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The New Institutional Economics: A Useful Concept for Development Practitioners?

Dec. 13th, 2008 | 12:03 pm

There is now widespread accord amongst growth economists that institutional quality holds the key to prevailing patterns of prosperity across the world. Rich countries are those where individuals feel secure about their property rights, fiscal and monetary policies are grounded in solid macroeconomic institutions and the rule of law prevails. Poor countries are those where such arrangements are absent or ill-formed. Simple policy changes are ineffective, the argument now goes, unless they are grounded strongly in institutional reforms. This line of reasoning has largely emerged from the body of work known as the “New Institutional Economics” (NIE) which represents an attempt to incorporate a theory of institutions into economics by modifying and extending neo-classical theory.

Ever since Adam Smith, economists have recognised that the gains from specialisation and trade are key to the wealth of nations. However, it has always been assumed that the process of exchange is costless and hence unproblematic.  In reality, information is rarely complete and is often asymmetrical – transactions therefore have costs associated with finding out what the relevant prices are, of negotiating and of concluding contracts and then of monitoring and enforcing them. This was first noted by Ronald Coase, who argued that the existence of “real world” firms’ actual administrative organisation stems from the fact that they allow for the reduction of information and transaction costs. According to the NIE, institutions that evolve to lower these costs are the key to the performance of economies.

Consider a small local economy that is independent from the wider world. Individuals will either engage in repeat dealings with others or have a great deal of personal knowledge about the characteristics of each other; a dense social network of interaction will develop, which will drastically reduce the costs of exchange. However, in a large-scale complex economy, the network of interdependence widens the impersonal exchange process, and this gives considerable scope for all kinds of opportunistic behaviour (cheating, shirking, moral hazard etc.) and hence the costs of transacting can be high. A highly specialised and globalised economy means that each person relies on a vast network of interconnected parts to provide the multitude of goods and services they need. Dependence creates vulnerability and necessitates the creation of institutions to constrain human behaviour such that incentives to specialise are realised, thereby increasing efficiency.

In Western societies over time, complex institutional structures have been devised to constrain the activity of participants and reduce the uncertainty of social interaction – this has meant that individuals have been more willing to specialise, invest in sunk assets and undertake complex transactions. Examples of such institutions include elaborately defined and effectively enforced property rights, formal contracts and guarantees and bankruptcy law. However, the customs, traditions and norms of society must also be considered as institutions since they shape the beliefs and actions of citizens. The evolution of more complex economic systems (and the benefits they bring) will not occur if the institutional structures do not reduce the uncertainties associated with such systems, since agents will not have confidence in outcomes that are increasingly remote from their personal knowledge.

According to proponents of the NIE, the most developed countries today are those that endowed the state with the power to enforce contracts, protect property rights and assure stability and peace. The resources that are devoted to reducing transaction costs in these countries therefore represent a large proportion of GNP, but the productivity gains associated with greater specialisation are even larger; high rates of growth and development have therefore characterised Western societies. In countries where the government has been too weak to support such institutions, exchange and specialisation – and therefore growth – has been limited. Thus, underdevelopment can be viewed as the result of a lack of institutional development that is compatible with the growth process.

So how useful is the NIE for development practitioners? Well, we can be fairly confident that today South Korea is much richer than North Korea because of the creation of a more growth-enhancing institutional path. Therefore, if we can identify the institutional structures built during previous development experiences, we may be able to create institutions for today’s developing countries. However, it is one thing to describe the characteristics of economic change; it is something else to prescribe the correct medicine to improve the performance of economies. Sadly, merely changing the formal institutions – for example, through World Bank governance reform – is not enough. Unless you can also change the belief systems of the population, successful outcomes will remain elusive since it is the way agents perceive the world that will shape choices. Furthermore, the institutional framework is typically stable in most countries: since the current organisations owe their existence to the current institutional setup, they will attempt to assure the continuation of that institutional structure. Even if the current setup creates negative outcomes, the private benefits that accrue to the government may outweigh the costs of changing it. Thus, the institutional matrix is likely to be path dependent and difficult to change.

