Institutions as Capital?

In the recent Liberty Forum held in New York sponsored by the Atlas Economic Network, Michael Fairbanks, philanthropist and author of a couple of books, talked about the elements that characterize the process of creating prosperity. His talk, heavily based in his framework "Changing the Mind of a Nation: Elements in a Process of Creating Prosperity", advocates moving away from economists' common view of prosperity as a "flow" concept to a "set of stocks" concept. This basically considers prosperity as "the enabling environment that improves productivity." This is connected to Mr. Fairbanks's work of finding ways to improve people's lives through enterprise development and technological innovation.

I took great interest in how he enumerates seven kinds of capital (the "prosperity as a stock" he refers to, page 1 to 2):

1. Natural endowments such as location, subsoil assets, forests, beaches, and climate.
   
2. Financial resources of a nation, such as savings and international reserves.
   
3. Humanly made capital, such as buildings, bridges, roads, and telecommunications assets.
   
4. Institutional capital, such as legal protections of tangible and intangible property, efficient government departments, and firms that maximize value to shareholders and compensate and train workers.
   
5. Knowledge resources such as international patents, and university and think tank capacities.
   
6. Human capital, which represents skills, insights, capabilities.
   
7. Culture capital, which means not only the explicit articulations of culture like music, language, and ritualistic tradition but also attitudes and values that are linked to innovation.
   

I take exception on how he considers the last four as social capital. Unless he has a broader concept of social capital, the term is typically used to pertain to the value of network trusting relationships between individuals in an economy. “Social capital” can be considered capital in the sense that strengthening the network will help an individual achieve his or her productive endeavors. However, by categorizing institutional capital and knowledge resources as social capital, the analytical discourse gets confused. The former pertains to economic and political institutions and the latter to technology or knowledge resources, which are different from the term “social capital” as commonly used in the literature. For instance, can institutions be considered as a form of capital? One of the most basic things you learn in economics is that capital is a factor of production that is not wanted for itself but for its ability to help in producing other goods. Institutions are therefore not capital because these are not factors of production. Institutions are, in a sense, the rules of the game--it can either enhance or diminish productivity. Good institutions are productivity-augmenting, much like technology in a standard neoclassical growth model.

Mr. Fairbank’s reference to Nobel Laureate Douglass C. North under the section "Institutionalize the Change” also needs some clarification. He cites: "Douglass North writes that institutions are norms. Change needs to create new norms of behavior. We look not to creating new institutions but to upgrading existing institutions that have reached their functional limits due to globalization, changes in how prosperity is created, and worldwide shifts in values and attitudes. This means improving the rule of law and building democracy to upgrading schools, private firms, and civic organizations."

From this citation, it can be gleaned that North is referring to institutions as the “rules” of the game. Categorizing it as capital makes it more like a "tool" of the game, which is far from what North describes it to be in his famous treatise on institutions (from his 1991 JEP article, "Institutions"):

"Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights). Throughout history, institutions have been devised by human beings to create order and reduce uncertainty in exchange. Together with the standard constraints of economics they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity... Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline."

Institutions are hardly factors of production used by the economy as they pursue economic growth. Institutions' contribution can be thought of similar to technology's contribution to economic growth--they augment production and expand an economy's production possibility frontier. But institutions cannot be found in either the x-axis or the y-axis.

It can be construed as the framework or environment under which economic players – labor, consumers, and capitalist – interact. Being a framework, economic players cannot individually control institutions as they would any machinery and make tradable goods out of raw resources, much like they would do with capital.

The view that institutions augment the typical neoclassical growth model is hardly new. There are papers, such as Daron Acemoglu, Simon Johnson, and James Robinson's 2001 paper "The Colonial Origins of Comparative Development" where institutions are analyzed within the framework of the neoclassical model. The literature, however, is yet to come up with a comprehensive theory that will capture how institutions contribute to economic growth. Some papers such as Jose Aixala and Gema Fabro's "A Model of Growth Augmented with Institutions" and Edinaldo Tebaldi and Ramesh Mohan's "Institutions-augmented Solow Model and Club Convergence" attempt to do this. But there is still much that needs to be done.

I may take a crack at this frontier.