and implement the rules of the game: While it is expedient to succumb to bribery and ‘lagay’, exerting pressure for the government to define rules more clearly and encourage players to stick to these rules will help businesses in the long-run. Viewed as a repetitive process, transaction with the government under an environment of weak governance can only be damaging to business in the long run. An acknowledgement of the significance of this transaction cost to businesses’ survival, prompting needed reforms to address it, can strike at the heart of level 3 institutions.
2. Helping build the foundation for better norms and traditions through scholarship programs that recognize merit and excellence. This in the long-run can help re-define level 1 institution making our country a nation of achievers.
3. Supporting non-government organizations such as Transparency International and other deserving non-government organizations with credible background who are engaged in social marketing programs (e.g., anti-corruption campaigns, campaign for clean elections).
4. Being vigilant and critical about (a) reform policies being promulgated by the government and (b) actions by the government to help promote good governance and accountability.
5. Practicing responsible advertising (i.e., advertising that promotes good values)
And then again, institutions of whatever level can only be described by the aggregation of the characters of individuals who compose it. Good individuals make good institutions. Practicing good citizenship and observance of the rule of law in our daily lives and in relating to our individual spheres of influences could help in growth promotion and poverty alleviation. If each of us does these, even if we could only hope that the multiplier effect is more than one, one day we will be out of the rot our nation is currently in.
References
Harford, Tim. 2006. “Why Poor Countries Are Poor”. The Undercover Economics.
Coase, Ronald. 1998. "The New Institutional Economics." The American Economic Review. 88(2):72-74.
North, Douglass C. 1993. "The New Institutional Economics and Development." Mimeo. Washington University, St. Louis.
Williamson, Oliver E. 2000. "The New Institutional Economics: Taking Stock, Looking Ahead." Journal of Economic Literature." Vol.38 (September): 595-613.