However, perhaps the biggest problem with converting the theory of NIE into practise is that we do not know what the specific rules, legislation or institutional design is actually responsible for successful development. To appreciate the significance of this, compare Russia and China. In Russia, an investor has in principle the full protection of a private property rights regime enforced by an independent judiciary. In China, there is no such protection, since private property has not been legally recognised and the court system is certainly not independent. Yet during the 1990s, investors consistently gave China higher marks on the rule of law than they did Russia. The apparent disconnect between the perception of the rules and the actual rules means that effective institutional outcomes do not map into unique institutional designs. What matters is that investors feel safe, regardless of how that safety is achieved. The NIE does not tell us how that safety is attained, only that it matters a lot.

Observing the world around us, it is clear that the central argument of the NIE is correct: in order for countries to become rich, they must develop the institutions necessary to foster greater specialisation and exchange. In this sense, the NIE provides us with a “grand theory” of economic development that is persuasive in explaining many growth experiences. It explains why institutions exist and why they are crucial in the process of economic growth. It also re-establishes the complexity between the choice of state and market and suggests that both can be responsible for economic stagnation. However, it poses more questions than it answers, since it provides us with no specific guidance on how to create the necessary institutional arrangements; as such it is far more useful as a critique of the status quo than as a tool that can be utilised in the field.

Given this conundrum, economists do not yet know enough about the institutional determinants of economic prosperity to prescribe solid policy guidance. However, the good news is that institutional transformation is hardly ever a prerequisite for getting growth going – although the long-run correlation between prosperity and good institutions is undisputed, many growth spurts have been recorded without significant change in institutional arrangements. We therefore need to distinguish between stimulating economic growth and sustaining it. Solid institutions are much more important for the latter than the former – once growth is set into motion, it becomes easier to maintain a virtuous cycle with high growth and institutional transformation feeding on each other. The NIE, by arguing that (a) growth cannot occur without institutional change; and (b) that such change is unlikely to occur in the short run, has resulted in overly pessimistic verdicts on the plight of many LDCs.

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Growth Diagnostics: A Synopsis

Dec. 10th, 2008 | 11:06 am

Ever since the days of Adam Smith, economists have attempted to address the question of what makes some countries rich and others poor. Yet more than two hundred years later, the mystery of economic growth remains. Today, almost half of the world’s population survive on less than $2 a day where even the most basic requirements of living remain elusive. Helping those who live in poor countries achieve the standards of living that people in the developed world currently enjoy has become one the most pressing issues of our time However, given the crucial importance of growth, it is rather tragic that we know so little about how to generate it. This ignorance is reflected by the sheer number of growth strategies that have come and gone over the past century, most of which have led to outcomes far below the expectations of their proponents.

The failure of the developing economies to ‘catch up’ with the advanced economies has been a huge disappointment for those working in the major multinational institutions that have shaped the policy agenda for the past three decades. Perhaps the greatest ‘surprise’ has been the experience of Latin America, where free market reforms have been enthusiastically embraced since the early 1980s. The graph below (click to enlarge) maps an index of economic reform which measures – on a scale of 0 to 1 – the extent of trade liberalisation, financial deregulation, tax reform, privatisation and other key areas of the reform agenda. As we can see, the regional average for this index rises steadily from 0.44 in 1990 to 0.58 in 1999, suggesting that the economic climate for private economic activity across the region has improved substantially since 1990.



However, the rate of growth during the reform period has not been as high as expected. Rather, GDP growth has been far more cyclical and has not reflected the improvements in policy that have taken place. Indeed, only three Latin American countries (Argentina, Chile and Uruguay) performed better in the 1990s than during the period 1950-1980. As a result of these and other failures, it is fair to say that nobody really believes in the Washington Consensus anymore. This inevitably leads to the question of what will replace it and whether it will succeed where the others have failed. One alternative has been proposed by Hausmann, Rodrik and Velasco (HRV) of Harvard University who argue that policy makers should undertake an exercise of growth diagnostics in which analysts attempt to identify the most pressing bottlenecks to economic growth. But what is growth diagnostics exactly?

In most low-income countries almost all aspects of the economy are far from perfect. Presented with a long list of reforms, governments often face pressure to eliminate all existing problems simultaneously. However, not only is this impractical but it is also bad economics, since it has frequently led to inappropriate sequencing of reform and subsequently to negative outcomes, where reform in one area has created unanticipated effects in another. A typical economy will have more than one distortion, hence partial reform designed to alleviate one problem will have to be checked against its effects on other distortions. If policies in one area of the economy exacerbate other existing distortions, reform may end up producing an actual welfare loss – a phenomenon known as ‘second best interactions’. To avoid these problems and achieve more successful outcomes, HRV argue that countries should focus on a small number of areas that represent the main bottleneck to economic growth. Since a full list of required reforms is unknown and understanding all of the second-best interactions that could exist across markets is a near impossible task, it is logical to focus on those reforms whose direct effects are expected to be most significant. Growth diagnostics is a process of identifying the most ‘binding constraint’ to economic growth where reform will yield the greatest return – that area of the economy that can offer ‘the biggest bang for the reform buck’.

A developing country that suffers from low growth is likely to suffer from the problem of low investment and entrepreneurial activity. The diagram below is a taxonomy that maps out the possible explanations for this and following on from the HRV growth model, suggests that it is due either to the high cost of financing investment, or the existence of low returns to investment spending. If the problem is with low private returns, that in turn must be due to either low economic returns or low private appropriability.



The first step of the diagnosis is to identify which of these situations characterise most accurately the economy in question. In an economy that is constrained by the high cost of finance, it seems likely that we would expect to observe a low level of domestic savings, high rates of interest, a current account deficit that is as large as external borrowing constraints allow and an abundance of investment opportunities that cannot be realised. By contrast, in an economy that is constrained by low private returns, interest rates will be much lower, banks will have excess liquidity, the current account will be near balance or even in surplus and local entrepreneurs will tend to invest abroad rather than at home. In this case, the next stage is work whether the low returns to investment are due to low economic/social returns or a lack of private appropriability. If it is the former, we would expect to observe a relative shortage of the complementary factors of production: low levels of human capital, poor infrastructure or other similar factors. To identify whether this is indeed the problem, we must try to find the suitable symptoms – relatively high returns to education would suggest that human capital could represent a serious constraint to growth, whilst bottlenecks and high prices in transport or energy markets would suggest a serious problem with infrastructure.

Appropriability problems can exist under two sets of circumstances. First, it could be due to ‘government failures’ – high levels of taxation, a poor institutional environment that doesn’t protect private property rights, macroeconomic instability, high levels of corruption, and so on. Alternatively, it could be due to ’market failures’ such as co-ordination failures, lack of entrepreneurial rents or too little ‘self discovery’, where the central problem is the inability of an entrepreneur to capture the returns to their new investment, since other entrepreneurs can rapidly imitate such discoveries. The likely symptoms of these problems are the existence of low total factor productivity and an export composition that is heavily dependent on traditional output.

Once the problem has been identified, the second step is to apply an appropriate policy response. The key here is to focus reform on those areas that are identified in the previous step as the key constraints to growth. If the binding constraint is the high cost of finance, an increase in investible funds such as foreign aid should spur on investment, whereas in an economy that suffers from low economic returns, such a policy would simply finance the consumption of luxury goods, encourage capital flight and do little to encourage entrepreneurial activity. In such circumstances, industrial policy may be the suitable solution to combat the problems of co-ordination failure and low productivity. In some cases, the wrong policy response could even lead to an overall welfare loss: institutional reforms designed to improve the business climate (e.g. reduced taxation) would further increase investment demand and put upward pressure on interest rates. This is the nature of the possible second-best interactions that can exist.

So how useful is growth diagnostics? The language of ‘growth diagnostics’ has certainly had a remarkable influence within the multilateral institutions and academic circles considering its relative infancy. For example, the World Bank’s recent assessment of economic reform over the last two decades, Economic Growth in the 1990s: Learning from a Decade of Reform is full of references to ‘binding constraints’ and emphasises the need for greater flexibility in the formation of policy according to individual country circumstances. However, it is important to recognise that the growth diagnostics approach is not a panacea. This is not to say that the approach is wrong or not useful, but merely a caution against the exclusive use of what is a comparatively new and untested approach.

First and foremost, identifying the binding constraint to growth is a difficult task which relies on the ability of the researcher to formulate hypotheses and create a plausible explanation that can be tested empirically. Specifically, it requires the estimation of price and non-price signals, both of which are difficult to measure and may not necessarily reflect the extent of a particular constraint to economic growth. For example, when assessing co-ordination problems as a possible binding constraint to private investment in Tanzania, only 27 percent of enterprises rated the problem of business licensing as a serious obstacle to enterprise growth. However, evidence such as this is likely to be misleading since it is clear that enterprises which are already operating in the marketplace are much less likely to see entry restrictions as the most pressing issue. Indeed, it seems likely that they may welcome more burdensome regulation that limits competition and boosts their profits.

It is also important to note that the underlying model of economic growth employed by HRV is staunchly neo-classical. Consequently, as is common with much of the growth literature, HRV completely ignore the role of demand. This as a serious oversight, since effective demand problems are quite common in developing countries and can operate as a serious constraint to growth. In order to generate the competitiveness required to engage with the global economy, developing countries must exploit economies of scale by building up capacity beyond the needs of its own population. As a result, external demand becomes crucial to the growth performance of the economy, since the domestic market is typically inadequate to absorb all the output that is produced. It is clear that in many developing countries the problem is not a shortage of capital equipment, but a lack of demand that results in the under-utilisation of available resources. A large number of studies have suggested that the growth of trading partners’ economies have an extremely powerful influence on the success or otherwise of the economy in question. In Africa, countries such as Sudan, the Democratic Republic of Congo, Nigeria and Ethiopia will have to grow more rapidly in order to improve the export prospects of a ‘typical’ African country. However, this type of demand-led growth is completely absent in the model of HRV.

This is not to say that the method is of no use. On the contrary, it is an extremely useful way of working out what the most pressing problems in a specific developing country are. Although there is still a lot that needs to be learned on how to carry out the exercise effectively, it does force us to confront policy priorities in a systematic rather than a random manner. As the World Bank has acknowledged, successful countries have been those that have crafted policies tailored to the specific constraints of the economy. However, it is clear that if this were not so difficult, we would have had many more success stories. Growth diagnostics deserves to be employed by the World Bank and other donor agencies as an additional tool for prescribing policy and as a means of avoiding the contradictions of the Washington Consensus. However, the enormous intellectual challenges and practical tasks that are involved in the promotion of economic growth should generate a degree of humility. Given the failures of development policy over the last two decades, it is reassuring that experts have tried to rethink the development agenda by developing new areas of enquiry, such as growth diagnostics. This is most encouraging, but it is at best an incomplete and ongoing process.

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The Failure of Doha: A Disaster for Development?

Aug. 14th, 2008 | 01:22 pm


The collapse of the Doha trade negotiations over the last few weeks has generated an extremely one-sided commentary from the West that has emphasised the 'disastrous' consequences of our failure to negotiate a new agreement on the global trading system. However, given how politicised the debate over free trade has become, it is worth looking into the issues involved with a little more care before we can truly comment on any alleged “disaster”.

The first thing to remember is that this round of trade talks was supposed to be a "development round" that would asymmetrically benefit the developing countries after years of being marginalised in world markets. However, as a recent World Bank projection illustrates (see diagram here), low income African countries would actually have lost out at the expense of more affluent nations. Furthermore, the benefits to the richer countries would have been rather modest. One reason for this outcome is that low-income countries would have lost much of their preferential market access (through trade diversion) to rich countries as the latter lower their tariffs against other countries. However, the issue that has got most attention has been food prices, which have escalated at on unprecedented level over the past few months.

The conventional wisdom amongst the liberal press and orthodox economists is that there has never been a better time to remove distorting agricultural subsidies and open up the markets for food imports from the developing world. However, it stands to reason that removing direct subsidy for agricultural production would actually increase food prices even further! According to the 2008 World Development Report on agriculture, complete trade liberalisation would lead to an increase in the relative prices of cotton by 20.8 per cent, oilseeds by 15.1 per cent, dairy products by 11.9 per cent, wheat by 5 per cent and rice by 4.2 per cent. What is not fully appreciated is that  many of the poorest countries in the world are actually big food importers. Clearly, such a huge spike in the prices of basic food stuffs will hurt those countries that are net importers of food and increase urban poverty.

Unfortunately, the orthodox view that facilitating global trade agreements and encouraging free trade has almost nothing to do with the underlying economic theory or actual outcomes. Instead, an ideologically-driven battle is being fought against any kind of government intervention, both in the developed and developing world. Instead of placing faith in free markets, policy-makers must focus on alleviating the set of structural constraints faced by farmers in the third world in order to generate a strong supply-side response. Between 40 and 60 per cent of agricultural output in Africa is wasted at the farm gate, a damning reflection of the agricultural sector in developing countries. Far more attention should be given to increasing agricultural productivity in sub-Saharan Africa through the adoption of modern technology, improved production techniques and adequate irrigation.

Doha a disaster? What a joke.


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Have the Tories become Keynesian?

Jul. 6th, 2008 | 11:14 am

Hardly a day goes by these days without a newspaper headline shouting at us that the economy is about to implode. The "credit crunch" and the recent increases in the price of basic foods and fuel have led to widespread gloom over the future of the UK economy. 

However, much less ink has been spilt on the apparent reversal of Conservative Party economic policy since the 1980s. For the past few months, the Opposition have been crying that "Brown has not prepared the UK for a rainy day," and that "the time to fix the roof is when the sun's shining." Even the staunchly free-market Adam Smith Institute has criticised Brown on this front, stating that "when the economy hit a rough patch, there was no money in the Treasury to carry us through it." 

A long time ago, Keynes emphasised the inherent instability of the capitalist economy, which is often directed by "market sentiment" as a result of uncertainty caused by what we would today call "information asymmetries". The solution was for government to balance out the business cycle through saving during the boom years and spending during the bust years, thereby offsetting a possible recession and keeping the economy on a stable path. 

However, the Conservative government of the 1980s rejected this system in favour of a more laissez-faire approach in which the state took a far lesser role in directing the economy. The free market, it was argued, had the necessary incentive structures to guarantee stability - government action was not required, and could actually be very damaging. These arguments are still used today, despite the obvious fact that the global economy is highly unstable. What the experience has demonstrated is that the mindset of the 1980s has proven itself to be woefully inadequate in taking account of this reality.

It is therefore very interesting to see the Opposition complaining about the lack of government policy to 'fix' the economic problems that we see today. Are the Tories re-discovering Keynesianism? The comments quoted above are certainly shaped in Keynesian rhetoric, and it is clear that the central message of Keynes has not been forgotten. Evidently, good ideas die hard.

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Gordon Ramsay's war on Africa

May. 10th, 2008 | 07:42 pm

Any of you who have had the misfortune of watching "Gordon Ramsay's Kitchen Nightmares" in the recent past will have realised by now that he is indeed a complete ass. However, the foul-mouthed former footballer has now reached new levels of stupidity and arrogance by suggesting that we ban the imports of foreign fruit and vegetables from some of the poorest countries in the world. Ramsay said:

Chefs should be fined if they haven't got ingredients in season on their menu. I don't want to see asparagus in the middle of December, I don't want to see strawberries from Kenya in the middle of March. I want to see it home grown. There should be stringent laws, fines and licensing laws to make sure produce is only used in season.

I see. So Ramsay is proposing that the UK should ban restaurants from importing out-of-season produce from other countries for no reason other than to maintain our traditions. The fact of the matter is that we import out of season produce precisely because there is a demand for it from the British public, and to simply ban this process would make everyone worse off. Ramsay actually seems to be arguing that the average punter would rather be eating boiled spinach that imported strawberries in the nice May sunshine we've been having recently.

Furthermore, a huge number of developing countries rely on the rich world buying their produce - a Ramsay ban would cause enormous damage to the living standards of some of the poorest people in the world. Rich countries, for good or for bad, have been encouraging poor countries to focus on exporting agricultural produce as a means to become rich - to turn our back on this by enacting a Ramsay ban would therefore be a complete outrage . Far from banning imports, we should encourage people to buy as much produce as possible from the developing world.

Ramsay claims that by proceeding in this way, we can help ease the process of climate change by cutting down on air miles. However, such a tiny reduction in CO2 emissions could never outweigh the devastating effects on third world poverty that would result from a ban. If Ramsay is so obsessed with global warming, maybe he should stop swanning around in big 4X4's on his "Kitchen Nightmares" programme.

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Principles of Economics - Translated

Mar. 27th, 2008 | 02:54 pm

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Book Review

Mar. 25th, 2008 | 04:06 pm

Margaret Thatcher once expressed a desire to "abolish economists", an objective borne out of the frustration of successive economic advisors offering conflicting solutions to the same problems. Indeed, the 1960s and '70s were periods of great debate within the economics profession - Keynesians on one side, emphasising the crucial role of government in organising a successful economy, and the Friedmanites on the other, yearning for the unfettered free market. The ideas of the latter eventually came out on top amongst academic economists, and as a result much of this debate has disappeared. All we are left with is 'monoeconomics', a system of analysis that is judged appropriate for all economies at all times. 

It is refreshing, therefore, to see that Ha-Joon Chang has broken the mould with the release of his new book, 'Bad Samaritans'. Chang documents the disappointing performance of developing economies over the last three decades and attributes them to the bad policies that the rich, industrialised countries have been recommending since the late 1970s. These policies typically involve trade liberalisation, de-regulation, financial liberalisation, privatisation and a whole host of other market reforms that neo-liberal economists believe will spur economic growth. However, the results have been poor - growth has slowed, becoming negative in large parts of Africa, inequality has risen and macroeconomic instability has become rife.

So what has gone wrong? The main reason is that economic theory is largely irrelevant for developmental concerns. For example, the big push towards free trade since the 1980s is based on David Ricardo's theory of comparative advantage, which argues that welfare will be maximised if nations specialise in the goods and services in which they are best at producing. There is no point for the UK to waste resources on producing fine wine if the French can do it twice as well - we should be concentrating on other things, HP sauce for example. We can then trade these goods on the market having maximised output, so the theory goes.

However, while this makes sense for rich countries, surely this is not the case for developing countries? A country that specialises in agricultural products and produces nothing else cannot be said to be engaged in a development process. Development surely must require the construction of new industries and new products in order to create new wealth for that country to share. Under free trade, this is very difficult due to the competition from countries that are already competent in producing more advanced goods, and thus infant industries invariably shut down. Without developing a modern manufacturing sector through the use of moderate protection, growth and hence welfare will not materialise.

This seemingly obvious complaint is lost to economists. If you deny the glories of free trade, you aren't a real economist! Likewise, if you object to 'shock therapy' and mindless privatisation, you are branded a socialist with no concept of economic reality. Yet the evidence is all there to support Chang's thesis: governments still have a crucial role in managing the economy and promoting economic development.

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Mar. 25th, 2008 | 02:41 pm

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Mar. 24th, 2008 | 08:58 pm

Hello all readers, and welcome to this blog! 

The decision to start writing a regular blog on topical issues stems from my dissatisfaction of existing blogs on the subject of economics and development issues. Many are unnecessarily confusing and ideological and, more often than not, the reader ends up more confused than before. This blog will attempt to reverse this trend. 

Economics is often regarded as an esoteric, tedious and increasingly irrelevant subject and to some extent these sentiments are true. However, the central conclusions that result from complex economic modelling greatly influence the policy decisions made by national governments, decisions that impact individuals' lives. At the heart of every news story is an economist: What are the economic implications of increased immigration to the UK? What should poor countries do to attract foreign investment? How have efforts to liberalise trade impacted developing countries? These are important issues, and are often glossed over by economists as 'no brainers' despite doubts amongst the greater public. This blog will attempt to shed some light on some of the most pressing issues concerning the global economy today.

I hope you enjoy reading it.

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